Written December 1, 2016
Convertible debt is a type of security frequently issued by startups when raising capital in their seed round. The debt converts to equity at the Series A round, where the seed investors receive equity at a discounted rate.
With convertible debt, the startup issues the seed investor a promissory note, for the investment amount, that contains a conversion feature. The conversion feature is the mechanism by which the debt (the promissory note) will convert to equity (new shares for the investor) upon various future events.
Most (if not all) convertible promissory notes contain an automatic conversion clause that dictates the automatic conversion of the convertible debt upon a “qualified financing.” The qualified financing is typically defined as an equity financing by the startup, in which $1,000,000 is raised. (The exact amount can vary by deal, but it's typically 1 million.) Thus, the qualified financing event is the trigger by which the convertible debt will automatically convert to equity. The conversion is considered automatic because it does not require the vote of either the startup or the investor.
The convertible debt held by the investor will convert to qualified securities in the Series A round. The amount of shares of the qualified securities issued to the convertible debt investor is dependent on the conversion discount per the terms of the convertible promissory note.
Because investors at the seed round are making a riskier investment, convertible promissory notes have a conversion discount feature by which the convertible debt holder will exchange the debt for qualified securities at a price per share equal to 80% (this amount can also vary per deal) of the price per share paid by the qualified financing investors (the Series A investors).
Angel invests $100,000 in Startup.
Startup issues Angel a convertible promissory note for $100,000. The convertible promissory note has an automatic conversion feature at $1,000,000 with a conversion discount equal to 20%. Startup closes $1,000,000 Series A Preferred Stock round by a VC at a Series A Preferred Stock price of $1.00 per share. Since the Automatic Conversion feature in Angel’s convertible promissory note is triggered by the Series A round, Angel’s convertible debt will be converted to Series A shares at a per share price of $0.80. Startup issues Angel 125,000 shares ($100,000/$0.80 per share) of its Series A Preferred Stock. The convertible promissory note is canceled.
Alternatively, convertible notes offer the seed investor a “price cap” which is the maximum valuation that their investment will convert into shares.
For example, if a price cap is set at $5,000,000, no matter how high the startup's valuation grows between the time of investment and qualified financing, the money invested will convert into shares at no higher than a $5,00,000 valuation. This often results in a savings of more than 20% for the original investors.
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