Convertible Notes: What Founders Need to Know

1
SEEDCHANGE
#ConvertibleNotes

About Your Hosts
Kevin Smith
Founder and CEO
Gadiel Morantes
Partner
SEEDCHANGE

What’s a convertible note
(and why should you care)?
3www.seedchange.com www.earlygrowthfinancialservices.com
• Historically used for bridge
rounds
• Now standard for early stage
funding (unless you’re in
ROW)
• When to use convertible
notes:
– Seed
– Bridge
– Supplement

Startup funding cycle

Looks like a fish, flies like a bird. . . .
5
• Debt / equity hybrid
• Technically debt (interest and terms)
• Behaves (mostly) like stock: will convert when
the company does a sizeable equity
investment round
www.seedchange.com www.earlygrowthfinancialservices.com
IOU

The FAB of convertible notes—
Features
6
• Short agreement
• Simple
• Flexible
• No company valuation
• (Largely) standardized terms

Advantages of convertible notes
7
• Short  Quick close(s)
• Simple  Low legal fees
• Flexible  Close any time
• No valuation  No negotiation
• Standard terms  No negotiation

Benefits of convertible notes
8
• Short  Quick close(s)  Save time
• Simple  Low legal fees  Save $
• Flexible  Close any time  JIT funding
• No valuation  No negotiation  Save $/time
• Standard terms  No negotiation Save $/time

How it works: a 1-page manual
9
• Decide amount of round and minimum investment
• Provide note terms to (accredited) investor
• Agree terms
• Sign and date
– the note purchase agreement (company and investor) and
– the note (company)
• Exchange executed note purchase agreement and
note for check/wire
• Add noteholder to cap table (debt page)
Convertible note is classified as debt
until it converts to equity

All the terms that matter
• Interest rate
• Note term (Maturity date)
• Discount
• Note cap

Interest rate
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• All convertible notes include interest rate: IRS says so
• Methods for determining the interest rate:
– Round number: 5%
– Tied to accepted standard: LIBOR
• Interest is paid in shares, not cash
• Interest begins to accrue on the date the note is signed
• Interest is paid when the note converts to stock
Use 5%

Term (Maturity date)
12
• Date of conversion/repayment
• Typically converts after 12 or 18 months
• On maturity
• Convert or repay
• If neither, talk to your investors about amending
the note purchase agreement
Use term = 18 months

Discount
13
• Discount on share purchase at time of
conversion to stock
• Compensates early investors for greater
risk
• 20% is standard
• Recent trend in Silicon Valley toward
15%, 10%, 0% discount
Use 20%

Convertible note cap
14
• Dilution protection, not company valuation
• Allows conversion to stock at a ratio
guaranteed not to fall below $_____
• Aligns incentives between investors and
founders
• Investor chooses to convert using either note
cap or discount – not both
Median note cap = more or less approx.
something like $4.5 million

Conversion example #1
Assumptions:
Note converts after equity investment of $1.5m.
Excludes 5% interest paid to noteholders in the form of shares issued at the time of conversion.
Assumes no post-money option pool (the last worksheet adds an option pool to this scenario)
Company (pre-funding): DISCOUNT CAP
Shares outstanding* 8,500,000 Series A at conversion Series A at conversion
Effective valuation $3,781,250 Effective valuation $3,925,000
Convertible note terms: Share price $0.44 Share price $0.46
Note Size $575,000 No. of shares 3,371,901 No. of shares 3,248,408
Note Cap $4,500,000 Equity 25.00% Equity 25.00%
Note Discount 20%
Note Holder at conversion Note Holder at conversion
Series A terms: Share price $0.36 Share price $0.46
Series A investment $1,500,000 No. of shares 1,615,702 No. of shares 1,245,223
Series A valuation $4,500,000 Equity 11.98% <----- Equity 9.58%
Return 1.25x Return 1.00x
Note holder converts via DISCOUNT -----> CONCLUSION
At this Series A valuation, the note converts
using the DISCOUNT, creating 2.4% more
equity for the note holder compared to a
CAP. The note holder's return on the Series A
is 1.25x.
Cap Table (Ownership) shares %
Team 8,500,000 63.02%
*Shares issued to founders and
employees
Series A 3,371,901 25.00%
Note holder 1,615,702 11.98%
13,487,603 100.00%

Conversion example #2
Assumptions:
Note converts after equity investment of $1.5m.
Excludes 5% interest paid to noteholders in the form of shares issued at the time of conversion.
Assumes no post-money option pool
Company (pre-funding): DISCOUNT CAP
Shares outstanding* 8,500,000 Series A at conversion Series A at conversion
Effective valuation $12,781,250 Effective valuation $11,775,000
Convertible note terms: Share price $1.50 Share price $1.39
Note Size $575,000 No. of shares 997,555 No. of shares 1,082,803
Note Cap $4,500,000 Equity 10.00% Equity 10.00%
Note Discount 20%
Note Holder at conversion Note Holder at conversion
Series A terms: Share price $1.20 Share price $0.46
Series A investment $1,500,000 No. of shares 477,995 No. of shares 1,245,223
Series A valuation $13,500,000 Equity 4.79% -----> Equity 11.50%
Return 1.25x Return 3.00x
Note holder converts via CAP -----> CONCLUSION
At this Series A valuation, the note converts
using the CAP, creating 6.71% more equity
for the note holder compared to a
DISCOUNT. The note holder's return on the
Series A is 3x.
Cap Table (Ownership) shares %
Team 8,500,000 78.50%
*Shares issued to founders and
employees
Series A 1,082,803 10.00%
Note holder 1,245,223 11.50%
10,828,025 100.00%

The down sides of convertible notes
(and an alternative)
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• It’s still debt—and investors really want equity
• Debt incurs interest—and investors really don’t
care
• Debt has to be repaid---but what if you can’t?
Why not create something that looks and acts
more like stock?
Someone did: SAFE (Simple Agreement for Future Equity)

Q&A and Thank You!
Kevin Smith
415 Jackson Street
San Francisco, CA 94111
www.seedchange.com
info@seedchange.com
1.877.711.9883
@seedchange
Gadiel Morantes
www.earlygrowthfinancialservices.com
contact@earlygrowthfinancialservices.com
415.234.3437
@EarlyGrowthFS
SEEDCHANGE

Convertible Notes: What Founders Need to Know

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