We previously reviewed convertible notes and identified the reasons for their popularity. A convertible promissory note’s main characteristic is that the debt investment automatically changes later into firm stock at a reduced price per share. However, some investors believe that the conditions of the conventional convertible bridge note do not appropriately reward an investor for the risk incurred during the early stages of a firm.
Convertible debt is now seen to be a desirable structure for a startup’s angel round, but is it beneficial for investors?
First, let’s define a convertible bridge note with a price limit in terms of finance.
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What is the definition of a convertible bridge note?
Investors may now refuse to conduct convertible bridge financings unless the debt conversion price is restricted. An investor, for example, may request that the conversion price be the lower of a reduced Series A price or a price per share based on a predetermined value.
The valuation is typically a reasonable projection of a range related to the Series A, and it is typically higher than what would be set if the investor and the company negotiated it at the time of the convertible bridge note, but lower than the expected Series A valuation if the company meets their objectives.
Convertible Note with a Price Cap: Victory or Weapon?
A price limit might be placed to the convertible note to provide investors with upside protection. This is stated as a pre-money value and serves as a price-per-share ceiling.
Example: An investor invests $2 million in a firm and receives a $5 million pre-money value with a $100,000 convertible note at a 25% discount. Following the Series A round, the investor will own 1.9 percent of the firm right away. If the investor instead receives a $15M pre-money value, they will own. After the Series A, the startup owns 78 percent of the company
Because of this oddity, regardless of the conversion discount, the investor has no motivation to assist improve the value prior to the Series A investment. As a result, this form of letter effectively puts the investor’s and the startup’s aims at conflict.
Unfortunately for startups, the price restriction is often used as a weapon. The anti-dilution clause is a word in conventional term sheets that works like this: if the business obtains money after this investment at a lower price than this investor paid, the investor receives a discount on the investment they are making now. Working with an experienced startup lawyer who can explain the ins and outs and repercussions of the note is critical for entrepreneurs since the rationale and how it works whether the market goes up or down may make the difference between losing huge sections of your business or maintaining them.