What to look out for in Convertible Note Agreements

Convertible notes are a common type of agreement signed by younger startups who are fundraising. Founders are effectively taking out a loan from an investor that either converts to equity in their company during the next financing round, or gets repaid at the maturation date. While these agreements are favored due to their relative simplicity compared to an upfront cash for equity investment, there are still a number of terms that are important to negotiate. Let’s dive into it!

Interest on the Loan

Investors invest in startups not to make a interest on their loan, but to take a stake in a company they hope will return tenfold or more down the road. As such, it’s important for founders to negotiate low to no interest at all on the loan. The market currently averages anywhere from 4 - 8%. For the founder, the lower, the better.

Loan Duration

The length of the loan is the period of time during which the loan can convert to equity before it has to be repaid. Too short a duration and the founder runs the risk of needing to repay in cash before they can finalize a fundraising round or renegotiate to extend the loan at less favorable terms. Convertible notes can run as short as a year to as long as 5, but we see the sweet spot right around 2 - 3 years.

Other Triggers for Repayment

During the period of the loan, a startup could go bankrupt, get acquired, or completely change its company leadership. From the investor’s point of view, they may want their money returned when the company has changed dramatically from their time of investment. While the standard is for a repayment in full during special cases such as a Change in Control, founders may negotiate instead for automatic conversion, while investors may push for extra fees on top of repayment.

Terms of Conversion

The terms of conversion include stock type, discount rate, valuation cap, and qualifications of the next financing round. For these terms to matter, the first one to evaluate is what qualifies as the next financing round. Typically, there is a monetary trigger (e.g. $1M raised). If it’s too low, the conversion risks getting triggered prematurely; too high, and the conversion risks never triggering at all.

Once triggered, investors look for special treatment on their equity conversion. Namely, they want the loan to convert to preferred stock for preferential treatment during liquidation at a discounted price of 15 - 25% off the price of the round. From the founder’s perspective, keep an eye out for investors pushing for participation preferred stock (allowing them to cash out twice during liquidation) and high discounts.

Low Valuation Caps

Let’s deep dive into valuation caps as there’s a bit of math we want to highlight. The price of an investor’s converted equity is typically the lower of the discounted price and the valuation capped price.

Let’s take an example:

1. You raise $1M on a $10M valuation with a share price of $1 per share.

2. With a discount of 20%, the discounted price is $0.80 per share.

3. However, the investor negotiated a $5M valuation cap.

4. As a result, the valuation capped price is $0.50 per share.

5. The investor gets to convert their loan to equity at $0.50 per share.

What effectively happens when a valuation cap is set too low is the founder providing the investor with a further discount that may make fundraising difficult from other investors without similar terms. From the founder’s perspective, it’s preferable to have a high valuation cap or no cap at all.

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Although we’ve only scratched the surface of convertible notes, we want to lay a foundation for the terms that founders can negotiate. We also want to emphasize the negotiability of convertible notes as many of the terms have a wide range of what’s acceptable, and can even be left out entirely. For example, the savvy founder can negotiate for automatic conversion at loan maturity and remove the risk of them ever needing to repay in cash. As always, reach out if you have any questions!

For advocacy and beyond,
The Ask Ginkgo Team