How Convertible Debt Works
Convertible debt is a type of security frequently issued by startups when raising capital in their seed round. With convertible debt, the startup issues the seed investor a promissory note, for the investment amount, that contains a conversion feature. The conversion feature is the mechanism by which the debt (the promissory note) will convert to equity (new shares for the investor) upon various future events.
The Qualified Financing
Most (if not all) convertible promissory notes contain an Automatic Conversion clause that dictates the automatic conversion of the convertible debt upon a “Qualified Financing.” The Qualified Financing is typically defined as an equity financing by the startup, for the purpose of raising capital, in which the aggregate of $1,000,000 (this amount can vary per deal) is purchased by investors. Thus, the Qualified Financing event is the trigger by which the convertible debt will automatically convert to equity. The conversion is considered “automatic” because it does not require the vote of either the startup or the investor.
The Qualified Securities
The equity raised in the Qualified Financing (the $1,000,000 above) is typically termed “Qualified Securities.” Think of this as the Series A round. The convertible debt held by the investor will convert to the Qualified Securities. The amount of shares of the Qualified Securities issued to the convertible debt investor is dependent on the conversion discount per the terms of the convertible promissory note.
The Conversion Discount or Price Cap
As a sweetener to the convertible debt investor, convertible promissory notes have a conversion discount feature by which the convertible debt holder will exchange the debt for Qualified Securities at a price per share equal to 80% (this amount can very per deal) of the price per share paid by the Qualified Financing investors (the investors with the new $1,000,000 above).
Additionally, many convertible notes offer the seed investor a “Price Cap” which is the maximum pre-money valuation that their investment will convert into the next round’s shares (i.e., the Qualified Securities). Note that if you offer a price cap or even a discount to your investors, you should also be mindful and include language about creating a parallel series of “Qualified Securities” so that things like liquidation preferences of the seed investors don’t get out of whack.
It is good to note that the conversion discount and the price cap are not both applied upon conversion — only one of the two mechanisms.
Convertible Debt Conversion Example (Discount)
Here’s the basic outline of how convertible debt works:
(1) Joe Angel invests $100,000 in Startup.
(2) Startup issues Joe Angel a convertible promissory note for $100,000. The convertible promissory note has an automatic conversion feature at $1,000,000 (the “Qualified Financing”) with a conversion discount equal to 20%.
(3) Startup closes $1,000,000 Series A Preferred Stock round (the “Qualified Securities”) by a VC at a Series A Preferred Stock price of $1.00 per share.
(4) Since the Automatic Conversion feature in Joe Angel’s convertible promissory note is triggered by the Series A round, Joe Angel’s convertible debt will be converted to Series A shares at a per share price of $0.80.
(5) The Startup issues Joe Angel 125,000 shares ($100,000/$0.80 per share) of its Series A Preferred Stock. The convertible promissory note is cancelled.
Note that the example above excludes interest assumes that a parallel series of Series A Stock is not being issued here and that a price cap has not come into play.