Standard Convertible Note Terms: Everything You Need to Know
Standard convertible note terms are parameters for a specific form of short-term business debt.3 min read
2. Advantages of Standard Convertible Note Terms
3. Conversion Calculation Methods
Standard convertible note terms are parameters for a specific form of short-term business debt. A convertible note will convert into equity at a future date, meaning that the investor loans money to an entrepreneur and receives equity in the company rather than payments on the principal plus interest.
What are Convertible Notes?
Convertible notes offer a major advantage because they don't force the investors or issuer to determine a company's value. In fact, the company may only be an idea or in its earliest stages of development when an investor chooses to jump onboard.
So-called seed stage investments are often structured as convertible loans or straight equity. These are investment deals ranging from about $100,000 to $1.3 million. With straight equity, a business issues investor stock shares and designates them as “Series Seed,” making sure to include enhanced rights. If an investor prefers, they can invest in a convertible note where the security isn't issued until the next round of financing.
By nature, standard convertible notes have added investment risks specifically related to a company's preliminary stages. Because of this fact, the notes may contain extra clauses such as caps and discounts.
Here are a few parameters and convertible note terms to be aware of:
- Class security: Will the note be converted into ordinary or preferred stock?
- Conversion triggers: Convertible notes are meant to be converted in the future, so you must consider the expiration of maturity date at which point the note-holder must convert the outstanding loan amount, ask for the money back, or have the company extend the maturity date.
- Note interest: A convertible note is a form of debt, so it accumulates interest over a set time; this interest rate is typically 4 to 8 percent, and it is converted during the next financing round.
- Security: Is the convertible note secure and, if so, are the company's assets being used as collateral?
- Warrants: This is another form of investment incentive which enables the investor to purchase extra shares.
- Valuation cap: This places a maximum price that the loan will convert into equity, which rewards seed investors for the excess risk they're willing to take on.
- Discount rate: This calculates how much is owed in compensation for the extra investment risk.
- Next equity financing: The next round of financing for the convertible note; in most cases, conversion is automatic.
- No next financing: This occurs when conversion is allowed by raising next equity financing fails.
Essentially, standard convertible note terms protect both businesses and investors, providing a quick, inexpensive, simple means of raising funds.
Advantages of Standard Convertible Note Terms
Seed investors will often negotiate a discount in the next equity round for their price per share, which rewards early investors. Having a conversion discount term attached to the standard convertible note can help attract seed investors from the earliest stage. These discounts vary, ranging anywhere from 10 to 74 percent.
One of the biggest advantages of standard convertible notes is the conversion cap. Conversion caps allow parties to put off negotiations until the next round of financing. While some risk exists for the seed investor, namely that the valuation is often much higher and more expensive for the investor, the discount can offer certain protections against inflation.
For example, let's say a company has a $1 million convertible loan without a discount or cap. It goes on to raise $5 million at a pre-money valuation of $20 million. This scenario results in a per-price share of $1. That note would convert into one-million shares divided by $1 per share. However, if the convertible note had a $5 million cap, the shares would convert at a $0.50 per-share rate instead of $1 per share.
Conversion Calculation Methods
Calculating standard convertible notes typically involves one of three methods:
- Pre-money method
- Fixed percentage method
- Dollars invested method
The pre-money method is set at $8 million and is best for founders because they end up with 60 percent. Founders don't benefit as much from the fixed percentage method, which is also referred to as the post-money method. With the fixed percentage method, founders end up with 55.7 percent. To achieve balance, some investors and business owners opt for the dollars invested method, but it doesn't hold the obvious benefits to either party.
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