businessâConvertible Notesâ is what you most likely will hear the first time you get money for your first startup. They will give you cash asking to give them the convertible notes (or SAFE, which is very similar). Convertible notes are just a few pages of paper with two signatures at the bottom. Not too much to worry about. Itâs basically a contract between your startup and an investor. Letâs see what exactly it says and what you, as a founder, should pay attention to.
Why Not Equity?
The first question is why convertible notes? Why not just shares of stock? And what the hell are âshares of stockâ in the first place, right? Basically, there are two questions in each business or in any group activity, be it a new mobile app, a multi-national corporation or a bank robbery: 1) who is the boss, and 2) who gets the profit. To regulate that process âshares of stockâ were invented (if you know who invented them and when, let me know).
Say weâre planning to rob a bank create a Facebook killer. There are three of us. We print three papers, each of which says: âwhoever holds this paper has one vote and will get an equal part of the profit.â How does that sound? Each of us has the same paper. When itâs time to decide whether we use Java or PHP, we sit together, show our papers and vote. One vote for Java, two for PHPâthe decision is made, we will use PHP. When our startup finally dies and itâs time to decide what to do with the domain name, we sell it for $300 and give $100 to each holder of that paper, since there are just three papers and they have equal rights.
Thus, basically, each share of stock (this is an official name of that piece of paper) is a promise. A promise of some rights to vote and to make profit. The company (our startup) is making us a promise.
By the way, I can sell my share of stock to my friend. When itâs time to decide whether itâs Java or PHP, he will show up and vote. You may not like that, since you are seeing this dude for the first time, but you will have to obeyâheâs got that paper in his hands. Thatâs why shares of stock are also called equity. I can sell them just like I can sell my car. No matter who owns them, he or she has exactly the same rights as the original or the previous owner. They are assets.
Usually, there are millions or billions of shares of stock. When a company starts, it prints, say, a million of them, giving 200,000 to each co-founder and leaving 400,000 in the so-called âpool.â Later, an investor shows up and says: âI will put $500,000 to the bank account of the company and the company will print 300,000 more shares of stock for me.â The amount of shares âissuedâ is growing. For example, at the time of writing there are 7.91 billion shares with Microsoft name of them. Microsoft Corporation has been printing extra shares nine times after their IPO in 1986. When Bill Gates founded the company in April 1975, he had 500K shares, which were equal to 50% (Iâm guessing, do you know exact numbers?). Now he holds nearly 223M, which is just 2.8% of the total.
Now, the most annoying part. In reality, shares are not just pieces of paper with a few sentences on them, like in our example above. They are big legal documents that explain exactly how their holder can vote and exactly when and how he or she will get the profit. There are tons of legal clauses, which usually take weeks or months of discussions, between the company and investors. In reality, an investor says: âI will put $500,000 to the bank account of the company and the company will print 300,000 more shares of stock for me, terms and conditions of which my lawyer will discuss with you.â
If weâre talking about $500K, you will have no problem meeting that lawyers. However, if itâs just $25K⌠To make life easier for smaller investments, convertible notes were invented (well, there were a few other reasons). They are not equity. Investors that have convertible notes canât vote. They canât sell convertible notes and they canât get any profit from the company. So, what they are for then? Iâll explain in a minute. My goal so far was to show why young companies donât want to deal with shares of stockâbecause of greedy lawyers and, of course, the complexity of terms and conditions.
What are Convertible Notes?
They are just debts. They are not real investments. The company simply borrows money from an investor, promising to return them back. Why not just call them âmoney borrowing notes?â Because investors donât want their money back. They want equity.
So here is how it works. Say Iâm an investor, giving you $25K. You give me convertible notes. Then we wait. We wait until a more serious investor shows up and gives you a bigger sum of money. And itâs not just a matter of amount. Whatâs important is that this investor must get shares of stock from you. This will be called âequity financing.â You get finance and give away equity. When this happens, I show up, give you the convertible notes and you give me equity. On the same terms as you gave to that investor. I wonât send you my lawyers, you wonât discuss terms and conditions. You will just convert my notes to equity, on the same terms as agreed with that investor. Plain and simple.
