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.