What is the basic difference between a convertible note, a safe note, and a priced round (equity)?
That is a very good question. Below is a really quick overview on what each of them are.
A convertible note is effectively a loan to the startup that may pay annual interest (typically 6-8%) and/or provide a discount to buy in to a future round of equity (usually 10-20%)
A safe note is like a convertible note in that the investor buys not stock itself but the right to buy stock in an equity round when it occurs and can have a valuation cap, or be uncapped, just like a convertible note. But what the investor buys is not debt, but something more like a warrant.
A priced round (equity) provides a percentage ownership in the company in much the same way as investing in a public stock, but it’s a privately owned company.
A convertible note is basically a legal instrument that helps startups and investors avoid certain requirements that come with a priced (equity) round, such as setting a valuation. The typical components in a convertible note crucial to know are:
Discount Rate: Discount rate refers to the discount percentage you will get when the company you invested in raises a subsequent round of funding that qualifies your debt to convert into equity in that round.
Interest Rate: Interest rate refers to the interest you will be accruing [most likely annually] from the time you invest to the time your debt note converts into equity.
Cap: A cap refers to the highest valuation your note can possibly convert, which gets triggered when a bone fide round of capital occurs.
Bone Fide Round of Capital: A bone fide round of capital refers to an event, specifically a capital raise above a certain figure that would trigger the debt to convert into equity automatically.
Maturity Date: A maturity date is a specified future point in time in which the note becomes due to investors.
Turning theoretical into practical
Say you invested $10K in startup X on January 1st, 2013, which has convertible note terms giving an 8% interest, 20% discount and a cap of $5 million. In addition, the note specifies that if the company raises more than $1.5million, your debt automatically converts into equity in at that round’s valuation. Lastly, the maturity date of that note is January 1st, 2015.
One year (to the day) passes and Startup X raises their next round of capital of $3million at a valuation of $9million. What does that mean for you? That means your $10K investment is now worth $10,800 and you are entering the equity round at a valuation of $4million instead of $9million because of the 20% discount, and the $5million valuation cap. Therefore, when your $10,800 converts into equity, you will own .27% equity in Startup X.
Equity rounds require a sophisticated lead investor in order to launch publicly on the platform. Equity rounds have a lot of touch points that need to be negotiated, and it’s best done with one sophisticated investor that commits a substantial amount of the funds, usually between 5%-30% of the round size, which allows other investors to join the syndicate under already negotiated/favorable terms.