Introduction

Convertible notes are a popular form of funding for early-stage startups, allowing them to obtain funding that will later convert into equity at a future valuation. Unlike straightforward equity financing, convertible notes allow startups to defer assigning a valuation to the company until a later priced investment round.

This flexibility makes convertible notes appealing for early-stage companies who do not yet have significant traction or history to determine an accurate valuation. However, how the future conversion price of the note is determined can have a major impact on founder and investor outcomes. There are several main approaches used for setting the valuation cap or conversion price.

This article will provide an overview of the key methods used to value convertible notes from the perspective of Indian startups and global practices. We’ll explore the implications of different valuation approaches like valuation caps, discounts, anti-dilution provisions, and how they affect founders and investors. Understanding these methodologies can help startups determine the best funding approach for their situation.

Discount Valuation

The discount valuation method values a convertible note based on a percentage discount from the next equity financing round. Typically, the discount rate ranges from 15% to 30%.

With this approach, the conversion price is set at a discount from the share price of the next equity round. For example, if the next round share price is $1 and the discount is 20%, the conversion price would be $0.80 per share.

i. Pros of the discount valuation method:

• Simple and straightforward to understand. The discount rate is clearly defined upfront.
• Provides investors with a guaranteed discount compared to new investors in the next round.
• Motivates founders to grow the company and increase future round valuations. Higher valuations in later rounds mean investors get more equity when converting the note.

ii. Cons of the discount valuation method:

• Difficult to appropriately set the discount rate upfront. A rate that seems fair now may end up too high or low at the next round.
• Conversion price is unknown until the next round closes. Some uncertainty exists for both investors and founders.
• Heavily dependent on valuation at the next equity financing. Changes in market conditions or company trajectory can impact note value.
• Investors’ potential equity stakes are not capped. Large increases in valuation can lead to undesirably high ownership for noteholders.

Valuation Cap

A valuation cap is one of the most common ways to value a convertible note. With this approach, the valuation cap sets the maximum valuation that can be used to convert the note into equity shares at conversion.

For example, say a startup raises a $1 million convertible note with a $5 million valuation cap. If the startup raises its next equity round at a $10 million valuation, the note will convert at the $5 million cap rather than the higher $10 million valuation. This benefits investors by capping the maximum dilution they will experience.

Pros

• Protects early investors by limiting dilution from higher future valuations
• Simple to understand and implement
• Provides more favorable terms for investors

Cons

• Can increase the cost of capital for startups if the cap is set too low
• Removes upside potential for investors if company valuation rises well above cap
• May signal lower estimated startup valuation if cap is low
• Requires estimating future valuation, which is difficult

Overall, valuation caps are investor-friendly and common for convertible notes. Startups need to balance minimizing dilution with setting realistic caps to avoid overpaying for early capital. Setting the cap requires thoughtful analysis of future valuation potential.

Most Favored Nation

A Most Favored Nation (MFN) clause is a special provision within convertible notes that protects investors against future down rounds.

An MFN clause states that if the startup later issues convertible notes to new investors at a lower valuation cap or discount rate, the previous investors’ notes will automatically convert at the new, more favorable terms.

For example, if an investor purchases a convertible note with a $5 million valuation cap, and the startup later issues a note to a new investor with a $3 million cap, the MFN clause will reduce the first investor’s valuation cap to the $3 million level.

This guarantees that the earlier investors will get the benefit of any more favorable terms the startup agrees to in subsequent financing rounds. It prevents dilution of the early investors’ stake if the valuation decreases.

The MFN clause incentivizes founders to set high valuation caps initially to avoid re-pricing all the previous notes. It gives the early investors downside protection and potential for higher equity stakes.

However, convertible notes with MFN clauses may deter founders from accepting fair offers from new investors. It also signals pessimism about the company’s ability to increase its valuation.

Overall, MFN clauses favor the investors over the entrepreneurs. They provide insurance against lower valuations, but can handcuff founders if valuations decline for justifiable reasons.

Full Ratchet Anti-Dilution

The full ratchet anti-dilution provision is considered one of the most founder-friendly and investor-unfriendly terms in startup financing. This provision states that if the company issues shares at a valuation lower than the valuation of the investor’s shares, the investor’s shares will be repriced to the lower valuation.

For example, if an investor buys shares at a $5 million valuation, and the company later issues shares at a $3 million valuation, the investor’s shares will be repriced from the $5 million valuation to the $3 million valuation. This repricing doubles the number of shares the investor owns, allowing them to maintain their ownership percentage despite the lower valuation.

The full ratchet provision completely protects founders from dilution, while putting all the dilution risk on the investors. Investors dislike this provision because it means they can face extreme dilution if the company raises money at a lower valuation.

For example, in the scenario above where the valuation drops from $5 million to $3 million, the investor would face 2x dilution, instantly cutting their ownership stake in half. This disproportionate impact on investors makes the full ratchet provision highly controversial in startup investing.

Many investors push for weighted average anti-dilution provisions instead, which spread the impact of the drop in valuation over both founders and investors. The full ratchet provision remains common, however, especially for early angel and seed rounds where valuations are more unpredictable. But investors should understand the risks before accepting this founder-friendly provision.

Weighted Average Anti-Dilution

The weighted average anti-dilution provision is designed to protect investors from dilution in the event of a down round while avoiding some of the drawbacks of full ratchet anti-dilution.

With weighted average anti-dilution, the conversion price of the preferred stock is adjusted downward in the case of a down round financing. However, unlike full ratchet where the conversion price is reduced to the price of the new shares issued, the adjustment is proportional based on the size of the new round relative to the pre-money valuation of the company.

