13. The Convertible Note (Bill Payne)

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Bill Payne joins Nick on The Full Ratchet to discuss the Convertible Note including:

  • What is a Convertible Note?Bill Payne The Convertible Note
  • What are it’s key elements and terms that are often negotiated?
  • When did convertibles first begin to be used and why?
  • Can you explain how the cap, discount and interest rate work?
  • Can you highlight the often cited positives of convertibles and why some investors prefer them?
  • There are scenarios when they may be appropriate for angels… what are those?
  • What happens if an angel invests via a convertible, the startup is very successful & profitable and never does another fundraising round or has a qualifying event?
  • If we assume that the situation is appropriate for a convertible and an investor is negotiating the provisions of the note… what key terms and elements would you suggest to include and/or pay particular attention to?

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Key Takeaways:


The Major Elements of a Convertible Note:  There are a large number of provisions that can be included in a convertible note.  Not as many as a term sheet, but still a number of items.  Some are very boiler-plate in nature and some are more significant in a negotiation.  Let’s walk-through the six major elements of a convertible that were covered today.

Discount:  For taking on more risk than later investors, the early-stage investors will often get a discount.  The discount is a percentage that will be applied to the equity valuation at the subsequent fundraise.  So, assuming there is no cap, if an early-stage investor enters a convertible note agreement with a 20% discount and the later, Series A fundraise, comes in at a valuation of $5M, that earlier investor gets his equity at a $4M valuation (20% or a $1M reduction on the $5M).  This has been covered a few times before, namely, on our Valuation episode with Jeffrey Carter… but bear in mind the investor wants to be at a lower valuation b/c then his/her dollars invested comprise a higher percentage of the valuation, so he is awarded more equity.

 Interest Rate:  A Convertible Note will often include an interest rate that is capitalized, usually annually, into the note’s principle.  While most investors put less focus here because, ideally, convertibles should be short-term, they can have material impact if the percentage is high and the time-to-close of the Series A is long.  For example, a high interest rate around 15% that takes two years to trigger could, in theory, provide the early investor with 30%+ more of investable dollars at the time of conversion.  But, you’ll find that most investors focus on getting their value through the cap and the discount.  On top of the questionable timing before a triggering, the interest on a convertible is also taxed, which makes the investor benefit more efficient to structure through the other terms.

Cap:  The cap is a critical term that some entrepreneurs will fail to include and most savvy angel investors will pass on an investement in the absence of a cap.  As Bill explained, this is a proxy for the valuation and represents the maximum valuation that the early investors will receive for their money.  So, disregarding the discount, if a Series A has the fortunate valuation of $8M and there is a cap at $3M, the early investors get their equity at three. 

Triggers:  So Bill, also mentioned that there can be multiple events that can cause this debt instrument to be converted into equity.  The two most common of which are a subsequent fundraise (typically with a stipulated minimum), or a certain time period that, once elapsed, causes the trigger.  There can also be a milestone of Revenue or Earnings, for the startup that, if achieved, will cause the trigger to equity.  Most companies raising convertible notes will not be be ready for sale to a strategic and while Bill did not favor an acquisition or change-of-control as a trigger, it often does function as a trigger and, as he stated, can be very bad for the investor, but it really depends on the terms.  I’ve seen convertible notes that include a 2x or 3x liquidation preference.  Remember that a convertible is often riskier and at a worse valuation than a priced-round, so the other terms, like liquidation, may be higher.  I’ve also seen examples that have a contingent discount that escalates upon change-of-control.  So maybe it’s a note with a 25% discount and a $3M cap with a contingency to double the discount in the event of a change-of-control.  If the startup was purchased for $3M during the notes term, the investors can convert immediately prior to the event and, in this case, would take a 50% discount on the valuation.  So their money gets in at $1.5M and is immediately doubled upon the transaction.

Timing:  Recall that if no fundraise trigger occurs, then the convertible is paid back, with interest, at maturity.  There are also cases where an agreement will be struck between startups and investors to convert the debt to equity, at maturity, with a valuation lower than the cap.  Typically, if a startup is unable to raise a subsequent round, they may also not be able to service the debt, so it’s better that they avoid paying it down and have it converted to equity.  Bill also covered the nature of contingent discounts.  For example an investor may strike a deal for a convertible note at a discount of 10% that increases by 10% for every six months that elapse between the origin date and the trigger.  So, if the convertible is being used as a bridge to a large Series A Round and the entrepreneur projects high-confidence that it will be closed in 6 months to a year, then an investor may agree to the funding but with these escalating contingencies if the startup fails to follow-through on their fundraise timing.  If you listened to last week’s episode with Glenn Gottfried, you probably have a sense for the contingent nature of terms.  Although, I took time to describe greater discounts being granted for an investor that gets their money in first.  Today, Bill highlighted contingent discounts that escalate with an onus on the startup and their ability to reach a fundraise milestone.  He also described the ability to use warrants, in lieu of rolling discounts 

