Let's say you hold a convertible note with a 20% discount rate. If a venture capitalist invests in that company at $20 million valuation paying $3 per share, your note converts to equity at $2.40 ($3.00 * .8) per share. Note that discount rates usually are only applied when the valuation is below the Valuation Cap.
The interest rate is the amount charged by a lender, usually expressed as a percentage of principal annually.
Convertible notes also carry an interest rate. Unlike traditional loans, however, this interest is paid in additional shares upon conversion of the note instead of cash. Let’s say you invest $1,000 in a startup through a convertible note with a 5% interest rate. If they receive a series A investment one year later, you would have accrued $50 worth of interest and would be entitled to $1,050 worth of shares at the appropriate conversion rate.
While Convertible Notes have an interest rate, the interest and principal are rarely repaid in cash; rather, the accumulated interest entitles the investor to receive more stock if and when the note converts to equity.
A preferred stock is a class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preferred shares generally have a dividend that must be paid out before dividends to common shareholders, and the shares usually do not carry voting rights.
The pre-money valuation is the valuation of the company before an investment has been made. It does not include the value of the cash a venture capital firm is about to invest. Pre-money valuations for early-stage startups are most often determined by supply and demand. 'Hot' startups often have multiple venture capitalists chasing after them, and therefore command a higher valuation.
The post-money valuation is the valuation of the company after the investment has been made. It is equal to the pre-money valuation plus the amount of the investment.
For instance, a venture capitalist might determine a company has a pre-money valuation of $15 million. The VC then invests $5 million in exchange for a fourth of the company. The post-money valuation is $20 million.
The Valuation Cap is the most important term of a convertible note or a SAFE. It entitles investors to equity priced at the lower of the valuation cap or the pre-money valuation in the subsequent financing. Typical Valuation Caps for early stage startups currently range from $2 million to $20 million.
The valuation cap is a way to reward seed stage investors for taking on additional risk. The valuation cap sets the maximum price that your convertible security will convert into equity. To translate that into a share price, you divide the valuation cap by the series A valuation.
Let's say you invest in a startup using a note with a $3 million cap. If the series A investors decide that the company is worth $6 million dollars and pay $1/share, your note will convert into equity AS IF the price had actually been $3 million. By dividing $6 million by $3 million we get an effective price $.50/share. That means that you will get twice as many shares as the series A investors for the same price.