CONVERTIBLE NOTE SIMPLIFIED

Revenue is a key metric in #Valuation especially during a #fundraising process.

Certainly, there are other things to consider which include but are not limited to the company's  portfolio, assets as well as its growth potential - having as a context, the market conditions as well as competitors in a similar business.

Valuing a start-up is a subjective process and relies on many variables - but what happens when a Startup is literally "just starting"?

What option does an Investor have especially if they are investing in a pre-seed where the company is yet to have a valuation?

Typical suggestions would be a convertible note or a simple agreement for future equity. However, the emphasis of this post is the former. Let's dive in!

⏩️ Think of this as a loan secured with company equity rather than a physical collateral. It starts out as a debt with a potential to become equity (which happens if the conversion is successful).

In a note, you will find 4 basic but important terms:

■ Interest Rate ➡️ because a convertible note bears the characteristics of a Debt/Loan

□ Maturity Date ➡️ which is when the repayment becomes due in the event the note did not convert.

▪︎Conversion Terms ➡️ this would usually state the events that would lead to the conversion of the note.

▪︎ Conversion Discount ➡️ A discount on the price per share, usually as a reward to the initial investor(s) for the risk borne.

Example:

Company A is registered with 2 milliion share capital split in equal proportion between Founders A and B. The Company has approached Investor X for $100k on a convertible note with a yearly simple interest of 5% and a 10% conversion discount - the maturity date is 3 years.

2 years down the line, Company A has done pretty well - enough to attract Investor Y.

⏩️ Remember, there was no valuation at the time of executing the convertible note.

Investor Y intends to invest $1m at a $4m valuation - if this deal goes through, Company A's Post Money Valuation is $4m.

Pre-money valuation is calculated as: Post Money Valuation - Amount Raised; in this case ($4m - $1m) = $3m

The implication of this is that Investor X's convertible note will be premised on a $3m company .

Investor X:

$100k (Initial investment) + $10k (Interest for 2 years) is $110k

Price Per Share = Pre-money valuation ($3m) ÷ Number of Outstanding Shares (2m), this gives us $1.5 (one dollar 50 cents as the PPS).

Investor X also had a 10% conversion discount on the PPS - (10/100 × 1.5) = 0.15

Investor X will get a share for $1.35

Investor X's $110k will therefore convert to ~ 81,482 thousand shares in Company A.

Without the discount, Investment + Interest would have gotten Investor X ~ 73,333 thousand shares.

It is important to note that what triggers a conversion is often a qualified financing round or a liquidity event such as a merger, acquisition or even an IPO (Initial Public Offering). However, where none of this occurs, the conversion fails and the note becomes payable with its accrued interest.

The terms and mechanics of a convertible note can sometimes be a bit confusing - you just have to familiarise yourself with it over and over again until it sticks.

Let us know if you found this useful!