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Convertible Note Seed Financings: Econ 101 for Founders

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Editor’s note: Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, a boutique corporate law firm specializing in the representation of entrepreneurs. Check out his blog or follow him on Twitter as @ScottEdWalker.

This is the second part of a three-part primer on convertible note seed financings. Part 1, entitled “Everything You Ever Wanted To Know About Convertible Note Seed Financings (But Were Afraid To Ask),” addressed certain basic questions, such as (i) what is a convertible note? (ii) why are convertible notes issued instead of shares of common or preferred stock? and (iii) what are the advantages of issuing convertible notes?

This part will address the economics of a convertible note seed financing and the three key economic terms: (i) the conversion discount, (ii) the conversion valuation cap and (iii) the interest rate.

Part 3 will cover certain special issues, such as (i) what happens if the startup is acquired prior to the note’s conversion to equity? and (ii) what happens if the maturity date is reached prior to the note’s conversion to equity?

What Is a Conversion Discount?

As discussed in part 1, in the context of a seed financing, a convertible note is a loan that typically automatically converts into shares of preferred stock upon the closing of a Series A round of financing. A conversion discount (or “discount”) is a mechanism to reward the noteholders for their investment risk by granting to them the right to convert the amount of the loan, plus interest, at a reduced price (in percentage terms) to the purchase price paid by the Series A investors.

In other words, the founders are saying to the investors, in effect, if you take this risk and give us money today, we’ll reward you by giving you “20% off” at our Series A round down the road (20% being the usual discount, as discussed below). For example, if the investors in a $500,000 convertible note seed financing were granted a discount of 20%, and the price per share of the Series A Preferred Stock were $1.00, the noteholders would convert the loan at an effective price (referred to as the “conversion price”) of $0.80 per share and thus receive 625,000 shares ($500,000 divided by $0.80). That’s 125,000 shares more than a Series A investor would receive for its $500,000 investment and a 1.25x return on paper ($625,000 divided by $500,000). (The foregoing example does not include accrued interest on the loan, which is typically about 5%-7% annually, as discussed below.)

Discounts generally range from 10% (on the low side) to 35% (on the high side), with the most common being 20%.  In Fenwick & West’s 2011 Seed Financing Survey (the “Fenwick Survey”), the percentage of convertible note seed financings that granted a discount to investors was 67% in 2010 and 83% in 2011; and the median discount was 20% in both 2010 and 2011.

One of the significant advantages of issuing convertible notes, as opposed to shares of preferred stock, is the extraordinary flexibility they offer in connection with “herding” prospective investors and raising the round. Clearly, a greater discount can be offered to early investors who are assuming more risk, particularly where the startup is closing its financing on a rolling basis over an extended period of time (as is the trend).

Moreover, a note can include a discount that increases over time – e.g., (i) 1.5% per month up to 25%; or (ii) 10% if the Series A round closes within 6 months, 15% if it closes between 6 and 12 months, and 20% if it closes after 12 months. In the Fenwick Survey, the percentage of convertible note seed financings that included a discount which increased over time was 25% in 2010 and 5% in 2011.

Finally, founders should be aware that investors will sometimes push for the issuance of warrants in lieu of a discount. In a seed round, this makes no sense and only creates more paperwork and, accordingly, higher legal fees. In the Fenwick Survey, the percentage of convertible note seed financings that included the issuance of warrants was 0% in both 2010 and 2011.

What is a Conversion Valuation Cap?

A conversion valuation cap (or “cap”) is another mechanism to reward the noteholders for their investment risk (and for their efforts in increasing the value of the startup as a result of introductions, advice, etc.). Specifically, a cap is a ceiling on the value of the startup (i.e., a maximum dollar amount) for purposes of determining the conversion price of the note — which (like a discount) thereby permits investors to convert their loan, plus interest, at a lower price than the purchase price paid by the Series A investors.

Using the example above, let’s assume the cap were $5 million and the pre-money valuation in the Series A round were $10 million. If the noteholders invested $500,000 and the price per share of the Series A Preferred Stock were $1.00, the noteholders would convert the loan at an effective price of $0.50 per share ($5,000,000 divided by $10,000,000) and thus receive 1,000,000 shares ($500,000 divided by $0.50), which is 500,000 shares more than a Series A investor would receive for its $500,000 investment and a 2x return on paper ($1,000,000 divided by $500,000), not including any accrued interest on the loan. Notice that if there were a 20% discount and no cap, the noteholders would only receive 625,000 shares or a 1.25x return, as noted above.

