Course: What Are Convertible Notes and Its Value To Your Business? | AD SME

Course: What Are Convertible Notes and Its Value To Your Business? 

By: Abu Dhabi SME Hub
Fundraising, Financial Planning

Ever wondered what a convertible note is and what benefits it holds?

If you’re watching this video, then you may be thinking about raising capital from investors using this type of financial instrument.

If that’s the case, you need to make sure you understand it thoroughly, so you can strike the best possible deal with potential investors.

Let’s start by understanding what a convertible note actually is.

 

Commonly used by global accelerators like Y Combinator, convertible notes, also known as SAFE (or “Simple Agreement for Future Equity”), offer a short-term debt that eventually converts into equity. 

Basically, if you have an idea and are looking for funding to get your business started, investors or venture capitalists will lend you money to launch your startup. 

With time, rather than having to pay the money back with interest, you will provide them with shares of preferred stock, based on the pre-agreed terms of the note.

So the big question is: why would you, as an early stage startup founder, issue a convertible note when you could directly issue shares of common stock to investors instead?

In a nutshell, it is often difficult for the founders and the investors to agree on a company valuation, especially at a pre-seed and seed stage, and as a result, on the percentage ownership the investor will receive for a given amount of money.

But at this stage, given your company is mainly comprised of yourself and your idea, how will you be able to value and sell parts of it to investors? 

For example, how many shares and what percentage of ownership would you give an investor in exchange for a $100,000 investment? 

The solution is to issue a convertible note.

The mechanism essentially allows issuers to defer valuation negotiations until a future round of equity financing.

When you issue a $100,000 convertible note to a VC, this amount will act as a loan – for the time being. 

Then, after a year or two, when your venture grows into a veritable company, with a lot more data points and insights, you will be able to value your startup more rigorously, and will be ready for another round of funding.

At this stage, the VC firm that had initially lent you $100,000 can obtain it back, in the form of shares in the company. 

That way, both you (as the entrepreneur) and the VC can skip the risk of incorrect company valuation that could have adverse consequences on later funding rounds.

Convertible notes are speedy, simple and cost-efficient. 

Issuing shares of stock is complex. It can take weeks to negotiate all the terms and documents - not to mention legal fees.

In contrast, you could close a convertible note round in a day or two by issuing a 2-3 page promissory note. 

Another great advantage of issuing convertible notes: you avoid giving holders any control. 

Typically, when they receive shares of stock, investors are granted certain significant control rights, including a board seat and veto rights with respect to certain corporate actions.

Convertible noteholders are rarely granted control rights, and have little power to sway the outcome of their investments. This leaves more control rights for the founders.

Now that you properly understand what a convertible note is, drop by the Hub to learn more about some “key terms & definitions ” to keep in mind, and for a deep dive on “Conversion Methodology.”

 

Once you've reviewed the course, please take our 2 minute feedback survey so we can understand your needs, and refine our content and value proposition.

Time to quiz your knowledge on Convertible notes!

To make discussions with investors easier, any founder should understand this basic financial instrument.

So how much do you already know about the topic? 

Test your knowledge by taking through this short quiz, and check the hub’s Convertible Note series to strengthen your knowledge on the topic.

Once you've reviewed the course, please take our 2 minute feedback survey so we can understand your needs, and refine our content and value proposition.

What is a convertible note?

1 / 7

Convertible notes usually work well for early stage founders because they…:

2 / 7

What is the main reason for issuing a Convertible Note?

3 / 7

Which from the below is not a key term to keep in mind, when dealing with the concept of convertible notes?

4 / 7

True or False? Conversion events typically lead to the repayment of investors through equity shares or loan repayment.

5 / 7

There are 3 different calculation methods to calculate the price per share to which a note converts at. Which from the below is not one of them?

6 / 7

What calculation method is the fairest to both the investor and the founder?

7 / 7

The convertible note’s maturity date, a qualifying financing round, or an exit event are 3 conversion events to keep in mind if you are raising capital using convertible notes.

One way for a startup to raise capital is to issue a convertible note to investors. 

These investors loan the company funds and have a right to recover their loan amount - usually with interest -  and convert it into shares - usually at a discounted rate- when certain pre-agreed trigger events occur. 

Now the question is when does the conversion take place? And what are the events that trigger this conversion?

Convertible notes will typically convert into shares or be subject to repayment upon 3 types of events:

1- The maturity date

2- A qualifying financing

3-Or an exit event
 

The Maturity Date is a pre-agreed date on which the loan amount must be repaid or converted if another trigger event has not occurred

If a qualifying financing or exit event does not occur before the maturity date, a noteholder can choose to either recover their loan amount or convert their loan amount into shares. 

