With Novus Concilium, this article introduces you to convertible instruments and all the basic concepts related to them. From a legal perspective, in easy-to-understand terms, we’ll explain the following concepts about convertible instruments that every founder fundraising should know:
- What is a convertible instrument?
- Why invest using convertible instruments?
- When does a convertible instrument convert?
- Benefits of being a lead investor
What is a convertible instrument?
A convertible instrument is a contract that describes a debt owed by a legal entity, to be paid to the creditor in the future, subject to certain conditions. Examples of convertible instruments include: SAFE, convertible notes and KISS.
When does a convertible instrument convert?
A convertible instrument converts or matures when one of the following events occurs: a liquidity event or a capitalization event. Here’s what each of these events means.
What is a capitalization event?
A capitalization event is an investment round in which the startup receives money in exchange for issuing shares to the investor. Capitalization events typically occur in Series A, since that is when the startup is considered mature enough to have an objective valuation.
During a capitalization event, the startup must convert all convertible instruments it previously signed that have a “Trigger” tied to the capitalization event.
The creation of an Option Pool, as a general rule, is not considered a capitalization event, despite the issuance of shares during the process. Learn more about option pools and how they are treated in our article about cap tables.
What is a liquidity event?
A liquidity event occurs when any of the following takes place: the sale of the company, the sale of the company’s assets, or its dissolution. The occurrence of any of these events converts the convertible instrument into shares, followed by payment of the corresponding value of those shares.
Terms to negotiate in a convertible instrument
As with any contract, there are terms that both parties must agree on. The main terms negotiated in a convertible instrument are 2: a cap or valuation limit, and a discount. Both are intended to set a maximum price per share at which the investor can convert in the future.
Cap or valuation limit
A limit on the pre-money valuation that applies only to the investor who acquired the convertible instrument.
In other words, if the pre-money valuation in the investment round (capitalization event) exceeds the cap, the price per share at which the investor who acquired the convertible instrument subscribes will be determined based on the cap.
Price per share of the convertible investment = CAP/Fully diluted capitalization
Discount.
The discount is a % reduction in the price per share in an equity round, granted to the investor who acquired the convertible instrument.
In other words, the price per share at which an investor who acquired the convertible instrument subscribes will be the round’s price per share minus the discount percentage.
Price per share of the convertible investment = PPAC/1.%
Both concepts are intended to give the convertible instrument investor the best possible price per share. In other words, the two terms are never combined; the one that offers the investor the better terms is always chosen.
Benefits of being a lead investor
A common practice when raising investment is to offer the lead investor in your round greater benefits than the other investors in the round. Some of these rights may include:
- Information rights
- Co-sale rights
- A seat on the board of directors