Editor’s note:  Jim Verdonik and Benji Jones are the cofounders of Innovate Capital Law www.InnovateCapitalLaw.com and are regular contributors to WRAL Techwire

RALEIGH – Over the past two years, about 75% of our start-up clients that have raised money have sold Convertible Notes.

The amounts raised have ranged from $250,000 to $6.5 Million.  One of the biggest recent trends is that instead of being short-term seed financing, some Convertible Notes financings are becoming as big as many full Series A preferred rounds.

Because Convertible Notes are so important to our clients, we stay current about trends related to Convertible Notes. We recently reviewed statistics about Convertible Notes deal terms, which we summarize below.

But before we talk about specific terms and recent trends, lets address this question:

Why are Convertible Notes the financing instrument of choice for so many startups and angel investors?

  • Lower Transaction Expenses. The legal documentation for convertible notes is usually less extensive than for a traditional convertible preferred stock financing that historically was the most common financing structure.  Legal documentation might be ten pages compared to 100+ pages for a convertible preferred stock financing.  That means legal fees for a Convertible Notes financing are much lower than the traditional venture capital convertible preferred stock financing.
  • Delay the Valuation Discussion. It’s difficult to value a startup company that has no product, no customers, no revenue, an inexperienced founder team and a business plan that everyone knows is highly likely to change over time.  Convertible Notes are a mechanism for pushing the valuation issues to a later investment round. – or at leas shortening valuation negotiations.  We’ll discuss valuation more below, but the most important fact about valuation is that any fixed valuation that is fair to seed and early-stage investors in light of the risks of their investment would likely create dilution that is unacceptable to the founders and would probably make it more difficult to more capital later without having a “down round.”
  • Low Valuation for Equity Compensation Grants. With a large amount of debt on the balance sheet, the company may be able to justify a lower valuation when it grants its employees restricted stock or stock options.
  • Speed to Closing. Because documentation is thinner and the valuation discussion is (somewhat) delayed, instead of spending a month or more negotiating valuation and deal document with investors, founders and investors can often agree to fundamental terms at one meeting.  We’ll discuss valuation more below.
  • Investor Protection. Convertible Notes help protect early investors against dilution and provide a liquidation preference that is senior to all equity.  Of course, most start-ups don’t have much value to distribute on liquidation.  So, these lender protections are more relevant to later-stage companies.
  • Control Issues. Holders of Convertible Notes are usually passive investments.  Investors usually don’t have voting rights.
  • Maturity Date Hammer. Despite not having voting rights, noteholders can influence decision making, because at some point, the company must either repay the notes or renegotiate with investors if the notes mature without being converted.
  • Convertible Notes are designed to disappear.  They don’t affect the company’s long-term documentation.  Mistakes are buried.

We also do SAFEs offerings and Series Seed Preferred Stock offerings for early stage companies.  These types of securities are also designed to be more cost efficient than full convertible preferred stock deals.  However, investors often prefer Convertible Notes and our start-up clients are usually willing to accommodate investor preferences on deal structure.

Trends and Statistics

The Fenwick & West LLP law firm in California recently published statistics about the 100+ convertible notes offerings their clients did during 2019 and the first calendar quarter of 2020.

Fenwick is much bigger than our firm, Innovate Capital Law.  So, they do a larger number of deals each year than we do, but their statistics are consistent with deal terms we often use.

Here’s a summary of the statistics Fenwick compiled.

Deal Terms by Company Stage

The following table defines the basic structure of the conversion provisions in most Convertible Notes transactions.  We explain below how the Discounts, Valuation Caps and Change of Control Premiums referred to in this table work in Convertible Notes.

  Seed Stage

(No Preferred Stock issued yet)

Early Stage

(after Series Seed or Series A Round)


(Series B Round or Later)

% Deals with Discounts 82% 88% 74%
% Deals with Valuation Caps 84% 48% 21%
% Deals with Both Discounts and Valuation Caps 85% 46% 24%
% Deals with Discounts that Increase over time 2% 19% 19%
% Deals with MFV Discounts (match highest discount given to any other investor) 13% 14% 14%
% of Deals that have Change of Control Premium 46% 55% 68%


OK, now that we have defined the basic structure:  What’s market practice for the economic terms?

Here are the statistics for the MEDIAN Convertible Notes Rounds.

