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Convertible Debt – The Discount

As we start our convertible debt series, we’ll focus on the discount. Remember that a convertible debt deal doesn’t purchase equity in your company. Instead, it’s simply a loan that has the ability to convert to equity based on some future financing event (we’ll tackle the conversion mechanics in a later post.)

Until recently, we had never seen a convertible debt deal that didn’t convert at a discount to the next financing round. Given some of the excited market conditions at the seed stage, we’ve heard of convertible deals with no discount, but view this as irregular and not sustainable over the long term.

The idea behind the discount is that investors should get, or require, more upside than just the interest rate associated with the debt for the risk that they are taking by investing early. These investors aren’t banks – they are planning to own equity in the company, but are simply deferring the price discussion to the next financing.

So how does the discount work? There are two approaches – the “discounted price to the next round” or “warrants.” We are only going to focus on the discounted price to the next round approach, as it’s much simpler and better oriented for a seed round investment. We’ll cover warrants in a later post in the series.

For the discounted price to the next round, you might see something like this in the legal documents:

“This Note shall automatically convert in whole without any further action by the Holders into such Equity Securities at a conversion price equal to eighty percent (80%) of the price per share paid by the Investors purchasing the Equity Securities on the same terms and conditions as given to the Investors.”

This means that if your next round investors are paying $1.00 per share, then the note will convert into the same shares at a 20% discount, or $0.80 per share. For example, if you have a $100,000 convertible note, it’ll purchase 125,000 shares ($100,000 / $0.80) whereas the new equity investor will get 100,000 shares for his investment of $100,000 ($100,000 / $1.00).

The range of discounts we typically see is 10-30% with 20% being the most common. While occasionally you’ll see a discount that increases over time (e.g. 10% if the round closes in 90 days, 20% if it takes longer), we generally recommend entrepreneurs (and investors) keep this simple – it is the seed round, after all.

September 15th, 2011 by     Categories: Convertible Debt     Tags: , ,
  • http://www.facebook.com/drtonyratliff Tony Ratliff

    One of the last deals my group of investors looked at wanted to use this convertible note strategy and I personally thought it was a horrible idea. Admittedly, I’m new to the Angel/VC world, but I passed because I didn’t understand the financing structure or the reasoning behind it.

    I see the greatest advantage as being to the Founder because they get to avoid setting an early stage “valuation”, but I don’t understand or see any advantage to the VC or angel investor.

    What am I missing here?  Why would I want to wait until the valuation goes up to “convert”? Aren’t my “early shares” just as “at risk” as my loan –  unless the Founder somehow puts up a personal guarantee or something? If the company fails won’t I lose my “loan” money anyway? 

    As investors, we are not looking for interest on our money, we’re probably looking for a 3-5x at a minimum. Why would we want to write a note and risk the Capital? Isn’t there a lot of “opportunity cost” associated with this for the VC?

    • http://www.feld.com bfeld

      As we mentioned in the post, the main driver is that you use the convert to defer the pricing discussion until a more substantive financing. If a small amount of money is going into the company (say, less than $250k), then it’s probably not worth over-negotiating either way. 

      As Basil points out, this is rarely advantageous to the investor, but it’s often “close enough” especially for an entrepreneur-friendly angel investor.

  • http://www.angelblog.net basilpeters

    IMO, in almost every situation the convertible ends up not being fair to the angel investors.

    Either the discount is too low or the fact that it’s not really debt means that the next round investors will most likely reduce the angel’s returns below a fair value.

    To be fair, the discount has to be higher especially if the conversion is over 90 days.

    More at: http://www.angelblog.net/Convertible_Note.html

    • http://www.feld.com bfeld

      When I did angel investments from 1994 – 1996, I rarely did convertible notes. I sucked it up and priced the round, especially when I was the lead angel. I can’t remember a situation where the entrepreneur resisted this if I was willing to invest.

      In my second wave of angel investing (2006 – 2007) I saw a lot more convertible notes. When I reflect on them, I was fine with a 20% – 30% discount and a cap. It was always respected by the next round investor and I felt like I got a fair deal.

      The real asymmetry comes with an uncapped note, which we’ll discuss later in this series. This came intro fashion in the last year and makes little sense to me from an investor’s perspective.

      As a VC, I always try to be respectful of the terms of the convertible debt, but if they are too aggressive to the angels (which often happens), I’ll challenge that in the context of an investment. I believe a 50% – 75% discount is much too aggressive.