If we bump-up the pre-money valuation to $20 million and the cap remains at $5 million, you can see how the noteholders are rewarded (and protected): Their $500,000 loan now converts at an effective price of $0.25 per share ($5,000,000 divided by $20,000,000) and they would thus receive 2,000,000 shares ($500,000 divided by $0.25), which is 1,500,000 shares more than a Series A investor would receive for its $500,000 investment and a 4x return on paper ($2,000,000 divided by $500,000), not including any accrued interest on the loan. Again, if there were a 20% discount and no cap, the noteholders would only receive 625,000 shares or a 1.25x return.

As you can see, noteholders with a 20% discount and no cap would receive 625,000 shares whether the pre-money valuation in the Series A round were $10 million, $20 million or $50 million.  This is why sophisticated investors vehemently argue that a note without a cap (i) misaligns the interests of the founders and the investors; and (ii) penalizes investors for their efforts in helping the startup increase its value. The math can be tricky, but the bottom line is that noteholders without a cap do not share in any increase in the value of the startup prior to the Series A round.

Accordingly, as discussed in detail in part 1, a cap is akin to a valuation in a priced round (i.e., if the startup were issuing shares of common or preferred stock); however, the beauty of a cap is that it is not a valuation for tax purposes — which facilitates the financing by allowing the founders to grant different caps to different investors.

In the Fenwick Survey, the percentage of convertible note seed financings that included a cap was 83% in 2010 and 82% in 2011; and the median valuation cap was $4 million in 2010 and $7.5 million in 2011.

How Do the Discount and the Cap Interrelate?

If the convertible note includes both a discount and a cap, the applicable language will typically provide that the conversion price will be the lower of (i) the price per share determined by applying the discount to the Series A price per share; and (ii) the price per share determined by dividing the cap by the Series A pre-money valuation. As reflected in the examples above, the reason the conversion price is the “lower of” (not the “higher of”) is because the lower the conversion price, the more shares the noteholders are issued upon conversion.

In the first example above where the discount was 20%, the cap was $5 million and the pre-money valuation was $10 million, we saw that the conversion price was (i) $.80 when we applied the discount to the Series A price and (ii) $.50 when we divided the cap by the pre-money valuation.  Accordingly, the conversion price would be $.50 (the lower of) for purposes of computing the number of shares issued to the noteholders upon conversion.

Now watch what happens if we drop the pre-money valuation to $6 million: Applying the discount, the conversion price, of course, stays the same at $.80; but when we divide $5 million (the cap) by $6 million (the pre-money valuation), we get $.83, which is obviously higher than $.80 — and thus the discount applies, not the cap. This is a bit counter-intuitive because the pre-money valuation exceeds the cap by $1 million. Notice, however, that unless the pre-money valuation were greater than $6,250,000, the cap would not be triggered ($5,000,000 divided by $6,250,000 equals $.80).

If this weren’t confusing enough, there is one other complex issue that founders need to be aware of with respect to discounts and caps: the additional liquidation preference that is created. Indeed, this is a particular problem, and could result in a substantial windfall to investors, in a large convertible note financing with a low conversion price.

For example, in a $2 million convertible note financing with a 50% discount (or a 50% conversion cap ratio), the noteholders would receive $4 million worth of shares of Series A Preferred Stock upon conversion (not including accrued interest), which would include whatever liquidation preference is attached to the shares (typically 1x). Accordingly, the noteholders would receive an extra $2 million of liquidation preference.

There are several different approaches to solving this issue, the most elegant of which is to convert the notes into a different series of preferred stock (e.g., Series A-1), with a liquidation preference per share equal to the conversion price; however, for purposes of this post, it’s enough for founders simply to be aware of this issue and how it relates to discounts and caps.

What is the Typical Interest Rate and How Do the Investors Get Paid?

The third and final piece of the economics puzzle is the interest rate component. Again, a convertible note is a loan and typically requires the startup to pay simple (not compounded) interest on the amount of the loan. Interest rates on convertible notes have historically been in the range of 7%-10% annually, but recently have dropped to the 5%-7% range. In the Fenwick Survey, the median annual interest rate in convertible note seed financings was 6% in 2010 and 5.5% in 2011.

As alluded to in the examples above, the interest is not paid in cash on a periodic basis like a typical loan, but instead accrues (or accumulates), and then the total amount of interest due is added to the loan amount and converted into shares of preferred stock upon the closing of the Series A round. For example, if the interest rate were 5% in a $500,000 convertible note seed financing and the Series A closing occurred on the one-year anniversary of the convertible note closing, the investors would convert an additional $25,000 ($500,000 x .05).

Each state has its own laws (called “usury” laws) that limit the maximum interest rate that may be charged on a loan. In California, for example, unless an exemption applies, the maximum annual interest rate for a non-consumer loan is the higher of (i) 10% or (ii) 5%, plus the rate charged by the Federal Reserve Bank of San Francisco on advances to member banks on the 25th day of the month prior to the date of the loan (or, if earlier, the date of the written loan commitment).

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