If the noteholder decides to convert the loan into shares, the company will have to determine the noteholder’s number of shares by dividing the loan amount, plus any accrued interest, by a certain share price. 

A pre-agreed method of calculation set out in the convertible note terms will determine this share price. 

 

A Qualifying Financing is when the company raises a round of equity investment through the issue of shares to investors

If there is a qualifying financing, convertible notes will automatically convert into new shares. 

The company should calculate the number of shares to be issued to the noteholder on top of the company’s existing shares, and state the method used to calculate that number – we will dive into this in our next video. 

In a nutshell, the calculated price per share will determine the number of shares converted.

One thing to keep in mind is that the convertible note discount rate allows the noteholder to convert at a lower price per share.

And in the case where the convertible note includes a valuation cap, the price per share used for the conversion could be determined by reference to the valuation cap if it results in a lower price than the discounted price.

 

Finally, an Exit Event is when a company sells its shares and assets

The terms of your convertible notes will usually require the company to notify the noteholder and the noteholder can choose either to recover or convert, just like converting at the maturity date.

If the noteholder chooses to convert, the noteholder number of shares will be determined by dividing the loan amount- plus any interest- by the agreed share price, which is typically the fair market value of an ordinary share in the company at the time of the exit event. 

Again, in case the note includes a discount rate or valuation cap, the share price will be calculated in reference to whichever generates a lower price per share. 

In conclusion, keep these 3 conversion events in mind if you are raising capital using convertible notes, and understand their consequences.

Next, we’ll look into the conversion methods that can be used to convert convertible notes, starting with the “Pre-Money Conversion Method.

 

Once you've reviewed the course, please take our 2 minute feedback survey so we can understand your needs, and refine our content and value proposition.

When the time comes for you to convert your convertible note, you need to have a full understanding of the different conversion methods to be able to negotiate better terms with the investor.

To recap, a convertible note is a form of short-term debt that later converts into equity.

Its primary advantage is that it does not force the founder or the investor to determine the value of the company, especially at times when the company may still be an idea.

That valuation will usually be determined during your next equity round, most likely your seed or series A financing round, which triggers the conversion of the note from debt to equity.

So how exactly does the conversion happen? What basis and factors should be taken into account?

There are 3 different calculation methods to calculate the price per share to which a note converts at, each differing in the variable being fixed: the Pre-Money Method, Percentage-Ownership Method and the Dollar Invested Method.

Let’s focus on the first methodology: The pre-money method.

In this method, the pre-money valuation, or the company valuation that is determined during your equity round before receiving any financing, is the variable that gets fixed.

This allows you to calculate the price per share, which in turn helps you find the number of shares the convertible note holder and the new investor will eventually receive.

Let’s say you own 1 million shares in your company and you issued a $500,000 convertible note, with an agreed on 30%-discount rate upon conversion, with no interest rate or cap value to simplify the calculations.

After a year or two, you raise a Series A round of funding – $1 million from a new investor and your pre-money valuation was estimated to be around $10 million dollars.

So the question is, how many new shares will you need to issue for each, the investor and the note holder?

This method first finds the price per share by dividing the fixed variable (or your pre-money valuation) by the initial number of shares. In our case, we divide $10M by 1 million shares which results in $10 as the price per share.

Now that we have the price per share, we can calculate the number of shares, both the new investor and the convertible note holder will receive.

This new investor will receive shares for the value of $1 million - their initial investment - divided by the price per share we just calculated which is $10, to receive 100,000 shares.

For the convertible note holder, the same calculation applies but we need to take a pre-agreed discount rate into consideration.

In this case, the price per share would therefore be equivalent to the actual price per share with a 30% discount applied, or $10 multiplied by 0.7 resulting in $7 dollars per share. 

The note holder will receive the equivalent of $500,000 - the money they initially lent - divided by the DISCOUNTED price per share we just calculated which is $7.

This translates to about 71,428 shares, many more shares than the 50,000 shares they would have received had they been regular investors instead of noteholders 

Now, you, the founder, will still own 1 Million shares, while the investor will now own 100,000 shares and the note holder will own 71,428 shares.

In total, your company will now have 1,171,428 shares.

By dividing the number of shares for each shareholder by the total number of shares, you can calculate the ownership percentage allocated

to the founder: 85.4%

to the Investor: 8.5%

to the Note Holder: 6.1%

As explained, the pre-money method is one of the three methods you can use to convert the convertible note debt into equity.

