In return for $250K of seed capital, an angel investor is asking for a 20% discount, a 5% interest rate and a $4M cap using a standard convertible note agreement. What might these terms mean at series A when the note converts? In this post, we walk you through a simple, visual fundraising scenario.

*First, a little background on notes…*

Convertible notes establish a legal agreement between a startup, typically *seed* stage, and an investor. This agreement is structured as a loan (principal plus interest) but gives the investor the right to convert his or her debt into equity if, for example, the company raises a round of venture capital or sells the business.

The two main advantages of convertible notes are their legal simplicity and the fact that they do not *price* the company. They are a way for founders and seed stage investors to quickly agree on an investment and punt legal complexity and deliberation over company value to a later equity financing round.

*If you don’t manage your convertible notes carefully, it’s possible to end up giving away more equity than you had planned.*

Convertible notes, however, do have some important terms that make a difference at series A. It pays to understand the impact of these terms.

*Let’s look at our example…*

Time Capsule is a seed stage startup with a very simple equity structure; 2 founders, each with 3M shares. Here is the Time Capsule company cap table:

The cap table includes 2 standard convertible notes. The first note models a typical angel investor’s terms: $250k principal, 5% interest rate, 20% discount rate, and a $4M valuation cap. The second note shows almost identical terms but lowers the valuation cap to $2M.

*What’s the impact of the different cap sizes at series A?*

Let’s look at a fundraising scenario where the investors are offering $1M of investment on a $4M pre-money valuation. Below you see a LTSE Equity view of the round with just the first $4M capped note converting. The blue layer in the stack shows the impact of this note.

Here is more detail on the ownership structure after this round — The angel investor gets 588,235 shares or 6.25% of the company for their $4M capped note.

Let’s look at the same scenario but this time with the lower, $2M valuation cap note. After the round we see that the angel investor has earned 1M shares or 10% of the company.

Observe how the 2 notes, identical in all ways except for the cap amount, convert to significantly different numbers of shares and % ownership at series A.

*So what exactly is driving the difference?*

In the table above, we see the column *Effective Discount*. In the case of the $4M capped note this discount is 20% — the rate defined in the terms of the note. However, the $2M capped note has an effective discount of 50%. Where is this higher 50% discount coming from?

This higher value is actually being dictated by the note’s $2M cap. Because the valuation cap is set at $2M and the actual valuation is $4M, this cap will deliver a whopping 50% ($2M / $4M = 50%) of effective discount.

*Even though a note has both terms; the discount and the cap, only one term is ultimately utilized — whichever yields the greatest effective discount.*

What if the series A were to have a much higher pre-money valuation, e.g., $10M? How much equity would each of the 2 notes convert to? What difference do the 2 different cap amounts make in this scenario? What about a very small round of $2M or even $1M?

### Build your own cap table.

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### Further Reading

A very thorough overview of convertible note terms and how they play out. http://www.feld.com/archives/2011/10/how-convertible-debt-works.html

Great overview on notes, including convertible *equity* and a discussion of the “liquidation Windfall” problem. https://www.cooleygo.com/convertible-debt/