Convertible Notes: An Expanded Example

Introduction:

Let's expand upon the example scenario in our last post to provide a more detailed understanding of how a convertible note works in practice and the potential outcomes for both the startup and the investor.

Expanded Example Scenario:

Let’s consider a startup called TechInnovate Inc. that has developed a cutting-edge technology with strong intellectual property (IP), but it currently lacks a prototype and cash flow. The founders of TechInnovate Inc. need capital to continue their R&D and start developing a minimum viable product (MVP). They decide to raise funds through a convertible note because they believe their valuation will significantly increase after they reach certain milestones.

Convertible Note Terms:

• Principal Amount: $200,000
• Interest Rate: 5% per annum
• Maturity Date: 18 months from the date of issuance
• Conversion Discount: 20%
• Valuation Cap: $5 million
• Conversion Trigger: Next qualified financing round of at least $1 million

Step-by-Step Breakdown:

1. Issuance of Convertible Note:
   • An investor, Jane Doe, decides to invest $200,000 in TechInnovate Inc. by purchasing a convertible note.
   • The note has a maturity date of 18 months and accrues interest at a rate of 5% per annum.
   • Jane is taking a calculated risk because the startup has no revenue or prototype, but she is confident in the strength of the IP and the team’s ability to execute.
2. Accumulation of Interest:
   • Over the 18-month period, the note accrues interest.
   • At a 5% annual interest rate, the interest accrued over 18 months would be approximately $15,000. This brings the total amount owed on the note to $215,000 if it is not converted into equity before maturity.
3. Reaching a Conversion Trigger:
   • After 12 months, TechInnovate Inc. reaches significant R&D milestones and attracts the attention of a venture capital firm, which agrees to lead a Series A financing round.
   • The Series A round is for $3 million, which meets the note’s conversion trigger of a qualified financing round of at least $1 million.
4. Determining the Conversion Price:
   • The Series A round values TechInnovate Inc. at a pre-money valuation of $10 million.
   • Because Jane Doe’s convertible note has a 20% discount, her note would convert at an effective valuation of $8 million (which is 20% less than the $10 million Series A valuation).
   • However, the note also includes a valuation cap of $5 million. Since $5 million is lower than the $8 million effective valuation after applying the discount, the note will convert based on the $5 million valuation cap.
5. Calculating Equity Conversion:
   • With a $3 million Series A round at a $10 million pre-money valuation, the total post-money valuation would be $13 million.
   • Under the $5 million valuation cap, Jane’s $215,000 (principal + interest) converts into equity at the $5 million valuation.
   • Conversion Price per Share: If we assume the company has issued 1 million shares before the Series A, the price per share based on a $5 million valuation cap would be $5.00 per share ($5,000,000 / 1,000,000 shares).
   • Jane’s $215,000 investment would convert into 43,000 shares ($215,000 / $5.00 per share).
6. Comparison to Series A Investors:
   • The new Series A investors invest $3 million at a $10 million pre-money valuation, which equals a share price of $10 per share.
   • If Jane’s note converted without the discount or valuation cap, she would receive 21,500 shares ($215,000 / $10 per share). However, due to the valuation cap of $5 million, Jane ends up with 43,000 shares instead of 21,500 shares, effectively doubling her equity due to the cap.
   • Jane's 43,000 shares would be worth $430,000 post-Series A round. This reflects the increase in her investment’s value due to the favorable conversion terms of the convertible note (valuation cap and discount), providing her a substantial return (115% increase) compared to her initial investment of $200,000.
7. Impact on Ownership and Future Rounds:
   • Jane now holds 43,000 shares in TechInnovate Inc., giving her a more significant stake in the company.
   • As the company grows and seeks additional funding in the future (e.g., Series B), Jane’s equity position could appreciate significantly in value.
   • If the company continues to perform well, Jane stands to gain much more than her initial investment, benefiting from the early risk she took.

Key Takeaways from the Scenario:

• Investor Benefits: Jane Doe benefits from the valuation cap and conversion discount, which protect her from overpaying for her equity in future rounds and reward her for her early investment risk. This structure incentivizes early investment by providing potential for substantial upside.
• Startup Benefits: TechInnovate Inc. benefits from the quick and flexible funding that convertible notes provide. They avoided a potentially contentious and premature valuation negotiation and received the capital needed to reach critical R&D milestones.
• Risks Managed: The convertible note structure aligns the interests of the investors and the startup, facilitating a smoother transition into equity once the startup achieves critical milestones. However, both parties should be aware of the dilution risks and repayment obligations if the note doesn't convert.

Conclusion:

This expanded scenario illustrates how convertible notes can serve as a powerful tool for both startups and investors. Startups can access essential funding without immediate valuation, while investors receive potential upside and protections for their early-stage risk.

Questions for Reflection:

• Are you considering the right valuation cap and discount rate to attract early investors while preserving your equity?
• How will you position your startup milestones to trigger favorable conversion terms?
• Have you factored in the impact of potential dilution and future funding complexities?