Don’t Give Away the Farm in a Bridge Financing: Conversion Discounts vs. Conversion Caps

In the world of convertible debt, arguably the single most important term for both the startup and the investor is the provision concerning when and how the investor’s convertible promissory note converts into equity. Generally, the “when” is automatically, upon the “Qualified Equity Financing,” which is typically defined as a financing in which the startup issues shares of its preferred stock in exchange for cash in excess of some appropriate threshold. In most cases, the only issues to negotiate with respect to the “when” are the dollar threshold that triggers conversion and whether accrued interest will convert along with the principal amount of the note.

The meatier part of this provision is the “how.”  Investors who invest in bridge financings take on a higher risk profile than investors coming in later in the priced round that triggers conversion of the promissory notes. There is always the risk that the priced round will not occur, the investor’s note will not be converted, and the startup may never have the funds available to repay such note. For these reasons, investors who purchase convertible promissory notes generally don’t want their note to be converted into equity at the same price per share as the investors in the subsequent priced round. This is usually accomplished in one of two ways: a conversion discount or a conversion cap. Sometimes startups give their investors both the conversion discount and the conversion cap, giving the investor the option to convert their note using either method depending on which will yield the lowest conversion price.

Conversion Discounts

“The outstanding principal amount of, and all accrued and unpaid interest on, this Note shall automatically convert into shares of Preferred Stock at a price per share equal to 80% of the price per share paid by the other purchasers of the Preferred Stock sold in the Qualified Equity Financing.”

Conversion discounts are pretty straightforward. The language above is a typical conversion discount provision. This provision provides that, no matter what price per share the startup offers its Preferred Stock in the Qualified Equity Financing, the convertible note investor will pay only 80% of such amount. Thus, if the startup is selling shares of its Series A Preferred Stock for $1.00 per share in the Qualified Equity Financing, the convertible note investor will receive her shares of Series A Preferred Stock upon conversion of her note at $0.80/share.

Conversion Caps

“The outstanding principal amount of, and all accrued and unpaid interest on, this Note shall automatically convert into shares of Preferred Stock at a price per share equal to the price obtained by dividing: (x) $5,000,000 by (y) the Company’s fully-diluted number of shares, calculated immediately prior to the Qualified Equity Financing.”

Conversion caps are a little trickier to understand than conversion discounts. A conversion cap essentially provides a cap for the startup on the highest pre-money valuation at which the note will convert. For example, let’s assume the startup raises its Qualified Equity Financing on a $7,000,000 pre-money valuation and has 10,000,000 shares of stock outstanding on a fully-diluted basis. We know to determine the price per share by dividing the pre-money valuation ($7,000,000) by the startup’s fully-diluted number of shares outstanding (10,000,000), resulting in a price per share of $0.70. But the effect of the conversion cap provision above is that, despite the actual pre money valuation of the startup in the Qualified Equity Financing, the convertible note will convert into equity in the Qualified Equity Financing based on a pre-money valuation of no more than $5,000,000.  Thus, while the investors in the Qualified Equity Financing will be paying $0.70 per share, the note will convert into equity at a price of $0.50 per share. Alternatively, if the startup raised its Qualified Equity Financing on a $4,000,000 pre-money valuation, the convertible note investor would receive no added benefit for her riskier investment and would convert at $0.40 per share with the rest of the investors in the Qualified Equity Financing.

Discounts + Caps

“The outstanding principal amount of, and all accrued and unpaid interest on, this Note shall automatically convert into shares of Preferred Stock at a price per share equal to the lesser of: (i) 80% of the price per share paid by the other purchasers of the Preferred Stock sold in the Qualified Equity Financing; and (ii) the price obtained by dividing: (x) $5,000,000 by (y) the Company’s fully-diluted number of shares, calculated immediately prior to the Qualified Equity Financing.”

Some investors negotiate for both a discount and a cap, with the ability to convert their note using the most beneficial method. This is a way for the investor to hedge, and receive a discount in the event the startup raises its Qualified Equity Financing on a pre-money valuation that is less than the cap, as well as a cap in the event the startup raises its Qualified Equity Financing on a pre-money valuation that is greater than the cap. In this case, if the startup raised its Qualified Equity Financing on a $7,000,000 pre-money valuation, the convertible note investor would need to choose between converting pursuant to the conversion discount (resulting in a conversion price per share of $0.56) or the conversion cap (resulting in a conversion price per share of $0.50). Alternatively, if the startup raised its Qualified Equity Financing on a pre-money valuation of $4,000,000, the convertible note investor could use the conversion discount to convert its note at $0.32 per share (a 20% discount to the $0.40 per share paid by the investors in the Qualified Equity Financing).

Discounts vs. Caps

“Conversion discounts are generally more company-friendly, while conversion caps are generally more investor-friendly. Conversion discounts are always pegged to the price per share paid by the investors in the Qualified Equity Financing, so there is always some visibility as to the future conversion price, and it will always have a relationship to the price paid by other investors in the financing.”

On the other hand, conversion caps (especially low conversion caps) can serve to greatly benefit convertible note investors upon conversion, and can be incredibly dilutive in certain cases. Take the case of the startup that negotiates a $5,000,000 conversion cap with a convertible note investor, and then knocks it out of the park and raises its Qualified Equity Financing a year later on a $10,000,000 pre-money valuation. Here, the convertible note investor would receive a 50% discount to the other investors. In addition to being highly dilutive, situations like these generally irritate the new-money investors, which could result in deals being passed on or killed if the new-money investors require amendment of the conversion cap as a condition to doing the deal. For these reasons, conversion caps should be used with extreme caution and generally only when the Qualified Equity Financing is on the short horizon and the company has good visibility about its anticipated pre-money valuation.