It is increasingly common for businesses to raise funds by issuing convertible notes. So how does it work?
What is a convertible note?
A convertible note is a debt instrument that converts into equity. Before the conversion takes place, the convertible note is a debt of the company, which means it has a due date on which the debt has to be repaid, called the "maturity date". Interest will accrue during the period that the debt is outstanding.
A convertible note entitles its holder to convert the money paid for the notes into equity of the company at a discounted price. After the conversion, the holder of the convertible notes will become a shareholder of the company.
There are numerous ways of structuring a convertible note. This article discusses the mechanisms of the convertible note that you can create on our platform.
How does conversion take place?
Upon the company successfully raising funds exceeding a certain amount, called a "qualified financing", the investor will be entitled to convert the principal amount of the convertible note together with the interests accrued into equity of the company at a discounted price. The type of equity will be the same class of shares that the investors at the qualified financing will get.
At the qualified financing, the conversion price for the investor will be the lower of:
(a) price per share at the qualified financing at a discount (see below); or
(b) the valuation cap price, meaning the valuation cap (see below) divided by the number of issued shares at the time of qualified financing.
The size of a qualified financing is a matter of negotiation. It represents an amount that is sufficiently high for the investor to give up the debt instrument for equity in a sustainable business, but not so high as to risk failure to achieve.
What is the valuation cap?
The valuation cap must be understood as a "cap" and not as "valuation". The valuation cap is not a real valuation, which is often not possible at such an early stage of the business. The valuation cap merely operates to limit the highest price at which the conversion will take place.
In determining the size of the qualified financing and the valuation cap, you should consider the combined effect on the ownership position of the investor following conversion.
It is a very important feature of the convertible note that there can be different valuation caps for different convertible note investors.
What if a qualified financing does not happen before maturity date?
If a qualified financing does not happen but there is a "liquidity event", that is either the company has been sold to new owners (called a "change of control") or its shares get listed on a stock exchange, the convertible note will be converted into ordinary shares of the company at the price that is the lower of:
(a) price per share at the liquidity event at a discount; or
(b) the valuation cap price.
If there is no qualified financing or liquidity event by the maturity date, the convertible note will be converted into ordinary shares of the company at the price that is the lower of:
(a) price per share at the most recent fundraising event at a discount; or
(b) the valuation cap price.
What should the discount be?
The size of the discount is again a matter of negotiation. For startups, the discount typically ranges between 15% to 25%.
You should note that the discounted price only comes into play when it is lower than the valuation cap price. The lower that the valuation cap is set, the less likely will the discounted price be applicable.
For example, an investor subscribed for a convertible note in the principal amount of USD1 million issued by a company at a valuation cap of USD5 million and 20% discount. Assuming that the company achieves a Series A funding of USD 30 million at the issue price of USD1 per share, and the pre-money capitalisation of the company was USD10 million.
The discount price would be USD 0.8 per share, while the valuation cap price would be USD 0.5 per share. Thus the valuation cap price would apply, and the investor would receive 2 million shares.
What is pro-rata right?
"Pro-rata right" is the right for the investor to participate in the qualified financing, by buying additional equity with additional cash upon the terms of the qualified financing, up to an amount that when taken together with the equity converted from the convertible notes, will result in the investor maintaining the same percentage of ownership in the company.
Using the example above, the investor would receive 2 million shares which was very significant in a USD10 million company (20%), but this stake is substantially reduced post-money to merely 5% interest.
If the investor exercises the pro-rata right, he will have the right to buy additional equity at the qualified financing round, up to the amount that maintains his ownership at 20%.
Pro-rata right is a very important right for seed investors. You should note however granting such right to the investor will reduce the flexibility that the company has in subsequent rounds of financing, and could end up resulting in the founders having to give away their own stake in order to feed all investors.
Step 1: During the negotiation stage
A term sheet is a non-binding record of the major terms discussed between the company and the investor. You may create a term sheet for convertible note to facilitate discussion but it is not absolutely necessary.
You may consider entering into a Confidentiality Agreement during the negotiation process to protect the confidential information of your company.
Step 2: Create a convertible note
There are two ways to create a convertible note on our platform:
A. Create a Convertible Note Subscription Agreement, to be signed by the company and the investor. The benefit of using this approach is that only one document is involved.
B. Create a Convertible Note Instrument, to be executed as a deed. Then each investor will issue a Convertible Note Subscription Letter to the company, which only sets out the principal amount subscribed. The benefit of using this approach is that once the Instrument is created, notes can be subscribed by multiple investors at multiple times using a short and simple document.
Step 3: Shareholders' approval
Issue of a convertible note requires approval by the shareholders of the company. You should prepare (or instruct your company secretary to prepare) the relevant minutes for the shareholders meeting at which the creation and issue of convertible notes are approved or written resolutions of the shareholders approving the same.
Step 4: Issue convertible note
Upon the investor paying the principal amount to the company, the company must issue a Convertible Note Certificate to the investor. This certificate needs to be executed as a deed.