What does a “discount” mean in a convertible note?
What is a note?
A note is a loan. That is, a lender gives a company $100, and the company writes a note to the lender stating “we will pay you back $100 one year from today, along with 10% [or some other number] per year interest”.
What does convertible mean in a note?
The convertible part means that in addition to the straight repayment mentioned above, the lender and the company agree that instead of the company paying back the loan in cash, if the company raises money by selling stock to another investor before the loan is due, then the original lender (the “noteholder”) can use the amount of the loan (plus the interest) to purchase stock on exactly the same terms as the new investor. Depending on how the note is written and the amount and valuation of the equity (ie, stock) sale, the conversion may be either optional on the lender’s part, or mandatory.
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What does discount mean in a convertible note?
A discount on the conversion means that because the noteholder was willing to provide money to the startup before any investor was willing to come along and invest, that noteholder should be compensated for taking the early risk by being able to convert the note into the new equity round at lower valuation (or “discount”) to that of the new investor. So, for example, if the new investor is purchasing Series A Convertible Preferred Stock at $1.00 per share, a 20% discount means the original noteholder will be entitled to use his or her $100 (plus interest) note to buy the same Series A shares, but pay only 80 cents a share.
While this sounds like a good deal for the original noteholder, what it effectively means is that with, say, a 20% discount, the noteholder effectively has a maximum possible return of 25% on the original amount of the note between the time the original money changed hands, and the time the Series A investor came along (that is, $1.00 is 25% higher than $0.80.) In the high-stakes world of angel/venture investing, that is actually not very much…especially if the note was made as a pure seed investment when the company was barely formed (how much could it possibly be worth??) and the Series A investor values the company at, say $5-10 million.
For that reason, professional seed investors will almost always insist on putting a cap on the conversion valuation, which effectively says “no matter what valuation the Series A investor puts on the company for his or her equity investment, the valuation of the company at which the note will convert will never be greater than $X (where $X is typically the ‘true’ value of the company at the time of the note.) In this way, although the form of the original money coming is a note (or loan), the understanding of all parties is that for most purposes it is treated as if it were an equity investment itself at the valuation of the cap.
And that is why the majority of early stage financings these days among professional angel investors and experienced entrepreneurs are done in the form of convertible notes with a discount and a cap.
Gust Launch can help set you up as a Delaware C-corp on the path toward seeking investment as a high-growth startup.
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.