Startup Lawyer | How to Set Conversion Discounts in Convertible Notes
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How to Set Conversion Discounts in Convertible Notes

Posted 18 Dec 2009

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.

6 Comments
  • Casey
    Posted at 22:50h, 01 April Reply

    Hey Ryan, how often does it occur that different investor have different discounts? In other words, you get I1 in at a 15%, I2 demands 20%, and because you really want him, you roll with it.

    Obviously this isn't desirable, but will it cause irreparable damage come Series A time?

  • Casey
    Posted at 17:50h, 01 April Reply

    Hey Ryan, how often does it occur that different investor have different discounts? In other words, you get I1 in at a 15%, I2 demands 20%, and because you really want him, you roll with it.

    Obviously this isn't desirable, but will it cause irreparable damage come Series A time?

  • Ryan Roberts
    Posted at 13:42h, 04 April Reply

    Different holders can have different discounts, but it's typically due to compensation for risk. That is you might see someone get a 30% discount and a second investor comes in 3 months later at a 25% discount.

    You'll probably want to have all investors who invest at the same time have the same discount.

  • Ryan Roberts
    Posted at 08:42h, 04 April Reply

    Different holders can have different discounts, but it's typically due to compensation for risk. That is you might see someone get a 30% discount and a second investor comes in 3 months later at a 25% discount.

    You'll probably want to have all investors who invest at the same time have the same discount.

  • Steve Rosard
    Posted at 15:35h, 19 November Reply

    Ryan, I love your blog. It seems though that trading the valuation negotiation for the discount rate negotiation is only worthwhile when a qualified financing is on the horizon or when the angel can help lead the company to qualified financing in the near term. Otherwise, as you mentioned in another post, the angel has a negative incentive re: growing the company’s value, even with a ratcheted discount rate.

  • Steve Rosard
    Posted at 15:35h, 19 November Reply

    Ryan, I love your blog. It seems though that trading the valuation negotiation for the discount rate negotiation is only worthwhile when a qualified financing is on the horizon or when the angel can help lead the company to qualified financing in the near term. Otherwise, as you mentioned in another post, the angel has a negative incentive re: growing the company’s value, even with a ratcheted discount rate.

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