Explaining Convertible Notes – Keep It Simple

Recently, I have had a number of friends who asked me about how convertible notes usually work. Thought I will explain how convertible notes work (or at least the usual ones).

There are three key items in any convertible note (or in usual convertible notes):

  1. Valuation Cap. This is the maximum valuation you will invest into the company at.
  2. Discount. This is to compensate earlier investors for investing at an earlier stage of the company with less traction. Therefore, earlier investors will have a paper gain on the investment should there be a next round raised. Typical discount rates range from 10 to 30%, with the most common being a 20% discount.
  3. Coupon Rate. Similar to any bond you purchase out in the market, some convertible notes have a coupon rate attached to them. This is usually acting either as accrued interest, or as an interest that will be paid to investors at conversion. This may not be offered for all convertible notes though (though if offered, it usually ranges from 6 to 15%).

Now comes the tricky part: conversion. How do you determine the price you are converting at. I like to simplify it as follows:

  1. Calculate the amount invested into the company (including any interest that you are earning which will be accrued and converted to shares).
  2. Calculate the number of shares you will receive on each situation.
  3. Pick the one that is more favorable to you.

I have summarized the calculation methods in the diagram below.

Hope this helps.


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