Convertible note financing has become a popular vehicle for early stage companies raising capital. As we discussed previously in this series, the preference for debt over equity is attributable to multiple factors, including a faster time to close, fewer deal points to negotiate and the opportunity to raise capital while delaying the company's valuation until a later equity round.
In this post we will discuss two sweeteners commonly offered to debt investors, known as the "discount" and the "cap." Founders negotiating convertible notes should take care to fully understand the economic nuances of these key terms.
- A discount permits the noteholder to convert the note into preferred stock at a price below that paid by preferred investors in the next equity round. For example, if preferred stock is offered to new investors at $1/share, a note converting at a 20% discount would allow the noteholder to purchase the same equity at $0.80/share.
- A cap limits the company's implied valuation at the time of the equity financing. For example, a $5 million cap means that even if the value of the company in the equity round triggering the note conversion is $10 million, the note will convert as if the company is worth $5 million. The practical effect is a backstop on runaway valuation; noteholders are guaranteed a minimum ownership percentage upon conversion, even if the company's value skyrockets in the meantime.
The discount is generally considered a premium (a "stock ownership premium") for taking on the increased risk of an early seed investment. But discounts create another, less obvious premium that founders and investors should recognize when negotiating convertible notes: the "liquidation preference premium."
Preferred stock frequently carries a liquidation preference. A "1x" liquidation preference means that the company will pay preferred stockholders an amount equal to their initial investment (as determined by the original purchase price for the preferred stock) upon certain exit scenarios – before anything is paid on the common stock. When discounts and liquidation preferences intersect, investors can doubly benefit. And once a cap is mixed in, the results may be far richer for the investor than the founder intended.
Below are two examples of how investors can benefit from these premiums. These examples use assumptions modeled on the results of our informal survey that Fox Rothschild attorney Matthew Kittay analyzed in our most recent installment here. According to the survey, the most frequent discount is the "standard" 20% (28% of deals). 30% of deals do not include caps; for those notes that do include caps, the caps most commonly fall in the $3 million – $5 million range.
Discount Without Cap
Assume an investor invests $100,000 in exchange for a $100,000 promissory note. The note converts at a 20% discount and is uncapped. In the following equity round, the company sells preferred stock at $1/share, with a 1x liquidation preference.
Upon the equity financing, the note will convert at $0.80/share into 125,000 shares of preferred stock ($100,000/$0.80), . In this scenario, the stock ownership premium is 25,000 shares of preferred stock. Upon exit, the investor will receive a liquidation preference of $125,000 (based on the original purchase price of $1/share). The liquidation preference premium is $25,000. For its convertible note investment, the investor has received a greater stock ownership position than if it had instead invested in the equity financing; and it has received $125,000 for stock purchased for $100,000. Of course, the investor's liquidation preference premium also diverts funds in which the company's other equity holders would otherwise participate.
Discount + Capped Note
Now, let's assume the $100,000 note includes a $5 million valuation cap and the company's valuation at the time of the equity financing is $10 million. The note now converts at $0.50 per share (half that paid by the equity investors), for 200,000 shares of preferred stock. The liquidation preference premium jumps accordingly to $100,000 – a payout of $200,000 for an initial investment of $100,000.
Depending on the deal and the perspective of the parties involved, the liquidation preference premium may seem like fair compensation for the additional risk of an early investment – or it may seem like a windfall. Understanding how common economic deal points drive the "hidden" liquidation preference premium empowers the parties to negotiate the issue and more successfully obtain the intended result.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.