Some investors prefer to use the Percentage-Ownership Method or the Dollar Invested Method instead, since the pre-money method is advantageous toward the founder and it is usually hard to convince investors to use this method, since it results in a higher ownership percentage for the company owner.

Check out the Hub to learn more about the other two methods.

Once you've reviewed the course, please take our 2 minute feedback survey so we can understand your needs, and refine our content and value proposition.

A convertible note will convert into equity at a future date, meaning that the investor loans money to an entrepreneur and receives equity in the company rather than payments on the principal plus interest. 

Here are some of the main and common terms to keep in mind as you explore the topic.  

Once you've reviewed the course, please take our 2 minute feedback survey so we can understand your needs, and refine our content and value proposition.

When the time comes for you to convert your convertible note, you need to have a full understanding of the different conversion methods to be able to negotiate better terms with the investor. 

There are 3 different calculation methods to calculate the price per share to which a note converts at, each differing in the variable being fixed: the Pre-Money Method, Percentage-Ownership Method, and the Dollar Invested Method.

In our previous video, we explained the Pre-Money Method, its advantages and disadvantages. 

In this video, we will dive into the second method:

The percentage ownership method:

The Percentage-Ownership Method is known as the investor-friendly method.  The fixed factor is the percentage ownership that the new investor is purchasing. Let’s take the same example from the pre-money method discussed previously.

You own 1 million shares in your company and you issued a $500,000 convertible note, with an agreed on 30% discount rate upon conversion, with no interest rate or cap value to simplify the calculations.  

After a year or two, you raise a Series A round of funding - $1 million from a new investor and your pre-money valuation was estimated to be $10 million dollars.

So the question is, how many new shares will you need to issue for each, the new investor and the note holder?

The percentage ownership method fixes the ownership amount of the new investor.

This amount is calculated in two steps:

Find your post-money valuation, which is equal to the pre-money valuation plus the new investment amount. Find the percentage ownership which is equal to the amount invested divided by the post-money valuation.

This means you agree to give away 9% equity to this new investor in exchange for the $1 million. This percentage is the starting point for your calculations. Now that you identified the percentage ownership for your series A investor, you need to find the price per share so that you can convert the note. 

This is the tricky part because you need to test multiple prices to get to the right one. 

But don’t worry; you can download the hub’s conversion calculator to do that.

By using our conversion calculator, we find that the price per share is $9.2858, and now we can calculate all the other variables. The number of shares to be issued to the new investor is the amount invested of $1Million divided by the price per share of $9.2858 which equals 107,692 new shares.

Now that we’ve taken care of the new investor, we also need to consider the note holder. The conversion price is $6.5 to the convertible note holder. When you do the math, this translates to approximately 76,922 shares. Now that you have issued 184,615 new shares, your total number of shares are 1,184,615.

Ownership is then distributed as follows between:

The Founder: 84.42%

The Note holder: 6.49%

And the Investor: 9.0%

The post money valuation of the company is $11Million dollar (Illustrate 1,184,615*9.29 = $11,000,000)

Investors usually push towards using this method as it works to their advantage. 

However, founders and owners can feel like this method is a tad unfair, hence method 3 – the Dollars-invested conversion method.

Check out the Hub to learn more about the other two methods.

Once you've reviewed the course, please take our 2 minute feedback survey so we can understand your needs, and refine our content and value proposition.

When the time comes for you to convert your convertible note, you need to have a full understanding of the different conversion methods to be able to negotiate better terms with the investor. 

There are 3 different calculation methods to calculate the price per share to which a note converts at, each differing in the variable being fixed.

In this video, we will dive into the third method, the dollars-invested method, often used as a compromise between the pre-money method and the percentage-ownership method. 

In the dollars-invested method, the fixed factor is the Effective post-money valuation of the company which takes into account the money invested by the note holder.  Effective post-money valuation is equal to the agreed-upon pre-money valuation (in our case $10 million) plus the dollars invested by the note holders (or $500,000) and the new investment of $1 million. At this stage we need to fix the price per share, using the Effective pre-money valuation. Assuming 1 million outstanding shares, the price per share is $10.5. Which is equal to the Effective pre-money valuation divided by the number of outstanding shares in this case $10.5 Million divided by 1 million equals $10.5.

Now that the price per share is fixed we can proceed with the calculation of the other variables.

New investors shares to be issued equals 95,238 shares 

Conversion price for the note holder is $7.35 since it takes into account the 30% discount rate.

New shares to be issued for the note holders equal 68,027 shares. (Illustrate by showing the equation. Note holder amount $500K divided by Price per share $7.35)

Now that you have issued 163,265 new shares, your total number of shares is 1,163,265

Ownership is then distributed as follows between

The Founder: 85.96%

The Note holder: 5.85%

The Investor: 8.19%

So what method should you use?

