The Convertible Note Discount and Price Cap

If you follow this blog, you know that I think convertible debt is a good structure for a startup’s angel round. The main feature of the convertible note is that the debt investment made by the angel investor will typically later convert into equity. For this article, let’s assume this equity is the Series A Preferred Stock purchased by a venture capital fund.

Convertible Note Discount

As a sweetener to the angel investor (i.e., compensate the angel for the early risk), the convertible promissory note will have an automatic conversion discount feature by which the angel investor will exchange the convertible debt for shares of the Series A Preferred Stock at a discount to the price per share paid by the venture capital fund at a Qualified Financing.

For example, if a venture capital fund purchases Series A Preferred Stock at $1.00 per share, the discount may allow the angel investor to purchase the same Series A Preferred Stock at $0.75 per share. (For more background, check out this post for an example of how convertible debt and the conversion discount works.)

Incentive Misalignment

Convertible notes have drawbacks — they aren’t perfect. The main drawback is the quirk that the lower your pre-money at Series A, the more equity your angel investor gets.

EXAMPLE 1: If a VC invests $2,000,000 at a $5,000,000 pre-money valuation ($7,000,000 post money) and an angel investor has a $100,000 convertible note with a 25% discount, the angel investor will own 1.9% of the startup immediately after the Series A round.

EXAMPLE 2: But if the VC invested at a $15,000,000 pre-money, the same angel investor would own 0.78% of the startup right after the Series A.

Because of this quirk, an angel investor may not have much incentive to help increase your pre-money valuation before a Series A…regardless of the conversion discount. Meanwhile, you and your co-founders are doing everything possible to increase the startup’s valuation.

Convertible Note Price Cap

To provide upside protection, angel investors like to put a “price cap” on the convertible note discount. This price cap is expressed in terms of a pre-money valuation and effectively acts as a share price ceiling. Thus, an automatic conversion discount with a price cap might read something like this:

“The conversion discount shall be the lower of (i) a 25% discount to the Series A Preferred Stock share price, or (ii) the price per share if the Series A premoney valuation was set at $[6,000,000].”

Using the hypothetical in Example 2 above, an angel investor using this $6,000,000 pre money price cap would receive 1.45% instead of 0.78% as of right after the Series A.

Price Caps as a Weapon

The original idea was that price caps would provide upside protection for an angel investor. But occassionally I’ll see an angel throw in a really low price cap (<$400k) in the automatic conversion section. How many Qualified Financings are going to take place lower than $400k (and make the conversion discount percentage even a legit term)? Lowball price caps are essentially a “#$!@ you” to the startup.

Tags: Angel Investors, convertible note, price cap

40 Responses to “The Convertible Note Discount and Price Cap”

  1. Aris Smith June 23, 2010 at 9:13 pm #

    Ryan, in order for a company to issue convertible debt for angel financing, do they have to be incorporated as a C corp, or can you be an LLC or S corp and issue the note?

  2. Aris Smith June 23, 2010 at 4:13 pm #

    Ryan, in order for a company to issue convertible debt for angel financing, do they have to be incorporated as a C corp, or can you be an LLC or S corp and issue the note?

  3. Ryan Roberts June 24, 2010 at 3:03 pm #

    Aris:

    The startup can be a C, S, or LLC. But there will be conversion issues with an S or LLC (more with the latter).

  4. Ryan Roberts June 24, 2010 at 10:03 am #

    Aris:

    The startup can be a C, S, or LLC. But there will be conversion issues with an S or LLC (more with the latter).

  5. Simon June 28, 2010 at 10:13 am #

    Ryan, when offering a discount to angels using a convertible note that converts to preferred, does this have the affect of discounting the investor buying preferred at the qualifying financing round?

    i.e. preferred worth $1 at the qualifying round (series A), but angels get same stock at a discounted rate?

    Will VC’s typically not like this and prefer that discounts are offered as warrant’s over common stock (i.e. note value converts to preferred and warrant coverage over common stock).

