The ultimate founders’ guide: Convertible notes in Denmark
“It’s a little bit like riding a convertible.”
I’m writing this post due to popular demand.
Convertible notes are possibly overrated these days. They are not the holy grail of start-up financing. Still, they are useful in the right context.
Convertible notes may seem a bit counterintuitive until you understand how the mechanics work.
There’s a lot of underlying detail. In the following I have boiled it down the essence from a founder perspective:
#1 – Debt vs. equity
A convertible note is debt. This means that investor lends your company the investment amount. By doing so, investor does not become a shareholder in your company. Since investor is not a shareholder, the convertible note does not automatically give investor shareholder control over your company. Investor doesn’t automatically become a board member either.
So when does investor become a shareholder?
This happens when the debt is converted to shares. In this process, the debt “disappears” and investor gets to own a part of your company in exchange. Now investor has the control that comes along with being a shareholder. However, investor still doesn’t automatically become a board member.
#2 – Conversion price
When investor converts the debt into shares the following question arises:
How large a percentage of the company does investor now own?
The answer depends on two factors:
(1) The investment amount
(2) The conversion price
Let’s assume the following:
- The investment amount is DKK 5 million
- The conversion price is DKK 1 per share
- The company has DKK 45 million shares before conversion
- The company has DKK 50 million shares after conversion
Now investor wants to convert the loan into shares. Investor receives DKK 5 million shares in exchange for converting the investment amount of DKK 5 million. Since investor owns 5 million out of 50 million shares, investor owns 10% of the company.
In this example the conversion price is set as a price per share. Another technical way to set the conversion price is to set the price based on a valuation of the entire company. In our example, the conversion price set in this way would be based on a pre-money valuation of the company of DKK 45 million.
A rather popular way of setting the conversion price is not setting a price at all.
How does that work?
It is possible to set the conversion price as the price paid by other investors in future investment rounds. In this way, the founders and investor postpone the question of negotiating the valuation of the company.
It’s important to stress the word postpone since negotiating the valuation cannot be avoided and will have to happen eventually.
#3 – Caps & discounts
When start-ups and their investors decide to postpone the issue of price in this way, two investor-friendly tools are sometimes used.
The first tool is a discount.
The discount represents a percentage which is subtracted from the price that the convertible note investor has to pay. You can say that the discount is an advantage given to the convertible note investor for investing early in the company.
Let’s say the discount is 20%. If future investors invest at a valuation of DKK 60 million, the convertible note investor gets to invest at a valuation of DKK 48 million.
The second tool is a cap.
A cap sets a ceiling which limits the price which the convertible investor might have to pay.
Let’s say the cap is set at a valuation of DKK 100 million. If a company ends up raising money at a valuation of DKK 120 million, the convertible note investor gets to invest at a DKK 100 million valuation because of the cap.
It is possible to use a discount and cap individually or together. Investors would probably want both, while founders would probably want neither. Exceptions apply.
#4 – Conversion scenarios
The next question is when investor’s loan gets converted into shares.
There are three popular models:
(1) When a company raises a new round of funding. Sometimes a threshold is set so that the company must raise a certain amount, for instance at least DKK 20,000,000 million, before the loan converts.
(2) Investor decides freely when to convert to shares. This gives investor the freedom to assess when converting suits investor best.
(3) At maturity. Maturity basically means the date where the loan “runs out” and needs to be repaid if it has not already been converted to shares. If you believe in a succesful future you don’t really care about the maturity date because you assume that the loan has been converted before that. But sometimes the maturity date does end up mattering.
#5 – Interest
Here we’re talking about the interest which accrues on the convertible loan before conversion or re-payment take place.
The most common rates in Denmark rates 0% (interest-free), 2%, 4% or somewhere between 5-8%.
It matters whether the interest is simple or compounded.
Founders would typically be interested in interest-free or a lower interest rate with simple interest.
#6 – Shareholders’ Agreement
– The convertible note should also deal with the terms that would apply to investor once investor actually becomes a shareholder. I consider this crucial.
– There are different ways of solving this issue:
– Negotiate a solid term sheet, including key terms of an eventual shareholders’ agreement, before agreeing on the convertible note
– Making investor accept the terms of an existing shareholders’ agreement
– Making investor accept whatever terms later stage investors negotiate
Authored by Kristian Holte, start-up lawyer | [email protected]