Convertible notes are a financial instrument for early stage venture fundraising that provide benefits to both entrepreneurs and early investors. They move much faster than equity financing and give investors a premium for taking on early risk.

In San Francisco (AdLast is in South Park) coffee shops it’s common to hear:

“He invested $100,000 at a 20% discount with a $5M cap.”

Capped Notes (a form of “convertible debt”) convert to Preferred Shares in the Company at its next round of funding. For startups, this is usually a Series A round.

  • Notes usually have a Discount that gives investors a premium for being early and taking on more risk.
  • They can also have a Cap to help protect the investor’s upside if your valuation grows quickly. This helps fully align the incentives of the entrepreneur and the investor.

There are two main scenarios where a Capped Note converts to equity:

  • Scenario 1: The Series A round is at a valuation above $5M (for example, $10M). Investor gets 100,000/5,000,000 (2%) ownership.
  • Scenario 2: The Series A round is at a valuation below $5M (for example, $2M). Investor gets (100,000/(1-.2)) / 2,000,000 (6.25%) ownership.