A convertible note is a commonly used debt instrument that startups utilize to raise initial (seed) funding. When a loan is made in the seed round, there are no shares to issue since a company’s valuation is usually not ascertainable until you reach Series A. The note is a loan from early stage investors, which converts to equity (shares) upon the company receiving the qualified financing in the Series A round.
The discount is the agreed-to price per share that the noteholder can buy shares at, once the Series A funding is obtained. The price of the shares after financing will be discounted to a lower price for the noteholder since they took the greatest risk by providing funding early on.
The usual discount rate is 20%, though it can vary anywhere between 10-25%. So the way it works is like this:
- Angel (seed) investor offers $100,000 to Company in exchange for a convertible note (loan). There are no shares to be issued at this point.
- The note provides for a 20% discount upon conversion.
- Conversion is automatic upon the triggering event, which is Company successfully securing Series A funding.
- Series A closes with $1 million preferred stock.
- Noteholder/angel has 125,000 shares because of the 20% discount: $100,000/0.80
- Note is extinguished as a result of converting to equity (stock).
You can find out more about the terms that are commonly found in convertible debt notes here. For additional information about convertible notes and startup costs in general, there’s a good list of sources here.
Because of some of the challenges presented by convertible debt notes - namely, interest and maturity date provisions - a relatively new instrument called convertible equity was developed a couple of years ago. These are being increasingly used as an attractive alternative to traditional convertible notes. They essentially aim for the same result (automatic conversion of the loan to stock upon receiving qualified Series A funding), but they reduce the risk of a startup’s bankruptcy in the event that the Series A funding isn’t secured by the maturity date. You can learn more about how convertible equity works here.