Notice that there is no number for valuation caps.  We’ll explain why later in this article.

  Seed Stage

(No Preferred Stock issued yet)

Early Stage (after Series Seed or Series A Round) Mature

(Series B Round or Later)

Median Amount Raised $700K $2 Million $4 Million
Median Term 18 Months 18 Months 18 Months
Median Interest Rate 4% 6% 5%
Median Discount Rates 20% 20% 20%


Of course, some companies get better deals than others.  Here are the economic terms that were most favorable to company raising capital.

  Seed Stage

(no Preferred Stock issued yet)

Early Stage (after Series Seed or Series A Round) Mature

(Series B Round or Later)

Longest Term 36 Months 36 Months 60 Months
Lowest Interest Rate 1% 2% 2%
Lowest Discount Rate 10% 5% 10%


Of course, the company doesn’t always get the most favorable terms.  Here are the terms that were most favorable to investors.

  Seed Stage

(No Preferred Stock issued yet)

Early Stage (after Series Seed or Series A Round) Mature

(Series B Round or Later)

Shortest Term 3 Months 3 Months 3 Months
Highest Interest Rate 8% 8% 15%
Highest Discount Rate 30% 50% 30%


Primary Convertible Notes Terms

For those of you that aren’t familiar with what the terms in the foregoing statistics mean, here’s an explanation of the most common Convertible Notes terms.

Conversion Provisions – The Meat of the Deal

Convertible Notes are meant to eventually become an equity investment.  So, the conversion provisions are the meat of the deal.  Usually, both principal and interest converts to equity.  Here are the most typical conversion negotiating points and terms.

  • Discount Conversion Price. Most seed and early stage notes convert at a price that is a discount to what investors pay in a later investment round rather than having a fixed conversion price, but fixed conversion prices become more common fir later stage financing.  A 20% discount is the most typical number, which means that if investors in a later round pay $1 per share, the Notes would convert at a price of 80 Cents per share.
  • Valuation Cap. Investors don’t want the company to use their money to build its valuation and then charge the investors a high conversion price when the notes convert.  If the new investors pay $10 a share later, the 20% discount rate would produce a conversion price of $8 per share.  If the company was really worth $2 per share when the noteholders invested, the noteholders will not be adequately compensated for the amount of risk they took.  That’s why so many seed and early-stage Convertible Notes have a valuation cap provision.
  • Lower of Discount Rate or Valuation Cap. Smart early investors usually insist on the conversion price being the lower of (i) the discounted conversion price or (ii) the price calculated using a stated valuation cap.  Depending on the terms of the next round (such as the price per share the new investors pay and the actual pre-money valuation), the valuation cap and the number of pre-money fully diluted shares, the discount rate price or the valuation cap rice may give noteholders more shares.
  • Setting the Valuation Cap. Earlier in this article, we indicated that Convertible Notes are used to minimize, but not eliminate, valuation discussions.  Since there is the possibility that noteholders will get a lower conversion price, because of the discount rate provision, investors are usually more willing to compromise on the size of the valuation cap.  Valuation caps are often a compromise between what the company is worth now and what parties think the company will be worth when the company raises its next round.  So, to set a Valuation Cap, you need to estimate how much progress the company can make using the capital raised by selling the Convertible Notes and then estimate the value at that later date.
  • How to Calculate Conversion Price Using Valuation Cap. To find the conversion price of the notes using the valuation cap, divide (i) the valuation cap by (ii) the number of pre-money fully diluted shares when mandatory conversion occurs.  The higher the number of pre-money fully diluted shares, the lower the conversion price of the notes (and the more shares the noteholders receive upon conversion).  The primary issue related to this calculation is defining what is considered “fully diluted shares” at the time of conversion.  Most often the tricky issue relates to how the management compensation pool is treated.  Are granted options included? Are currently reserved options included?  Are increases in the pool that investors in the new round require included?  All of these points are open for negotiation.
  • Mandatory Conversion. Since it is difficult to raise money selling equity in the next investment round if the debt remains outstanding, conversion at the price described above is usually mandatory if the company raises a pre-determined amount of capital in an “priced” investment round (i.e. on that has a fixed purchase price per share).  The size of the round that triggers mandatory conversion is the term that varies the most from one company to another.  Several factors make it advisable to require that the amount raised to trigger mandatory conversion be a multiple of the amount of notes being converted.  One factor is that a large round often reduces risk for the earlier investors by giving the company growth capital to execute its business plan.  Another factor is that the noteholders are trusting the next round investors to negotiate a fair deal for all investors.  A large round often requires an institutional investor (like a VC fund) that is sufficiently experienced in negotiating valuation and other terms that the deal reflects fair market terms given the company’s status at the time of the new round.
  • Securities Issuable on Conversion. Holders of Convertible Notes generally receive the same or similar class of securities that investors receive in the investment round that triggers mandatory conversion.  Often, this is convertible preferred stock.
  • Shadow Preferred Stock. Investors in the round that triggers mandatory conversion sometimes object that the noteholders will receive liquidation references, dividend rates and antidilution protection that affords them a bonus compared to the lower price they pay.  Anticipating this objection, companies often have noteholders agree in their notes that upon conversion they will receive a class of convertible preferred stock that is the same as the class that new investors receive, except that the liquidation preference, dividend rate and antidilution protection reflects the lower price per share the noteholders actually used for converting the notes into shares.  This class with slightly different rights is often called “Shadow Preferred.”
  • Optional Conversion. Some convertible notes give noteholders the right to voluntarily convert to Common Stock at any time at a fixed price or to convert into a round that is smaller than the round that would trigger a mandatory conversion.