    Interested in your thoughts on the “typical” way this is done.

    cheers

  6. Simon June 28, 2010 at 5:13 am #

    Ryan, when offering a discount to angels using a convertible note that converts to preferred, does this have the affect of discounting the investor buying preferred at the qualifying financing round?

    i.e. preferred worth $1 at the qualifying round (series A), but angels get same stock at a discounted rate?

    Will VC’s typically not like this and prefer that discounts are offered as warrant’s over common stock (i.e. note value converts to preferred and warrant coverage over common stock).

    Interested in your thoughts on the “typical” way this is done.

    cheers

  7. Ryan Roberts July 1, 2010 at 7:59 pm #

    Simon,

    VCs are fine with the convertible note discount, provided it is not some outrageous discount. The discount is better IMO b/c there is no potential warrant overhang…discounts are just cleaner.

  8. Ryan Roberts July 1, 2010 at 2:59 pm #

    Simon,

    VCs are fine with the convertible note discount, provided it is not some outrageous discount. The discount is better IMO b/c there is no potential warrant overhang…discounts are just cleaner.

  9. Adam July 6, 2010 at 4:23 am #

    Ryan,

    Thank you for running such an interesting blog. The posts are interesting and well written and the hypertext definitions make the articles accessible to a wide audience. Keep up the good work.

    Two questions about regarding this post:

    1) You state that Angel Investors have an incentive in keeping the pre-Money valuation low. In your example, it appears that in either case, the IA will have 133,000 after the conversion discount. Certainly, the AI’s percentage of the total pie is smaller but this is only because the overall size of the pie is larger. If the AI is receiving the same return either way, what is the AI’s incentive for keeping the pre-money valuation low?

    2) How did you calculate the price per share your price cap example?

  10. Adam July 5, 2010 at 11:23 pm #

    Ryan,

    Thank you for running such an interesting blog. The posts are interesting and well written and the hypertext definitions make the articles accessible to a wide audience. Keep up the good work.

    Two questions about regarding this post:

    1) You state that Angel Investors have an incentive in keeping the pre-Money valuation low. In your example, it appears that in either case, the IA will have 133,000 after the conversion discount. Certainly, the AI’s percentage of the total pie is smaller but this is only because the overall size of the pie is larger. If the AI is receiving the same return either way, what is the AI’s incentive for keeping the pre-money valuation low?

    2) How did you calculate the price per share your price cap example?

  11. Aris Smith July 6, 2010 at 5:14 am #

    When you say conversion issues, do you mean conversion issues in general for when you raise a Series A or do you mean a specific conversion issue with the debt? We plan on having to do the conversion from LLC to C before we raise Series A, but I was hoping that doing the angel round w/ convertibles would not require the conversion at this stage.

  12. Aris Smith July 6, 2010 at 12:14 am #

    When you say conversion issues, do you mean conversion issues in general for when you raise a Series A or do you mean a specific conversion issue with the debt? We plan on having to do the conversion from LLC to C before we raise Series A, but I was hoping that doing the angel round w/ convertibles would not require the conversion at this stage.

  13. Ryan Roberts July 6, 2010 at 8:35 pm #

    Adam,

    I think your calculations are off. The higher the pre-money, the less shares an investor will get (whether at series A or a convertible note conversion).

    The incentive for the convertible note investor to keep the pre-money low is right before the financing, but the incentive to keep it low is removed once the conversion takes place.

    I calculated the price per share in the price cap example using the cap pre-money, the amount of shares outstanding (pre-money FD…which I assumed) and the investment amount ($100k).

