Understanding Convertible Notes, Discounted Rate, Maturity Date & Valuation Cap

In today’s video of Startup 101 series, we will be talking about startup funding and how a startup can raise funds using convertible notes. We will also learn what are convertible notes, what are its advantages and disadvantages and some key terms associated with convertible notes.

00:00 Introduction
01:26 What are convertible notes?
03:05 Discounted rate
05:07 Valuation cap

What are convertible notes?

A convertible note is just another way to raise capital for an entrepreneur. The way convertible notes work is that an investor lends money to the startup just like debt, which has a certain rate of interest attached to it. But, it also gives the investor an option to convert his debt investment into an equity investment at the end of the loan term or when the company goes out to raise more funds.

So, why would you use convertible notes to raise funds? Well, since your startup is in the very early stage and you need the capital to build your product but you don’t want to give any equity so early on. This is when convertible notes would be the best option for a startup entrepreneur. Another important factor why entrepreneurs might consider convertible notes is that when raising funds using convertible notes, you don’t need to set a valuation on your startup.

Here are some key terms to keep in mind when using convertible notes:

Discounted rate – This represents a discount on the valuation of the startup for the investor who had invested through convertible note prior to the funding round where your startup is getting a valuation and raising more capital. This simply means, that if your startup is now valued at say $10 million and this investor is getting a discounted rate of 20% and he previously invested $1 million, instead of getting a 10% equity, he will be getting 12.5% while all the new investors will get the same 10% for their $1 million investment. This is the benefit of an investor who had invested early on in your startup for taking a higher risk.

Maturity date: A maturity date is nothing but the date when your startup needs to pay back the investment or allot him his equity. This date is usually decided during the time of raising the money through a convertible note. It can either be a specific date with a set time period like 1/2 years or the date when your startup goes out to raise its next funding round.

Valuation cap: This is another benefit that the investor might get for his early investment. It essentially means that even if your startups valuation skyrockets at the time of next fundraising, this investor can cap the price at which his notes will convert into equity. It simply means that suppose the investor expects your company’s valuation to really skyrocket at your next fundraising round say $50 million, he can cap his investment with a valuation cap of $5 million.

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[AnanyaSingh-icwp]

Really great video, got clarity over the concepts like conversion cap and discount rate.

[naamra]

Great crisp video. But not clear on factors that determine valuation cap

[hendriyajude]

You really got to slow down, I was finding it very hard to follow

[AllAboutInvesting]

Hi Prithvi, have one question. How often can investors verify the valuation cap of a company?
Recently there was a media report that Ola valuation was reduced by half during the Coronavirus pandemic.
What parameters could had been internally used in Ola case to check that? Was it only Revenue stream considered? Or is growth, customer engagement, founder preference, etc, were also considered for Ola too? What was the actual impact?

[afhamyoung]

Superb explanation! While you explain if you can do chart like this how this work something! Then it will be more transparent to understand the formulas

[purnimaparimala]

My client is a start up company . Recently it has got funding in the form of convertible note . How to pass initial accounting entries

[rohitpunetha]

please, It will be more helpful if you speak little slower and make your video in presentation or animation form, it will be easy to grasp your interesting and important concepts, thanks for video...

[cspayalchowdhary]

How to pay stamp duty on convertible note in delhi

[pravinsonavanessktutorials]

I need help on investment I have my own startup but no idea how to go ahead to raise funds

[JJk]

80% discount factor is what i have been told. Where did you get 20% from?

[mr.ajaysurya]

the topic is great but i think you have to be more slower and detailed simple explanation is needed for better understanding

[chaitanyabalajiguduru]

Information is great! It would be very helpful if you add some animation to understand better and faster.

[deepmodi]

please can you speak little bit slower speed.

[visible]

thoda slow bhi bol bhai ..english ka itna bhi ghamand accha ni ..english hamebhi aata h

[shivam]

Hy come on!
The frequently asked question man!
What books shud we read....pls answer? @bwm community