Convertible securities (or convertible promissory notes) are debt instruments that may convert into equity at some point in the future. Generally, a convertible security will be converted into equity in the subsequent equity financing round at that round’s valuation.
So, for example, let’s say you invest $100k in Company X before any financing rounds have taken place. Rather than trying to determine a valuation and receiving a grant of equity based on that valuation (which is generally more difficult the earlier the stage a company is in) you receive a convertible note with principle of $100k and some interest rate and maturity date. Several months later, Company X raises a Series Seed round with a valuation of $2M. Either automatically at the occurrence of the financing (depending on the agreement) or at your choice, the convertible note will convert into equity at that $2M valuation – the $100k resulting in 5% equity (100,000/2,000,000). Note that for the example, we are using no interest.
Now wait a second – you invested much earlier, taking on more risk, than the investors in the series seed round. Shouldn’t you get a better deal? This is where conversion caps and conversion discounts come in. Perhaps the founders of Company X recognized your early faith and willingness to take on the risk of investing in their young company and attached a conversion cap of $1M to your convertible note as compensation for that extra risk. A conversion cap of $1M means that if the valuation of the following round exceeds $1M, the convertible note will purchase equity at a $1M valuation. So if, as in our previous example, Company X raised a Series Seed round with a valuation of $2M, you would now receive 10% equity in the company – as opposed to 5% without a conversion cap. That’s quite a difference! What if Company X raised a Series Seed round with a valuation of $500k? Your conversion cap wouldn’t apply; your 100k would convert into equity at the $500k valuation, taking 20% equity in the company.
Conversion caps aren’t the only way to incentivize early investors – there is also the conversion discount. Simply put, a conversion discount allows a convertible note to convert to equity at a discount of the valuation of a round. Back to our example:
Instead of giving you a conversion cap on your convertible note, let’s say Company X gives you a conversion discount of 20%. Several months pass, and along comes the Series Seed round. The round values Company X at $2M. In this scenario, your 100k converts to equity at a valuation of $1.6M (2,000,000*0.8).
As a result, you would receive 6.25% equity in the company, as opposed to the 5% you would have received without a discount. What if the Series Seed round valued Company X at $500k? The conversion discount would still apply, and your $100k note would convert to equity at a valuation of $400k (500,000*0.8). You would receive 25% equity with the discount, instead of 20% without the discount.
Some convertible notes may have both a cap and a discount. In these cases, investors generally get to apply whichever will get them the next equity (but not both).