    • Adam July 9, 2010 at 10:59 am #

      Ryan,

      Here are my calculations:

      Angel Investors shares = $100,000/0.75 = 133,333 shares

      Assuming $5M pre-money valuation, then:

      Equity % held by AI = 133,333 / (2M + 133,333) = 6.2%

      Price per share = $7M / 2,133,333 = $3.28/share

      AI's total equity value = $3.28 x 133,333 = $437.332 (approx. 6.2% of $7M)

      If $17M pre-money valuation, then:

      Equity % held by AI = 133,333 / (2M + 133,333) = 6.2% (same)

      Price per share = $17 / 2,133,333 = $7.97/share

      AI's total equity value = $7.97 x 133,333 = $1,062,664 (approx. 6.2% of $17M)

      Assumptions: 1) VC is investing $2M in both scenarios 2) IA and VC are the only investors 3) VC purchases Qualified Shares at $1/share.

      Are my assumptions wrong or am I totally off base?

      Adam

      • Ryan Roberts July 12, 2010 at 10:27 am #

        Adam,

        Your numbers are off because your first calculation is ($100,000/.75) when it should be ($100,000/(Series A Per Share Price * (1-discount)).

        The number of shares an angel would get is not fixed, which is how you have approached it.

  14. Ryan Roberts July 6, 2010 at 3:35 pm #

    Adam,

    I think your calculations are off. The higher the pre-money, the less shares an investor will get (whether at series A or a convertible note conversion).

    The incentive for the convertible note investor to keep the pre-money low is right before the financing, but the incentive to keep it low is removed once the conversion takes place.

    I calculated the price per share in the price cap example using the cap pre-money, the amount of shares outstanding (pre-money FD…which I assumed) and the investment amount ($100k).

    • Adam July 9, 2010 at 5:59 am #

      Ryan,

      Here are my calculations:

      Angel Investors shares = $100,000/0.75 = 133,333 shares

      Assuming $5M pre-money valuation, then:

      Equity % held by AI = 133,333 / (2M + 133,333) = 6.2%

      Price per share = $7M / 2,133,333 = $3.28/share

      AI's total equity value = $3.28 x 133,333 = $437.332 (approx. 6.2% of $7M)

      If $17M pre-money valuation, then:

      Equity % held by AI = 133,333 / (2M + 133,333) = 6.2% (same)

      Price per share = $17 / 2,133,333 = $7.97/share

      AI's total equity value = $7.97 x 133,333 = $1,062,664 (approx. 6.2% of $17M)

      Assumptions: 1) VC is investing $2M in both scenarios 2) IA and VC are the only investors 3) VC purchases Qualified Shares at $1/share.

      Are my assumptions wrong or am I totally off base?

      Adam

      • Ryan Roberts July 12, 2010 at 5:27 am #

        Adam,

        Your numbers are off because your first calculation is ($100,000/.75) when it should be ($100,000/(Series A Per Share Price * (1-discount)).

        The number of shares an angel would get is not fixed, which is how you have approached it.

  15. Ryan Roberts July 6, 2010 at 8:38 pm #

    Aris,

    Potentially both. LLCs are trouble, but you can have an issue if an investor is not an ‘individual’ and the debt converts to equity in your (now former) S-corporation.

    I’d just skip the LLC, unless someone (typically some wealthy angel investor) can really get some tax benefit.

  16. Ryan Roberts July 6, 2010 at 3:38 pm #

    Aris,

    Potentially both. LLCs are trouble, but you can have an issue if an investor is not an ‘individual’ and the debt converts to equity in your (now former) S-corporation.

    I’d just skip the LLC, unless someone (typically some wealthy angel investor) can really get some tax benefit.

  17. Jay July 7, 2010 at 5:13 am #

    Thanks for the great info.

    I get a slightly different equity result for the cap example:

    - Assuming that the debt is included in the pre-money Series A valuation
    - I’m using $ figures instead of shares, but result is equivalent

    1) seed investor’s 100K w/ the cap effectively contributes $150K to the post-money valuation:
    100k / conversion discount from cap = 100k / (10m / 15m)

    2) 150k “contribution” / $17m post-money val = 0.88% equity for seed investor

    Perhaps I am interpreting incorrectly?

    thanks

  18. Jay July 7, 2010 at 12:13 am #

    Thanks for the great info.