Company Sale Premium.  What if the company is sold before another financing round?  Investors don’t want to just their money back, plus interest.  They want a multiple of the amount they invested, because the company used their money to grow value.

Investment Contracts on Conversion.  Convertible Notes often condition conversion into a new investment round on the noteholders signing the types of documents that new investors sign.

Amendments.  Most Convertible Notes allow a majority in interest of the noteholders to approve amendments to the Convertible Notes that bind the holders of all the convertible notes.  This type of amendment may include extending the maturity date or making concessions that new investors require.

Other Notes Terms – Traditional Debt Terms

Although Convertible Notes are primarily a vehicle for investors to eventually receive equity of the company, the also include many of the standard terms of non-convertible promissory notes, except that these other terms are generally more favorable to the borrower than banks and other lenders offer.

Due Date.  Like all debt, the lenders have the right to be repaid at a defined date.  The due date (or “maturity date”) should make sense in light of two factors – how much money is the company raising and whether the amount of time and the money raised are sufficient to permit the company to become more real and increase its valuation.  Most deals fall in the range of 18 months to two years, but the Notes usually convert to equity before the maturity date or the lenders and the company negotiate an extension because the company lacks money to repay the notes.  Also, unless the company is about to shut down, most noteholders want to the opportunity to receive equity rather than to receive their principal back with a small amount of interest.  Very short term convertible notes (several months) are often given by investors who plan to soon do a bigger equity investment (or a “bridge”) round -often after a term sheet for the bigger investment has already been negotiated but the company needs some cash as a runway while the documentation gets finalized.

Interest.  The IRS requires that all debt bear interest. If the notes do not state an interest rate, the IRS will imply an interest rate.  If investors are overly concerned about the interest rate for a seed stage financing, they probably don’t understand the investment.  Interest should really be viewed as a way to increase the discount on conversion.  The longer the time period until the notes convert the more extra shares investors will receive when the accrued interest converts to equity.  Talk to your tax adviser about how converted interest should be treated for tax purposes.

Personal Guarantees.  Unlike bank loans, few Convertible Notes include personal guarantees.  Investors are more focused on upside potential that downside protection.

Security Interests and Negative Covenants.  Few Convertible Notes are secured.  Most start-ups have few assets.  In a minority of deals, sometimes investors will require either a security interest in patents and other intellectual property or a negative pledge that the company will not grant a security interest in its patents or other intellectual property to other lenders.

Subordination.  For later stage companies that may be eligible for bank loans, repayment of the loan may be subordinated to banks of other senior lenders.

Choosing the Right Capital Raising Tool

That’s the Good, the Bad and the Ugly about Convertible Notes.

Convertible Notes are a great capital-raising tool, but no tool is right for every job.  We’re in the business of helping both companies and investors choose the right tool for their unique circumstances.

We’re happy to answer any questions about your goals and the best tools to achieve them.

(C) Innovate Capital Law