Seed-stage start-up financing (Part 1): convertible note

Étienne Brassard and Guillaume Synnott

As entrepreneurs and investors know, seed-stage start-ups are synonymous with high risk for investors. However, that does not mean that all of them avoid investing in a project they believe in, and some, often “angel investors”, do decide to get involved. The convertible note is one of the most common and most popular debt financing instruments for a seed-stage start‑up. Its popularity is a result of its simplicity and low cost, and its speed in comparison to traditional methods of raising capital. It also defers issues relating to valuation of the enterprise to the next round of equity financing.

The basic features of a convertible note include those of a standard loan agreement, such as a term (generally between six and 36 months), an interest rate (generally between 4% and 12% per annum), and positive and/or negative covenants. Convertible debt can also be secured (e.g. against intellectual property), but is most often seen as unsecured.

Automatic and voluntary conversion

A convertible note will generally provide for automatic conversion into shares of the company when an equity financing round takes place in which the company raises a minimum amount of capital. This is generally referred to as qualified financing. The minimum amount must be negotiated by the investor and the company.

A convertible note will sometimes provide a voluntary conversion mechanism, allowing the investor to convert the loan into equity prior to qualified financing or the maturity date. In that case, the investor will not generally be given the benefit of a discount or valuation cap. Before agreeing to a voluntary conversion right, founders should bear in mind that such a conversion may trigger legal consequences in advance of a financing round when that is not the ideal time.

Valuation cap and discount

Other investor-favourable features of convertible notes are valuation caps and discounts, their purpose being to provide early investors with a higher return on investment than interest on a loan, given the risk of investing at the seed stage.

A valuation cap sets a limit on the price of converting the loan into shares of the company. Ordinarily, an investor will be offered either a discount or a valuation cap, depending on which provides them with the best share price.

In an automatic conversion, the discount allows for conversion of the full amount of the loan (including both principal and interest) into shares of the same type as the next investor’s. However, the share price under the conversion will be lower than the price paid by the next investor. For example, at a 20% discount, if the next investors pay $10.00 per share, the early investor will pay $8.00 per share for the same share. The discount rate is negotiated by the early investor and the company, and is generally between 10% and 30%. It is ordinarily applied when the share value is lower than the valuation cap.

In practice, the early investor’s loan will be converted to the lower of the valuation cap and the pre-money value of the share.

An investor invests $100,000 at the seed stage, using a convertible note with a pre‑money valuation capped at $3M and a 20% discount rate

Example 1

One year later, a financing round (Series A) results in capital being raised from a risk capital firm that subscribes on the following terms: a pre-money value of $6M with a purchase price of $10.00 per share

Price per share with the discount: $10.00 x (100% – 20%) = $8.00

Price per share with the cap: $10.000 x ($3M ÷ $6M) = $5.00

The convertible note would be converted at $5.00 per share: $100,000 ÷ $5.00 = 20,000 preferred shares (Series A) (which is a latent return of 100%)

Example 2

One year later, a financing round (Series A) results in capital being raised from a risk capital firm that subscribes on the following terms: a pre-money value of $3.5M with a purchase price of $10.00 per share

Price per share with the discount: $10.00 x (100% – 20%) = $8.00

Price per share with the cap: $10.000 x ($3M ÷ $3.5M) = $8.57

The convertible note would be converted at $8.00 per share: $100,000 ÷ $8.00 = 12,500 preferred shares (Series A) (which is a latent return of 20%)

Issues relating to securities regulations

Start-ups that want to use convertible notes (or any type of convertible securities) are strongly advised to consult a legal advisor to ensure that the convertible note is issued in accordance with a prospectus exemption that is in effect under the applicable securities legislation.

The convertible note therefore represents a useful financing instrument that is generally attractive for founders and potentially offers positive returns on investment at a discounted price. It is one of the most popular financing instruments available to seed-stage start‑ups today, but it would still be worth observing how their popularity may be affected by the introduction of new industry initiatives such as the SAFE [Simple Agreement for Future Equity] or the KISS [Keep It Simple Security].


  1. This article is based on part of the following article by the same authors: “Early-Growth Financing and Capital Structure, Guiding Your Company to the Next Level” in LEXPERT, online: http://www.lexpert.ca/article/early-growth-financing-and-capital-structure/?p=13%7C56&sitecode=CCCA.