      • http://www.angelblog.net basilpeters

        Thanks for your thoughtful reply and thanks for taking on the whole
        project of trying to develop some best practices in this area.

         

        My experience is similar. I didn’t see convertibles in the 1994 – 1999 range.
        It wasn’t until the tech bubble burst that angels in my area started thinking
        about convertibles. Their motivation then was downside protection.

         

        In the early 2000s a few of us met at workshops and conferences and
        said “Hey, what’s all this interest in convertibles? That’s just not a fair way
        to invest (as it was being done then). I think I wrote the first version of the
        post I referred to above around 2003.

         

        Through working with the Angel Capital Association, and what is now
        called the Angel Resource Institute, Bill Payne and others felt we had pretty
        much eradicated angel convertibles. I saw very few in 2004 – 2006.

         

        Then, as you say, the idea seemed to pop back into favor again in 2006 –
        2007. This was a really big surprise to us. We are all still scratching our
        heads about it.

         

        Brad, I think we have an opportunity here to help a lot of people by
        shining a light on this.

         

        If you are game, I’d like to start by saying that your reputation is as
        a fundamentally fair guy. I think you’d agree that in early-stage investment,
        you make the most money if the investment agreement is “fair and equitable” to
        both sides. I suggest that be our guiding principle here (and for all early
        stage investors).

         

        Second, I think you would agree that to be a competitive asset class,
        that an angel portfolio has to deliver something in the range of 25% overall to
        account for the inherent risk. This is of course, similar to VC numbers because
        risk and reward are universal.

         

        I’m sure you are also aware of how the math in VC and angel portfolios
        works. In simple terms, all of the returns come from 10 to 20% of the
        investments. About 20% go sideways and about 60% crater.

         

        If you spend a while in an Excel spreadsheet, I believe the inescapable
        conclusion is that the fair discount on a convertible has to be quite a bit
        higher than 50 – 75% per year. And to be clear, I am saying that this is simply
        a matter of math – not, in any way, opinion.

         

        Then assuming we agree on the math, let me add that I also agree with
        you that almost everyone will agree with your statement: “I believe a 50% – 75% discount is much too aggressive.”

         

        So, IMO what is fundamentally “fair and equitable” is not
        psychologically acceptable. Or at least market acceptable. As a result, I
        continue to believe that convertibles, as they are most often applied, are
        mathematically unfair to the investors and therefore should be avoided.

         

        I agree that caps can, in some rare cases, make convertibles fair.

         

        There are also a couple of underlying statistically realities I haven’t
        fully described above. I think they are pretty obvious, but if you, or your
        readers are really interested, I’d be pleased to dig deeper.

        Thanks again for your contributions to the entrepreneurial economy.

        • JamesHRH

          Basil – being on the entrepreneur side of the table, I would much rather have a valuation set. I like Brad’s comment about ‘sucking it up and setting a valuation’. My assumption is that a pro early stage investor sets a price; am amateur does not. The amateur should pay for not being a pro, which it seems they do (going with your math here).

          • http://www.angelblog.net basilpeters

            James: Yes - I believe its better for both the entrepreneurs and investors to set a realistic valuation.

  • Pete Griffiths

    Brad – if the note is sizeable – say $750K and is primarily financed by friends and family would you nonetheless advise bringing in one or two angels to help with the next round – which is pretty much destined to be institutional?  Does it matter to you as a VC whether there are angels involved so long as the terms of the note ‘normal?’  Does the amount of the note matter so long as it does not likely distort any subsequent valuation?

    • http://www.feld.com bfeld

      It doesn’t really matter to me who is in the note as long as the terms are “normal”.

      • Pete Griffiths

        Thanks

  • http://thegongshow.tumblr.com andrewparker

    I don’t mean to make this more complicated than you would like for the first post in this series, but in general, do you see the interest also being given the same discount rate?

    To return to your hypothetical example:
    - New investors paying $1.00/sh.
    - $100K note outstanding from angel investors.  
    - To make the math easy, this new financing is happening exactly 1 year after the note was issued.
    - Note has 8% interest rate.

    So, $108,000 is being converted into equity in this round.  $100K converting at $0.80/sh is perfectly clear in your example.  How about the $8k of interest?  Does it convert at $1.00 or at $0.80?

    • http://www.feld.com bfeld

      Interest usually converts at the same discount. In the grand scheme of things it’s generally noise since the interest is relatively small.

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  • Benard Maingi

    clear and to the point