Convertible promissory notes do not include a stated pre-money valuation. Instead, the convertible note seed investor and startup agree that the pre-money valuation for the convertible note investment will be determined by the pre-money valuation the startup receives at the Series A round. However, the convertible note investor does not receive the Series A pre-money valuation, but rather a lower pre-money valuation as determined by the conversion discount.
The convertible note seed investor gets a lower pre-money than the Series A investors for investing in the startup before the Series A round. Since the convertible note investor made the higher-risk investment in the startup, the seed investor’s reward is the ability to purchase (not by investing new cash, but by exchanging the debt) Series A shares at a price per share lower than the per share price paid by the other Series A investors.
So how do you set the conversion discount in a convertible note?
Conversion discounts are set to approximate the amount of risk the convertible note investor is taking by investing in the startup. In addition to the general risk of investing in an early-stage startup, other factors include time and the likelihood of the startup’s valuation increasing between the convertible note investment and the Series A round,
The majority of convertible note deals I see have the conversion discount set at a fixed percentage somewhere between 10% and 40%.
Occasionally, I have drafted conversion discounts that increase over periods of time. For example the conversion discount may be:
(i) 15% if the Series A round occurs within 6 months of the convertible note investment;
(ii) 25% if the Series A round occurs within 7-12 months after the convertible note investment; or
(iii) 40% if the Series A round occurs 12 or more months after the convertible note investment.