Other:  There are a number of other terms that should be included in a convertible note, maybe less critical than the above, but I’ll mention them briefly.  First you can establish a ranking for the level of debt and, of course, if it’s secured or unsecured.  If there are other debt holders or may be more debt holders in the future, your ranking  (senior, junior, subordinated) will establish you position in the stack.  Goes without saying that it is best for the investor to be senior, where possible.  And on the security-side, most convertible notes will be secured against valuable assets.  We discussed today both IP and large hardware assets that may secure the debt. And recall that when a conversion event takes place, the lower of the discount or the cap will apply for the investor.  Here are two examples that show when the cap would apply and when the discount would apply.

Example 1
  • Convertible with a Cap of $3M and a Discount of 20%
  • Subsequent fundraise @ a $3.5M pre-money valuation
  • The Cap valuation is $3M
  • The Discount valuation would be $2.8M ($3.5M – $0.7M…  20% of $3.5M)
  • So the Discount applies and the early investors will “Convert” to equity at a $2.8M Valuation

Example 2

  • Convertible with a Cap of $3M and a Discount of 20%
  • Subsequent fundraise @ a $7M pre-money valuation
  • The Cap valuation is $3M
  • The Discount valuation would be $5.6M ($7M – $1.4M…  20% of $7M)
  • So the Cap applies and the early investors will “Convert” to equity at a $3M Valuation
The third point is on Bill’s point about not investing in service businesses.  If you’ve followed startup investing, you’re probably aware that SaaS or Software as a Service companies have been a hot category for startup investors.  And this is because they have the ability to scale in a way that the traditional service model or a service agency can not.  Maybe down the road we can devote an episode to SaaS and what the key success drivers are for businesses with this model.  But, keep Bill’s advice in mind, if you’ve come across businesses that are utilizing a difficult-to-scale service or easily replicated model where the service is not SaaS.


Tip of the Week:  Beware the Convertible



  • Gijs C.

    Thanks a lot for this great episode, it’s been very helpful for me working in venture capital. I was wondering what your opinion is on priced Convertible Debt for seed stage companies? Would you consider this founder unfriendly?

    • Hi Gijs! Glad you enjoyed the episode. When you say priced Convertible Debt, do you mean a convertible with a cap? If so, this is the standard in the industry. I do not know many investors that will invest in a Convertible without a cap nor startups that raise a convertible without a cap. The issue with no cap is that investors are taking a significantly higher amount of risk at the seed stage vs. the series A, yet the reward is only a small discount on the Series A valuation. With no cap, risk far outweighs reward.

      • Gijs C.

        Hi Nick, with priced convertible debt I mean actually priced,
        as in you agree beforehand to have the option to convert the debt at eg.15% for 300k after 16 months. What would be your opinion on this sort of Convertible debt?

        • Got it. So, there is often a time component for any convertible, where if the startup has not raised a subsequent round by the date agreed upon, then the investor may either:
          a) Request the money back + interest
          b) Auto-convert the note into equity at a “set price”

          The “set price” is often equal to the cap, but doesn’t have to be. You could set it up like:

          Convertible Note w/ 20% discount
          Cap of $3M
          Time to maturity: 18 months
          Conversion price at maturity: $1M

          So, if no conversion trigger occurs prior to maturity date, then the investor can choose to recoup investment + interest or Convert to equity @ $1M. As long as you consult your lawyer and define terms explicitly in the Note, this is fairly normal.

          Reaching the maturity date, having not had a trigger, often only happens in two situations:
          1) The startup is doing great, has plenty of cash and doesn’t need to raise capital or
          2) The startup has not done well and is unable to raise capital

          For #1, the startup will happily pay back the principal + interest. For #2 the startup can’t pay back the note, so it must be converted to equity. So it’s not only advantageous for the startup, but necessary. The only thing that would make this unfriendly is if the conversion price at maturity is set abnormally low.

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  • John Pemberton

    Great episode. Definitely some nuggets in this discussion with Mr. Payne. Can’t wait to hit Epi 15. JP