19 Jul “Interest”ing Point about Convertible Notes
So, you’re a start-up using convertible notes to raise money from investors and want to do all you can to attract investors. You know that the investors primarily focus on the discount percentage to the next round of equity (typically 20%). You also know that offering higher interest rates on convertible notes attract investors. But what you may not know is how drastically the interest rate impacts the investment on a convertible note and how much you and your investors will suffer or benefit if you don’t understand the ramifications of the early choices you make about the interest rate.
Let me tell you a story of a typical company to illustrate why the interest rate is so important.
Techfast, Inc. is a company started by first time entrepreneurs who are seeking investments for their start-up but need the money quickly to take advantage of a contract with a large, on-line retailer. They want to use a convertible note because they have heard that convertible notes help finalize funding more quickly. They decide they want to give investors a 10% interest rate on their 3 year convertible note to help attract investors (because the 10% interest rate is higher than a more typical 5% interest rate). Techfast completes the funding round with this convertible note and has the money to take advantage of the opportunity with the large, on-line retailer. However, the company grows more slowly than expected and is now 2 ½ years from the date they closed their convertible note round. They are finally able to find a venture capital firm to invest at a price of $1.00 per share. As they look at the conversion rates of the convertible notes, they realize that Ted, a convertible note holder, will actually get significantly more shares than they expected because the accrued interest on the convertible note is not paid but is actually used as additional purchase price for the shares as illustrated below:
|10% Interest Example||Ted’s Initial Investment||Amount of interest to convert (2.5 years of 10% interest on $100K)||20% Discount off Next Round Price of $1||Ted’s Total Shares ($125K/$.80 per share)|
|SCENARIO #2||SCENARIO #2||SCENARIO #2||SCENARIO #2||SCENARIO #2|
|5% Interest Example||Ted’s Initial Investment||Amount of interest to convert (2.5 years of 5% interest on $100K)||20% Discount off Next Round Price of $1||Ted’s Total Shares ($112.5K/$.80 per share)|
By using the 10% interest rate rather than 5%, Techfast gave Ted 15,625 shares, an 11% increase in shares on conversion!
As you can see by this example, the interest rate you place on your convertible note can have a drastic impact on the total number of shares a convertible note investor receives on note conversion and you need to carefully consider this issue when determining the terms of the convertible note.
The good news is that you can avoid these issues by understanding a few very important points about interest rates.
First, the discount rate you give and the interest rate BOTH have an effect on the number of shares issued through conversion at the next round of equity. As pointed out above, all investors and founders tend to get overly focused on the discount rate to the next round of equity and completely miss the significant impact that the interest rate can also have on the number of shares they issue. You definitely need to think through the impact of the discount rate to the next round of equity but don’t forget to give some attention to the interest rate.
Second, the interest rate, because it is not paid and just accrues and converts, acts as additional principal to be converted on the next round of equity, which can have a significant impact on the amount of equity you are selling of the company. As I have seen with every serial entrepreneur after their first success, they are much more cautious about giving out equity the second time because they realize the value of that equity has a significant impact on their financial reward for all the work and risk they have put in on a successful exit. While you may need the money now, be careful about giving away more of the company then necessary to in order to get funding.
Don’t forget to focus on the interest rate, and its effects on the amount of equity you are offering, as you put the terms of the convertible note together!