Specifically, the conversion price is adjusted based on a formula that takes into account the number of new shares issued and the price at which they were issued compared to the number of shares previously outstanding. This weighted average method smooths out the impact of the down round.

The major advantage of weighted average anti-dilution over full ratchet is that it avoids the harsh, compounding effects of full ratchet provisions. By reducing the conversion price incrementally rather than setting it to the new lower price, the impact on investors is moderated.

Additionally, weighted average anti-dilution incentivizes founders and employees by allowing them to maintain more of their equity following a down round. This helps keep key talent engaged in the company.

In summary, weighted average anti-dilution offers a balanced way to protect investors in a down round scenario while avoiding the punitive effects of full ratchet anti-dilution on founders and employees. The weighted formula allows the impact to be shared proportionally among stakeholders.

Vanilla Note

A vanilla note is a simple convertible note with basic terms and no special provisions. The key terms are:

• Principal amount – The amount invested.
• Interest rate – Typically a low rate like 3-5%.
• Conversion discount – Usually 15-25% off the next qualified financing round’s price.
• Maturity date – The date the note converts or payment is due, often 12-24 months.

The advantages of vanilla notes are:

• Simple structure without complex terms. Easy for founders and investors to understand.
• No need to agree on a valuation upfront. The conversion price is set later.
• Investors get upside if the valuation increases. Founders avoid dilution if valuation stays flat.

The disadvantages are:

• Less investor protection compared to notes with valuation caps or discounts.
• Conversion price uncertainty until the next round.
• Potential for greater dilution vs other note structures if valuation rises steeply.

Overall, vanilla notes work best when founders and investors have an aligned vision for reasonable valuation growth. They avoid the complexity of notes with more investor protections. However, investors take on more risk without these protections.

SAFE Notes

A SAFE (Simple Agreement for Future Equity) note is an alternative funding instrument to a convertible note that is commonly used by startups and investors. SAFE notes were created by Y Combinator to simplify and standardize early-stage startup fundraising.

The key differences between SAFE notes and convertible notes are:

• Conversion mechanism: SAFE notes convert to equity when a priced round occurs, while convertible notes convert at the next equity financing based on a valuation cap or discount. SAFE notes have a post-money valuation cap.
• Interest rates: Convertible notes carry an interest rate while SAFE notes do not. This makes SAFE notes easier for startups.
• Maturity dates: Convertible notes mature after a set period of time if no priced round occurs. SAFE notes have no maturity date so the startup does not have to pay back if no priced round happens.
• Valuation cap vs discount: SAFE notes only use a valuation cap while convertible notes offer a valuation cap or discount. This gives investors a floor on the conversion price with a SAFE note.
• Equity treatment: SAFE notes are liabilities that only convert to equity at a priced round, while convertible notes are considered equity or debt-like instruments by investors.

Overall, SAFE notes reduce legal costs, remove interest rates, and have no maturity date while still providing investors downside protection. This makes them an attractive funding option for early-stage startups. The tradeoff is less flexibility compared to a convertible note.

Valuation Considerations

When setting the valuation for a convertible note, it’s important to consider several factors to arrive at a fair valuation. Both founders and investors want to agree on a valuation that properly balances risk and reward.

Some of the key factors that influence valuation include:

• Stage of the startup – Early-stage startups typically have lower valuations compared to those in growth stages. The startup’s traction, revenue, and metrics should be assessed.
• Market size and potential – Valuation is driven higher if the startup is entering a huge potential market. Investors consider TAM, growth trends, and competition.
• Team experience – An experienced founding team that has domain expertise or successful exits commands a higher valuation. First-time founders are riskier.
• Investor demand – Higher investor interest allows startups to command better terms. Exclusive access to deals can increase valuation.
• Milestones achieved – Meeting product, business, or growth milestones derisks the startup and boosts valuation. The startup’s momentum matters.
• Fundraising history – Prior funding rounds and valuation set a baseline, unless milestones significantly change. Investors want context on prior raises.
• Macro environment – The economic, industry, and startup climate impact valuations. Cyclical trends like recessions or sector downturns can lower valuations.

To set fair valuation caps and discounts, founders and investors should have open discussions on expectations, justify valuations based on benchmarks and projections, and leave room for negotiation. Overall, the valuation should balance risk-reward and incentivize founders to grow the company.

Conclusion

Convertible notes are one of the most common early stage financing instruments for startups, offering a flexible and founder-friendly approach to securing early capital. When structured properly, convertible notes can benefit both entrepreneurs and investors.

Summary of Key Points

• Convertible notes allow startups to delay setting a valuation while still receiving financing quickly. The valuation is set later during a priced equity round.
• Valuation caps and discount rates are key terms that impact the effective valuation. Caps limit the valuation while discounts reduce the price per share.
• Full ratchet and broad-based weighted average anti-dilution provisions protect investors against dilution but can deter future financing. Narrow-based weighted average is more startup-friendly.
• SAFE notes are a simplified form of convertible notes but lack certain investor protections. Vanilla notes lack both a valuation cap and discount.
• Founders should strive for caps and discounts that balance raising enough capital with minimizing dilution. Models like Andersen Capping can help determine reasonable terms.

Recommendations for Founders and Investors

For founders, focus on communicating your vision and potential for growth while setting fair terms that don’t over-dilute early shareholders. Understand how various provisions impact dilution. Model out scenarios to evaluate the tradeoffs.

For investors, communicate your interest in the startup’s success, not just financial returns. Seek fair terms but avoid onerous provisions that could deter follow-on financing. Be transparent about how you assess valuations and set terms.

With open communication and alignment around shared goals, convertible notes can be a win-win for startups and investors alike.