    I get a slightly different equity result for the cap example:

    - Assuming that the debt is included in the pre-money Series A valuation
    - I’m using $ figures instead of shares, but result is equivalent

    1) seed investor’s 100K w/ the cap effectively contributes $150K to the post-money valuation:
    100k / conversion discount from cap = 100k / (10m / 15m)

    2) 150k “contribution” / $17m post-money val = 0.88% equity for seed investor

    Perhaps I am interpreting incorrectly?

    thanks

  19. Ryan Roberts July 7, 2010 at 3:32 pm #

    Jay,

    Thanks for catching that. I think my error was I used $125k (instead of the $100k note) in the price cap calculation. Fixed.

    • Jay July 7, 2010 at 11:07 am #

      Hi Ryan,

      Thanks for clarifying!

      -Sanjay

  20. Ryan Roberts July 7, 2010 at 10:32 am #

    Jay,

    Thanks for catching that. I think my error was I used $125k (instead of the $100k note) in the price cap calculation. Fixed.

    • Jay July 7, 2010 at 6:07 am #

      Hi Ryan,

      Thanks for clarifying!

      -Sanjay

  21. Victor July 22, 2010 at 3:53 pm #

    Hi Ryan, thanks for this useful post.

    However, I don’t understand the issue of less % when the valuation increases.

    As an angel, you are investing in a company to get back X times your investment. Unless you want to take control of the company, the % of the equity you get is not very important.

    For example, a 1% of a $10M company is more than a 5% of a $1M one.

    Please, can you explain when/why this is such an issue?

    Thanks

    Victor

  22. Victor July 22, 2010 at 10:53 am #

    Hi Ryan, thanks for this useful post.

    However, I don’t understand the issue of less % when the valuation increases.

    As an angel, you are investing in a company to get back X times your investment. Unless you want to take control of the company, the % of the equity you get is not very important.

    For example, a 1% of a $10M company is more than a 5% of a $1M one.

    Please, can you explain when/why this is such an issue?

    Thanks

    Victor

  23. arsachs November 10, 2010 at 8:50 pm #

    Ryan I’m trying to figure out exactly how the Valuation Cap works and when I do the math, I’m getting ownership of around .83 vs. your .88 number. Can you explain in detail how you came to that ownership number?

    I tried taking the Note Investment ($100,000) / (Series A amount ($2,000,000) + The Cap (10,000,000)). And got .83%.

    Then I tried taking the Note Investment ($100,000) / (Series A amount ($2,000,000) + the Cap (10,000,000) + the Note Invesment ($100,000)). And got .82%.

    What am I missing?

  24. Ken Aston January 29, 2011 at 7:59 pm #

    arsachs, see Jay’s comment above for a way to calculate it.

  25. Ben Parker May 30, 2011 at 9:01 pm #

    Ryan,

    this was really helpful, as I am in the process of evaluating several startups for investment. I did have a question.

    1. Lets say I have a $50K convertible note in a company. Does that 50K simply give me the right to invest at the VC/institutional round? Or does that money go towards the discounted price I can pay when the VC steps in?

  26. Umar May 15, 2012 at 7:41 pm #

    Ryan:

    Thanks for this blog, it is very helpful.

    Another question: have you seen different caps set for the different conversion scenarios?

    For example, the “automatic” cap would be highest (the scenario being the next round of eq

  27. Umar May 15, 2012 at 7:44 pm #

    Ryan:

    Thanks for this blog, it is very helpful.

    Another question: have you seen different caps set for the different conversion scenarios?

    For example,

    1. The “automatic” cap would be highest, the scenario being the next round of equity financing,

    2. An “optional” cap would be the same (or different?) as the “automatic” cap and would kick in case of merger or acquisition

    3. A “repayment” cap would be the lowest and potentially be as low as current market cap and would kick in if the debt is not to be repaid at the time of maturity?

    Can you comment? Have you seen tiers like this?

    Thanks!

  28. Ryan Roberts May 16, 2012 at 9:19 am #

    Umar — Yes I have seen different caps for different conversion scenarios.

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