Broadly speaking, a convertible note holder is lending money to the company in return for the right to convert the note to equity under certain circumstances, for instance, a liquidity event. A convertible note will typically include a discount as an incentive for the lender. This is a percentage discount (usually around 10-25%) to the share price at which the convertible note will ‘convert’ to shares. It may also contain a valuation cap. We discuss both these concepts below.

What is the Impact of a Discount in a Convertible Note?

Consider a convertible note with a face value of \$1,000 that does not accrue interest and has a discount of 20%. This means that the investor has lent \$1,000, will not receive any interest on that loan, and when it is time for that note to convert, it will do so at a discount of 20% to the share price.

If, at a liquidity event, the company share price is \$1.00, the investor’s discount will mean that the ‘conversion share price’ is actually \$0.80 (which is \$1.00 multiplied by the 20% discount). This means that the investor will receive, on conversion, \$1,000 worth of shares (this is the investor’s investment amount) at \$0.80 per share – 1,250 shares. But, given the share price is actually \$1.00, the investor holds shares worth \$1,250 (when the investor only paid \$1,000 for those shares). For those who prefer formulae:

Example 1

Face Value (FV) = \$1,000

Discount (D) = 20%

Share price at liquidity event (SP) = \$1.00

Conversion share price (CSP) = SP * (1 – D) = \$0.80

Number of conversion shares (N) = FV/CSP = 1,250

Value of shares (V) = N*SP = \$1,250

The idea of the discount is that the note holder receives more shares for their note than they would without the discount. This works with a relatively stable share price.

But consider a situation where the share price has increased significantly — where does that leave the note holder? The convertible note holder is no better off. They still get a discount on the share price, but because the share price is higher, they hold fewer shares.

If we use the above example but change the share price at the liquidity event from \$1.00 to \$10.00, we will see from the formulae below that although the number of shares (N) changes, the value of shares (V) stays the same. The difference between the two examples is shown in bold:

Example 2

Face Value (FV) = \$1,000

Discount (D) = 20%

Share price at liquidity event (SP) = \$10.00

Conversion share price (CSP) = SP * (1 – D) = \$8.00

Number of conversion shares (N) = FV/CSP = 125

Value of shares (V) = N*SP = \$1,250

The convertible note holder who has lent money to a company may feel aggrieved that they have not participated in the company’s success in the same way they would have if they had invested in shares from the start. Although the business has grown, the value of their note has not.

This is where valuation caps come in.

How Does a Valuation Cap Work?

A cap on a convertible note sets a maximum company valuation that the convertible note can convert into equity. Investors of a convertible note usually get converted at the lesser of the valuation of the next qualified funding round and the cap. For example, if the convertible note cap is \$5 million and that note is set to convert at the next funding round that values the company at \$7 million, the convertible note will convert at the \$5 million valuation. But if the next funding round values the company at \$3 million, the convertible note will convert at \$3 million.

If we continue with our example above but put a valuation cap (for ease, on the price per share rather than the valuation of the company) of \$5.00 per share and the actual share price is \$10.00, the investor can share in the company’s growth. We have deleted the discount in the example below but discuss this in the next section:

Example 3

Face Value (FV) = \$1,000

Share price at liquidity event (SP) = \$10.00

Valuation Cap (C): \$5.00

Number of conversion shares (N) = FV/C = 200

Value of shares (V) = N*SP = \$2,000

How Do Caps and Discounts Interact?

If a convertible note has both a cap and a discount, it is important to understand how the two will interact. Generally speaking, the number of ‘conversion shares’ will simply be the higher of the two.

Looking at our examples above, Example 2 gave the investor 125 conversion shares whereas Example 3 gave the investor 200 conversion shares. In this case, the investor will receive the higher of the two: 200 conversion shares.

Note that convertible note terms sometimes describe this interrelation differently – not by reference to the number of conversion shares but by reference to the conversion share price. In that case, the convertible note will provide that the conversion price will be the lower of the discount and the cap methodologies. This is because the number of conversion shares is inversely related to the conversion share price – the higher the conversion share price, the lower the conversion shares.

It is important to read the terms of the convertible note carefully, so it is clear what will happen in the event there is both a cap and a discount!