A practical example. There is you and your co-founder. You guys have 1,000,000 shares of stock, 500K issued to each of you. I give you $25K, you give me convertible notes. In a few months, an investor comes in and your company issues 100,000 shares and sells them for $400,000 (your post a $400K check to the bank account of your company). This means that now there are 1,100,000 shares in total. You just sold 100K of them with the price of $4 per share. Now itâs time to convert my convertible notes. You will have to give me 6,250 shares and Iâll return you the notes. Thus, in the end, there will be 1,106,250 shares total and your companyâs post-money valuation will be $4,425,000. Got the math?
My shares will have exactly the same ârights, privileges, preferences and restrictionsâ as the shares you gave to the investor. And I wonât have an option to negotiate. I will just receive them and accept.
One more thing. If that investor will never show up, you still owe me $25K. A debt is a debt.
Now, since we know what convertible notes are for and how they work, letâs see what is important to pay attention to. There are just a few things, but they are really important.
The Valuation Cap
Letâs take a look again at the example above. You are selling 100,000 shares for $4. This technically means that the shares the two of you had, before the investor showed up, suddenly got some value, right? They were just papers, but now someone is ready to pay $4 for each of them.
This means that each of you, being a holder of 500K shares, owns equity for $2,000,000 (Iâm just multiplying 500K by $4). Also, this means that the valuation of the company is $4M. Iâm just multiplying the total amount of shares, which is a million, by the price of each share. This valuation is also called pre-money valuation (the valuation before that $400K landed at your bank account).
There is also a post-money valuation, which, as you can imagine, is calculated by multiplying total amount of shares after the investment, by their price. In this case, itâs $4.4M (1,100,000 by $4).
Letâs see what happened in our example with my $25K. I gave them to you when your company was very young. Your valuation was rather low, because you barely had any results. You needed small cash to pay your bills and fill your car with gas. The valuation was definitely lower than $4M. So why are you converting my notes as if at the time of my investment the valuation was already that high. Itâs not fair. I want to get more than 6,250 shares. I want my part to be calculated as if your valuation was, say, $500K. In that case, I will get 20,000 shares. Thatâs fair. The investor will pay $400K to get 100K shares, but I paid just $25K to get 20K of them. I earned more equity, because my risk was way higher.
To make that math happen, we put a âvaluation capâ into the convertible notes. There will be a clause that guarantees that no matter what will be that pre-money valuation at the moment of âequity financing,â in my formula it will stay $500K.
Obviously, for you as a founder, an ideal situation would be to have âno capâ convertible notes. Thatâs the first thing you should try to insist on: no cap! Most investors will smile back and disagree. Itâs only logical. Then, try to negotiate the value of the cap. Try to make it as big as possible.
But remember, itâs better to have money and a small cap than a big cap and no money. Does it sound too obvious?
The Discount
Here is the same problem, but a different instrument. Again, as an investor, I donât like that youâre selling me shares for $4. This is the price you are giving to the investor who came way later than myself. Their risks are way lower. I want a discount!
We can put a clause into convertible notes, which will say that the price for me will be same as for the investor at the moment of âequity financing,â minus, say, a 50% discount.
Again, as a founder, you should insist on âno discountâ convertible notes. Will I agree? Probably not. Especially if there is no cap. Try to negotiate a smaller discount. Maybe 10%, just to give me a feeling of appreciation.
The Interest
Remember that by signing convertible notes and sending you cash, investors are basically lending you money. You owe that $25K to them. And some of them will ask for an interest. And the interest may be payable annually. Say, 5% per year. That means that you will have to send them a check for $1,250 every year, no matter how your startup is doing.
Itâs only logical for them, but is totally against you. Do not agree to pay any interest.
The Maturity Date
Some investors are ready to wait until that âequity financingâ moment for as much as necessary. Others may demand you to pay them back on a so called âmaturity date.â Pay cash, with the interest. This date will usually be somewhere far ahead, like âthree years from now.â But donât feel too relaxed, this day will come faster than you expect.
Try not to give convertible notes with a maturity date to anyone.
SAFE is a form of convertible notes, introduced by YC, which doesnât have a maturity date at all. This technically means that you donât have to pay them anything back. Well, there is only one situation when you have to payâin case your startup dies. In that case, you will have to pay investors as much as you can, using the cash you still have in your bank account. Most likely there will be nothing, so donât worry.
There are other less usual or less important elements of convertible notes, which you most likely wonât ever see or should not worry about, like pro-data rights, for example. Just focus on the things listed above and you will be good.
