How does a Convertible Note work?
One of the most common methods used to invest in early-stage startups is something called a convertible note. A convertible note is a loan that converts into equity after the company has a bit more operating history under its belt and there is more information available to establish a fair price.
When you invest through a convertible note the startup receives the money right away, but the number of shares you are entitled to is determined during its next round of financing, or Series A. At that point the company will have some operating history that more experienced angel investors or venture capitalists can review in order to determine a fair price. Once the series A investors have determined a price, your loan converts into shares at a discount to the Series A price to reward you for the additional risk you took on by investing early.
The amount of equity that a note converts into depends on the price of the A round plus two key components of your note.
- Valuation Cap. The Valuation Cap is the most important term. 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 $4 million to $20 million.
- Discount Rate. The default is 0%. This term is now rarely used and not recommended unless a major investor asks for it. It gives investors a discount on the price of stock, when the pre-money valuation is less than your valuation cap. Typical discounts range from 0% to 10%.
These are extra protections not common in Regulation D fundraises with accredited investors that we've included in our boilerplate safe and suggest you include in your contract:
- Has Repurchase Rights. The company may opt to repurchase an investor's SAFE prior to conversion at Fair Market Value if the 12(g) reporting requirements are triggered. Fair Market Value is determined by an appraiser the company chooses.
- Can be Amended by One Lead Investor. The lack of a maturity date and interest rate negates the need for common amendments of convertible note financings. However, if an extraordinary situation requires an amendment, you will not be required to chase down hundreds of signatures. The company designates a Lead Investor Representative, and all investors agree to allow that person to unilaterally amend the SAFE.
- Grants CEO Power of Attorney for Minor Shareholders. Once the SAFE converts into equity, investors who are not Major Shareholders grant the then-current CEO a power of attorney to vote all shares and execute any documents on their behalf. This mitigates the potential problem of hundreds of minor shareholders slowing down follow-on financings.
- Investors Represent They Follow Investment Limits. All investors indicate if they are accredited or unaccredited. They represent they are in compliance with the investment limitations of Regulation Crowdfunding.