Convertible Note

Taking investment as stock requires pricing the company first. Accepting $230,000 for 10 percent means both sides agreed the company is worth $2.3 million. The problem is that there's nothing to base that on when the product just shipped and revenue is zero. Valuation normally climbs from numbers like revenue or profit, and those numbers don't exist yet.

Early negotiations became a tug of war with no rope. The founder names $3 million, the investor names $1.2 million, neither has anything to persuade the other with, and the outcome comes down to who blinks. Pagedeck spent three weeks in exactly that position on its first raise. The bank balance kept dropping the whole time, and when Grace ran the numbers, those three weeks had come straight out of runway.

A convertible note doesn't untie the knot. It defers it. The money moves now with no price attached, and when the next priced round arrives and institutional investors set a number, the earlier money converts into equity against that number. The decision waits until there is something to decide it with.

The money changes hands as a loan, and at the moment the next priced round closes it converts into shares based on the valuation set in that round. Four items actually get negotiated in the document.

1. Valuation cap. A ceiling, fixed in advance, on the valuation used to convert the money — no matter how high the next round prices. With a $4 million cap and a next round that closes at $8 million, the earlier money converts against $4 million, not $8 million. A $400,000 note becomes 10 percent. The cap is what rewards whoever took the risk first, and it is usually the single number both sides argue about longest.
2. Discount rate. A percentage knocked off the next round's price, commonly 15 to 25 percent. Twenty percent off an $8 million round gives a $6.4 million basis. When a note has both a cap and a discount, whichever produces more equity for the investor applies. In this example the cap yields 10 percent and the discount yields 6.25 percent, so the cap wins.
3. Interest. It's a loan, so interest accrues, usually 2 to 8 percent a year. In most cases it isn't paid in cash — it's added to the principal and converts along with it. A $400,000 note at 5 percent for two years converts $440,000 worth.
4. Maturity. Typically one to two years. If no priced round closes inside that window, nothing exists to convert against, and on paper the repayment date arrives. In practice the parties usually extend the maturity or agree on a price and convert anyway, but the investor's right to demand the money back is real.

Conversion issues new shares, which lowers everyone else's ownership percentage. That dilution all lands at once in the next round, and it's easy to lose track of the total when several notes have stacked up. That's why each issuance goes into the cap table alongside the ownership it would produce after conversion.

It appears most often at the earliest stages, where no basis for a price exists. Pre-seed and seed rounds are that territory, and because the amounts are modest, saving the legal fees and weeks a priced round costs is part of the appeal.

It also fills the gaps between priced rounds. That's the bridge round case: the numbers fall a little short of what a Series A requires, three months of cash remain, and existing investors put in a smaller amount that buys six months. Repricing the company at that moment would bake in the current weak numbers, so deferring the price works in the company's favor.

A third use is moving money ahead of a slow negotiation, so the company isn't idle while lawyers work. When agreeing terms will take two months, part of the amount comes in as a note now and the rest gets settled in the main agreement.

The thing to watch is that this instrument postpones pricing rather than removing it. The deferred math all comes due in the next round. Issue several notes at low caps and there may be too little left for a new investor, which makes the next negotiation harder than the one that was avoided.

"Let's do a $4 million cap with a 20 percent discount this time."

Proposing the conversion ceiling and the markdown; the actual ownership percentage isn't fixed until the next round prices.

"Maturity is six months out and I don't see a round coming."

There will be nothing to convert against, and a repayment demand becomes possible.

"If all three notes convert, how much do we have left?"

A request to add up the dilution across every outstanding note at once.

Here's the scene at Pagedeck while it prepared its Series A. Four months of cash remained and diligence plus signing needed five. Grace raised $400,000 from existing investors as a convertible note to buy time, on a $4 million cap, a 20 percent discount, 5 percent interest, and an 18-month maturity. The paperwork took ten days.

Four months later the Series A closed at $8 million, and that $400,000 converted against the cap into roughly 10 percent. Against the $8 million price it would have been 5 percent. The difference is what going in first, before anyone else would, paid out. Nobody had to argue about a price at the time the money arrived, which was the point.

Founders often assume that money raised is money they'll never repay. Funds land in the account and the counterparty is called an investor, so the assumption is natural. But the legal form of this agreement is debt, and if conversion hasn't happened by maturity, the investor keeps the right to demand principal and interest back. The companies whose next round slips are exactly the ones who meet that demand with no cash on hand, which is why the maturity should be set generously against how long the next raise could realistically take. Eighteen months is not a long time when a round takes five.

Reading the cap as the company's valuation is the other one. A founder signs at a $4 million cap and starts describing the company as a $4 million company, but a cap is a ceiling, not a price. If the next round closes at $2.3 million, conversion runs against $2.3 million. Mistake the cap for a valuation and you walk into the next negotiation asking for more than the last one supports.