fbpx

What is a Convertible Instrument?

By Dan Offner

StartupProgram.com

Whether it’s your Uncle Bob’s pocket money from selling a Chevy or a more significant investment from your friend’s professor’s brother who happens to be an angel investor, early investments in your startup may come from surprising places. Regardless of where the money comes from, one of the most common methods to document the investment for pre-revenue and pre-product startups is  by using some form of convertible instrument.  

What is a Convertible Instrument? 

Broadly, a convertible instrument is any security that can or will be converted into a different type of security.  In the startup world, there are multiple types of convertibles that are now market tools used to raise money early in a company’s life. 

Why have Convertible Instruments Become Popular with Startups?

Convertible instruments have become popular for startups and are frequently used for their first round (a.k.a. “Seed Round”) of financing. One of the main reasons convertible instruments have become so popular is that they are generally used in cheaper rounds and avoid one of the most perplexing ideas of our time: how to value an idea.  Angel investors are likely friends and family members, and angels are often affluent individuals looking to invest in and influence the startup. The dollar amounts in both these rounds are usually much smaller than what’s seen later in Series A Preferred Stock Financing, which costs a whole lot more in legal fees than issuing a convertible instrument. 

Convertible instruments are also used by founders for self-financing, ensuring that their out-of-pocket investments are put into the company correctly. From a financial standpoint, a founder’s funding via a convertible instrument is no different than other seed investment made with convertibles. 

Kinds of Convertible Instruments: SAFEs and Notes

Two of the more popular convertible instruments used by startups are the convertible promissory note (convertible note) and the Simple Agreement for Future Equity (SAFE). 

A convertible note is a debt instrument, meaning it is a loan, much like your car loan; it has a maturity date and accrues interest until it is paid off. Unlike your car loan, a convertible note can be paid off in cash or converted into preferred stock. One of the downsides of a convertible note is that when the maturity date is reached (and if the note has not already converted to shares), an investor can request their money back, plus the accrued interest. This can lead investors to file lawsuits in courts to collect on the principal and accrued interest on the loan, another downside of a convertible note.  More often, though, an investor will not cash out and instead will simply amend the terms of the note with a new maturity date, maintaining their investment in the company and hoping for the larger payoff of a big exit in the future. 

A SAFE converts in the same way as a convertible note (see below), but it is not a debt instrument, doesn’t have a maturity date and does not accrue interest like a convertible note.  Thus, a SAFE is more favorable to a company because an investor does not have the expectation of being paid their money back or having their SAFE converted by the maturity date,  as they do with a convertible note.  SAFEs, invented by startup accelerator Y Combinator in 2013, were created to simplify early startup investing. Without maturity dates or interest, and with much simpler legal terms, a SAFE is a more streamlined vehicle for startup investment.

Valuation Caps and Discounts in Convertible Instruments 

Both SAFEs and convertible notes have specific negotiated terms about how and when the instrument will convert into capital stock of the company.  The most common mechanisms include valuation caps or discounts. It is also common to have both a valuation cap and discount in a SAFE since it gives the investor upside and downside protection.

A valuation cap sets a maximum limit on the value of the company when the note or SAFE converts at a priced equity round (such as a Series A round).  It is assumed valuation in some sense and was designed to protect the investors from being diluted to nothing in the event of runaway valuation in the Series A round.  For example, if a company is valued at $10 million dollars at a Series A round, the holder of a note with a $2 million valuation cap will see her note convert at the $2 million limit, not the $10 million valuation. 

A discount is simply a percentage off the share per share price paid by the next preferred stock financing round. So, if the Series A investors pay a per share share price of  $10, a SAFE holder with a negotiated discount of 20% will pay $8 per share. 

If a convertible carries both a cap and a discount, the SAFE or note will convert at the lower of the two share prices, allowing the investor to purchase the most stock for her investment. 

What Triggers the Conversion of a Convertible Instrument?

For startup financing, there generally are three types of events that are set to trigger the conversion of a convertible note or SAFE: 

  • A “qualified round of financing,” most commonly defined as a sale off preferred stock,  for example a Series A. 
  • A sale or merger of the company.
  • The company’s initial public offering or direct listing.  

Additionally, although uncommon these days, some convertible notes convert upon the maturity date.

Sign Up for SUP Academy to See Examples of How Convertible Instruments Work

StartupProgram.com Academy includes detailed lessons on using convertible instruments, including walkthroughs on how share prices are determined with valuation caps and discounts applied. 

Perhaps more importantly, though, SUP Academy will show you how these early investments must be negotiated carefully, as they may set up a founder for problems later – including losing control of the company when a Series A round comes along. 

Additionally, StartupProgram.com’s cap tables are the perfect tool for modeling and tracking convertible notes and SAFEs, and how they affect share prices and dilution throughout the growth of a startup. 

Together, StartupProgram.com Academy and cap tables will help ensure you’re handling your early investments the right way. 

Sign up for our startup newsletter

SUP is a complete startup formation toolkit, including your own legal portal, automated document generation, our proprietary cap tables, and SUP Academy, our exclusive online learning curriculum. And it’s all backed by an experienced venture law firm, O&A, P.C.

If you're ready,
let's get started.

Startup tips, delivered.
Subscribe to the SUP newsletter for exclusive articles on establishing and running a startup  seeking venture capital.

Log in to SUP

If you’re already enrolled in SUP, you can log in to SUP Academy for your courses, or to your legal portal to generate forms, contact an attorney, and other tasks.

Not part of SUP yet? Learn more and sign up here.

Drop us a line

Have some questions about StartupProgram.com? Shoot us an email and we’ll get back to you.