PS#024: Convertible Instruments
Now that we have a better understanding of priced rounds, it’s time to discuss convertible instruments.
If you haven’t yet, I recommend reading the previous issue of Preferred Shares on priced rounds and the series on How to Value a Startup to help frame this conversation.
Convertible structures have become more and more relevant for investors and founders over the past decade. As the venture capital industry has matured, these instruments have offered temporary solutions for aligning stakeholder incentives.
Over the next few issues, we’ll walk through the details of these instruments and how to use them (as investors and founders) in detail.
Today, we’ll start with…
What are they?
How do they work?
Different types
What are convertible instruments?
Convertible instruments are a type of investment designed to convert into a different type of investment at a defined event or date.
The name gives this one away a little bit, but these are agreements that investors use to (hopefully) eventually convert their capital into equity ownership.
To be a bit more specific, these instruments allow investors to provide capital to a startup upfront without defining a specific valuation (in direct contrast to the priced rounds) with the hope that they will convert into equity at a future event or date.
This is particularly useful when it’s more difficult for investors and founders to align on the valuation of a startup. It provides a temporary solution for aligning stakeholder incentives, which, as we discussed in previous issues, is the main purpose of a startup’s valuation.
Remember – valuation is all about aligning incentives. That’s the key takeaway. For both priced rounds and convertible instruments, it’s all about aligning stakeholder incentives.
How do they work?
As I mentioned, the reason for using a convertible instrument is that the founder and investor either can’t agree on a specific valuation or don’t want to make that decision right now.
This happens for a whole host of reasons, ranging from a startup being very early (i.e., pre-revenue or pre-product) to awaiting the achievement of certain milestones. We’ll get into these scenarios in more detail in future issues of Preferred Shares.
For now, to solve this specific valuation problem, we can use convertible instruments to create a range of potential valuation outcomes as opposed to one specific price.
This is done through three concepts…
Conversion
Valuation Cap
Discount Rate
Let’s talk about these concepts in more detail.
Conversion
In the definition of a convertible instrument, I used the phrase “at a defined event or date.” This is the first piece of the puzzle. We need to know when the instrument will convert to equity.
Typically, there are two options…
Qualified Financing
Maturity date
A Qualified Financing is a priced round as defined by the convertible instrument agreement. The agreement could require a certain amount be raised or type of security be used to make sure that the investors are converting into a legitimate financing round for the startup. This will all be defined in the agreement.
Maturity Date refers to the date at which this convertible instrument expires and “must” convert into equity ownership. I put “must” in quotes because this date often forces a conversation between the investor and the startup, as opposed to forcefully converting into equity. Although legally (depending on the terms), the investor could convert to equity at this time. Alternatively, the investor could extend the note or (depending on the structure) request the capital be paid back plus any accrued interest.
Valuation Cap
This the maximum valuation at which the convertible instrument will convert.
If there is a valuation cap on a convertible instrument, the investment will convert at the lower of the valuation cap or the qualified financing round valuation.
For example, if the valuation cap is a $10M post-money valuation and the post-money of the next round is a $20M (and it’s a qualified financing), then the investor with the convertible instrument will convert at the $10M valuation.
Discount Rate
A discount rate gives the holders of the convertible instrument a discount to the valuation of the priced round upon conversion.
For example, if we have a 20% discount rate, we will discount the next round’s valuation by that amount. So, using our previous scenario, if the next round is priced at a $20M post-money valuation, the investor holding the convertible instrument will convert at a $16M post-money valuation.
It’s important to note that you will often have both a valuation cap and a discount rate. In these situations, you will take the lower of the two valuations as the conversion price. We’ll talk about this in more detail as we get into specific structures.
What are the different types?
OK, now that we understand how convertible instruments work, what are the different types?
There are two main types of convertible instruments…
Convertible Notes
SAFEs
Convertible Notes
Convertible notes, also known as convertible promissory notes, are short-term debt instruments that convert to equity upon a predetermined conversion event or date.
SAFEs
SAFE stands for “Simple Agreement for Future Equity.”
The structure was introduced by Y Combinator in 2013 after observing founders struggling to raise capital for pre-revenue or pre-product startups. As the name suggests, it is a simpler agreement than a convertible note.
At a high level, these two instruments behave similarly, allowing investors and founders to put off the question of valuation until a later date, helping the company get funded sooner. However, convertible notes provide more structure and protection for investors.
Don’t worry, we’re going to dive into these two structures in more detail over the next few issues.
