Understand Convertible Note Investment Option: The Valuation Game-Changer!
Understand Convertible Note Investment Option: Founder's and Investor's Perspective
Hey there, forward-thinking innovators!
Over the past few months, I've had the chance to talk to many startup founders like you, and one topic that often comes up is the convertible note. As a startup founder, I understand the challenges you face when trying to raise funds for your venture.
If your startup's valuation isn't reaching the desired level, securing equity funding at a lower valuation may result in higher equity dilution, meaning you have to give up more ownership. However, there is an alternative option that can provide you with the necessary funds to build your product while buying you time to reach a higher valuation before seeking equity funding: the convertible note.
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A convertible note is a kind of debt instrument but not like any bank loan where you have to give the interest rate with a principal amount after a certain period of it. Instead, it converts the debt into equity stake if future rounds are raised but this occurs at a discount price. (Will look into it)
But As a founder How the Convertible note can help you?
Because it allows you to delay being valued until the equity funding round and extending time will give you the time to build your product to reach that valuation.
How to tell if the convertible note good for your startup?
Convertible notes work best for early-stage companies, especially pre-revenue startups. That could mean a company that has solid proof of concept — a product that’s proven to work on the current scale. In this case, the companies are building their value, and the dollars they raise with a convertible note help them scale. The end result is that when they’re ready for an equity financing round, they’re already at a higher pre-money valuation than they would be otherwise. This is how convertible notes can help your business to raise your equity funding round at a higher valuation.
Convertible Note: Investor’s Perspective
For investors, a convertible note is riskier than the traditional funding route, but they give them an opportunity to get more equity for their money than if they wait until Series A. Let’s understand this with an example -
Example -
Consider investor Y investing a $25K convertible note with a $ 5M valuation cap with a 20% discount.
If you are not aware of the valuation cap and discount rate.
A valuation cap is used in convertible notes to give the noteholders a “ceiling (Maximum)” value at which their investment will convert.
Discount rate (often between 10-25%) is a rate by which the price per share that the note converts into is discounted compared to the price the priced round investors are paying.
I hope this definition gives you the basic idea, but don’t worry you will understand more about it in the example.
As investor Y invests a $25K convertible note in a startup, it means $25K is a kind of loan amount but investor Y will not receive any interest and principal amount at the end of a certain period. Instead of this, he will convert the debt amount into an equity stake in the next fund-raised round i.e. Series A. Investor Y will receive the equity at a decided valuation or decided discount rate of shares.
Let’s continue with that example, currently, that startup looking to raise Series A. Let’s consider two scenarios in the series A round with differences in the pre-money value of startups.
Series A: Scenario 1
Let series A VC firm invest at pre-money valuation = $10M'
Share Price = $5
Then Investor Y (Seed Investor) will convert the debt to an equity stake.
Option 1: 20% discount
Share price to investor Y = $5 *(1-20%) = $4
Total number of share = $25,000 / $4 = 6250
Option 2: $5M valuation cap
Share price to investor Y = $5 *($5M/$10M) = $2.50
Total Number of share = $25,000 / $2.5 = 10000
Option 2 - valuation cap giving more shares to investors. Hence investors will apply a valuation cap while converting debt into equity.
Hence, the actual total value of shares for investor Y = 10000 * $5 = $50,000
So the return for investor Y is 100%.
Let's take scenario 2 with a different valuation -
Series A: Scenario 2
New Series A VC investment at pre-money = $6M
Share price = $5
Option 1: 20% discount
Share price = $5 * (1-20) = $4
Total number of shares for investor Y = $25,000/ $4 = 6250
Option 2: $5M Valuation Cap
Share Price = $5 *($5 M / $6 M) = $4.1667
Total Number of shares for Investor Y = $25,000 / $4.1667 = 6000
As Option 1 gives more number of share to investors hence investors will apply a 20% discount rate.
Hence value to investor Y = $5 * 6250 = $31250
Hence return to the investor is 25%.
So, from an investor’s perspective, the investor will choose the option of valuation cap or discount depending on the amount of return the investor gets.
That’s it. I hope this article helps you to understand the convertible note from both founder’s and investor’s perspectives.
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