The pre-money method benefits the founder as they don’t get diluted as much as in the other methods.

The percentage ownership is the method that favors the investors and note holders.  And finally, the dollar invested method is a compromise between the two other methods, where everyone gets slightly diluted.  Generally, the percentage ownership is most often used, as new incoming investors have the most leverage. But founders and business owners must understand the difference between each method so they can negotiate a deal that works for all parties.

It may seem complicated at first, but don’t worry!

The hub has a handy template that you can use to test these different conversion methods and find what works best for your company!

 

Once you've reviewed the course, please take our 2 minute feedback survey so we can understand your needs, and refine our content and value proposition.

 

 

Both valuations are used to calculate the per-share price of the preferred stock sold in a financing round BUT the pre-money does not take into consideration any new money the company will receive in the pending preferred stock financing…whereas post-money valuation does factor in new money the company receives in the pending preferred stock financing.

Once you've reviewed the course, please take our 2 minute feedback survey so we can understand your needs, and refine our content and value proposition.

 

Are you thinking about raising funds using a convertible note?

If that’s the case, you should have a solid grasp of the financial instrument’s implications, and of the process, so you can negotiate and strike the best possible deal with your potential investors.

So what are the first steps to issue a convertible note? And how and when does one go about converting this investment into equity? 

All in all - are you really ready to get started on convertible notes?

Take this quiz to find out!

Once you've reviewed the course, please take our 2 minute feedback survey so we can understand your needs, and refine our content and value proposition.

You’re thinking of raising equity from external investors. A convertible note will be an appropriate financial instrument if you are…

1 / 6

You’re now ready to issue a convertible note. The first step is to:

2 / 6

Once you’ve issued your convertible note, what are major conversion events (resulting in equity distribution among investors) that you should keep in mind?

3 / 6

Your next qualified financing is:

4 / 6

You raise a Series A round of funding $1M at a valuation of $10M. You own 1M company shares and had previously issued a $500K convertible note (30% discount rate upon conversion, no interest rate or cap value.) How many new shares will you need to issue the founder, the investor and note holder?

5 / 6

Now’s the time for you to convert your convertible note. What method offers the most favourable investment terms to founders? (meaning founders don’t get diluted as much as in the other methods.)

6 / 6

Are you thinking about raising funds using a convertible note?                             
                                
If that’s the case, you should have a solid grasp of the financial instrument’s implications, and of the process, so you can negotiate and strike the best possible deal with your potential investors.

There are 3 different calculation methods to calculate the price per share to which a note converts at, each differing in the variable being fixed: the Pre-Money Method, Percentage-Ownership Method, and the Dollar Invested Method.    

• The pre-money method benefit the founder as they don’t get diluted as much as in the other methods.    
• The percentage ownership is the method that favors the investors and noteholders.    
• And finally, the dollar invested method is a compromise between the two other methods, where everyone gets slightly diluted.    
    
Generally, the percentage ownership is most often used, as new incoming investors have the most leverage. But founders and business owners must understand the difference between each method so they can negotiate a deal that works for all parties.    
    
It may seem complicated at first, but don’t worry!     
                           
Use this Convertible Note Calculator and find what works best for your company!

Once you've reviewed the course, please take our 2 minute feedback survey so we can understand your needs, and refine our content and value proposition.     

 

WHAT DID YOU THINK?

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Lessons

01. Convertible Notes: What are they?
02. Quiz: How much do you know about Convertible Notes?
03. Convertible Notes: Conversion Events
04. Convertible Notes: The Pre-Money Conversion Method
05. Convertible Notes: Key Terms & Definitions
06. Convertible Notes: The Percentage Ownership Method
07. Convertible Notes: The Dollars-Invested Method
08. Pre-Money vs. Post-Money Valuations: What is the difference?
09. Are you ready to use a Convertible Note?
10. Convertible Note Calculator
11. What did you think of the Convertible Notes course?
Lessons

Lessons

01. Convertible Notes: What are they?
02. Quiz: How much do you know about Convertible Notes?
03. Convertible Notes: Conversion Events
04. Convertible Notes: The Pre-Money Conversion Method
05. Convertible Notes: Key Terms & Definitions
06. Convertible Notes: The Percentage Ownership Method
07. Convertible Notes: The Dollars-Invested Method
08. Pre-Money vs. Post-Money Valuations: What is the difference?
09. Are you ready to use a Convertible Note?
10. Convertible Note Calculator
11. What did you think of the Convertible Notes course?

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