For earlier rounds, when it is often difficult to establish a valuation, investors will invest funds via a convertible note. This is often done for seed investors and Angel investors.
A convertible note is a legal agreement between the lender (the investor) and the Company which outlines the following:
- The date the note needs to be repaid
- The process that allows it this date to be extended
- The interest rate to be applied to the debt (if any)
- The triggers for the amount of the debt (including interest) to convert to the purchase of shares.
- Any discount that will be received on a future valuation when the conversion happens.
As an example, an investor lends $100,000 under a convertible note, with 10% per annum interest and a 20% discount to a future valuation on conversion.
A funding round is done 12 months later, at a “pre money” valuation of $4m. The total debt is $110,000.
The debt will convert at a valuation of $4m * 80% = $3.2m. Hence the investor will receive more shares than they would of if they had invested later, based on both the interest accumulated and the discount to future valuation.