Startups can obtain investment in their company through a convertible note. A convertible note is structured as a loan that automatically converts into equity when a certain trigger event occurs and/or at maturity.

In this way, startups can attract investment without having to value their company until a later round of investment of a particular size is complete (qualifying Equity Financing), or the company reaches a particular milestone. Convertible loan agreements sometimes include additional key clauses such as the conversion valuation cap (Cap) and the conversion discount (Discount). The convertible loan agreement incorporates these clauses in consideration for the additional risk taken by the investor investing in an earlier round. So, what do these terms mean?

What is a Discount?

The Discount sets a percentage reduction at which the convertible loan will convert compared to the next qualifying Equity Financing. Effectively, it allows an investor to convert the principal amount of its loan, plus accrued interest and fees, into shares at a discount to the purchase price paid by investors in the next qualifying Equity Financing. Discounts range from 0% to 35%, with 20% being most common.

By way of example, consider X is providing a convertible loan to the company that will automatically convert into shares at the next equity financing of over $2 million at a 20% Discount. The Company then obtains equity financing of $3 million from investors, and the purchase price of each share paid by the investors is $100. X can convert the loan, and any accrued interest and fees), into company shares on the basis that the conversion price of each share is 80 cents, after the 20% Discount.

What is a Cap?

A Cap sets the maximum company valuation at which the investment made via the convertible loan can convert into equity.

For example, X provides a convertible loan to the company that automatically converts into shares at the next equity financing over $2 million with a Cap of pre-money valuation of $6 million. The Company then obtains equity financing of $3 million from investors, based on a pre-money company valuation of $8 million. When determining how many shares X receives, the Company uses a pre-money valuation of $6 million, not $8 million. Accordingly, the conversion price will be the price per share determined by dividing the Cap by the next qualifying Equity Financing pre-money valuation.

What if the Convertible Loan Agreement has a Discount and a Cap?

If the convertible loan agreement has both a Discount and a Cap, the convertible loan typically converts at a price that is the lesser of:

  1. the price per share paid by investors in the next qualifying Equity Financing (discounted if a Discount applies), and
  2. the price per share determined by dividing the Cap by the next qualifying Equity Financing pre-money valuation.

What this means is that the investor receives the better of the two possibilities. A lower conversion price per share means that the convertible loan converts into more shares.

Conclusion

Convertible loans can be complex and may contain very sophisticated concepts. If you need a convertible loan agreement for your company drafted or reviewed to make sure it is market standard, please do not hesitate to contact LegalVision. One of our startup finance specialists would be delighted to assist you!

Jill McKnight

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