Brett Jurgens, CEO of Notion, explains how convertible notes work as a financing tool for startups. He covers valuation caps, discounts, interest rates, and how the debt converts to equity, plus the differences from priced rounds and what founders and investors each need to know.
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Another point I'll make on the fundraising piece, and I mentioned our first couple of rounds were convertible notes. Are you— is anybody here being pushed one way or another when you guys are kind of going out to initially fundraise to either do or not do convertible notes? Has that been a topic of conversation? Sure. Convertible notes. Convertible notes. What does it mean? That's a good place to start. So you can go raise equity, right? You give me $1 million and I give you X percent of your company at X valuation. A convertible note is debt to start with at least with the intent that it will convert into equity. So if I invest $1 million into your company, I don't get any equity. It actually starts to accrue some interest. So the terms of a note could be as follows. I'm going to put $1 million in at a $5 million cap, 20% discount, and a 5% interest rate. So let me walk through what all those things are. So, $1 million, pretty obvious. Second step, $5 million cap. $5 million valuation cap. So when you raise your next round, that debt will convert into equity at a cap of a $5 million valuation. So that next round is valued at $10 million. And that's what the series, let's say Series A investor's paying. Your investment at $1 million is capped at a valuation of $5 million. So you are getting that percent of the company. It's kind of saying here's your reward for investing early. We don't really know where valuation is going to come out at for an A round. That's where that cap comes into play. The discount basically says that's downside protection. So if the valuation of the next round is only $4 million even though your cap was $5 million, you get a discount of 20% on the $4 million. Because you invested early, you took a risk on us, you should still get a better price. That's what it really means of that round, even though it didn't exceed expectations and go above that cap. And then the third component that often is included is some kind of an interest rate. So a protection against time. If I raise $1 million, And I don't go raise another round for a long, long time. The thought there is you benefit some over time. Now nobody invests in convertible notes or startups for an interest rate per se. But it is somewhat of a reward for investing early. And the thought behind that piece a little bit is if I don't go raise an A round as a company, I'm not putting the company in a position to be as successful as I could. So that investor as they wait to see the higher level of success of the company gets some interest over time. Let me stop there because I wasn't quite sure what discussions have been around kind of private fundraising capital structures, those kinds of things. And see if there's any questions around kind of what a convertible note is, some of the stuff I just went over. Can you explain that 5%? Yeah, I apologize. So if you raise $1 million at a $4 million pre-money valuation, your post-money valuation is $5 million. In that scenario, if that was an equity round, you would own 1 into 5. You would own 20% of the company. OK. Okay. A $5 million cap means that if I invest that million and my valuation cap is $5 million, but the company is super successful and they go raise at a valuation of $10 million, that protects me. That adds to my ownership. It basically says, here's what you're going to own no matter what the Series A valuation is because you took a risk on us early. But instead of pricing around, instead of doing the analysis and the diligence to actually price around, which a lot of seed and angel investors aren't really willing to do, they just say, well, just cap it. I know that my million is going to be at least converted at that valuation. at that $5 million valuation. And hopefully you get a valuation much higher than that. The valuation of the A round then in that case doesn't actually impact that early investor. Because they have a guaranteed conversion price. So if you raise $10 million, their $10 million investment is still worth 20%? It just— exactly. So it, in a way, and it's kind of weird because it essentially sets a kind of sets a price for their investment anyway. But they don't then convert into a round that's say valued at $10 million. They aren't at risk for a higher valuation. Does that help? Yes. Okay. It's a little easier to see actually in a spreadsheet to be honest with you. And did I answer your questions about what a convertible note really is? Okay. Are there any other questions on— yeah. As an entrepreneur signing a contract with North, do you have any risks to you personally or is it just the company? Just the company. I would never give a personal guarantee on anything, which is kind of what you're talking about. Whether it be a lease for real estate or anything about the company. You know, you still have your fiduciary responsibilities, right? That doesn't change. But we're a corporation. So we're still kind of under that corporate veil. And at the end of the day, it is debt until it converts. So that's another piece that— let's say tomorrow somebody comes and buys us. We pay back the debt and the interest. We don't convert that into equity and they get 50%, 30%, whatever of the company. We can just repay the debt if we wanted to. The other piece is that it's not— there's some tax implications for investors. They've invested in debt instead of having an ownership stake in a corporation. Usually that doesn't have a big impact one way or another. If people are comfortable with notes, they're comfortable with notes. Some people are very uncomfortable with them. They'd rather have an actual ownership stake right now. That kind of, well, we could just kind of repay you the debt piece, some people don't really like that. So you could get pushback from some folks. The other thing that I was going to mention— well, I'll leave it at that. There's no real personal risk at all. So, yeah. Can you repeat the question? I was. I was, and it makes it easier with— I think it's commonplace enough now that it's not that big of a deal for investors. If they're really an investor, and I mean, are they active enough? Not are they a big massive VC, but are they an active investor? Is it an angel that has invested in enough deals that he's fully comfortable and aware of what convertible notes are, or she? Fine. Like, it shouldn't be an issue. I was pushing for them because it, in my opinion, it gets deals done a little bit quicker. There's a few less legal fees sometimes. It's not right to continue to do it forever. Our next round will be a priced round and it will convert those notes. We also don't want those outstanding forever because they're gaining interest, right? So they're taking more equity every day we don't convert them. But I was pushing for the convertible notes. Yep. A price round. Exactly. Just here's the valuation. Here's the equity. Here's your term sheet. Pretty standard price round. That's really the other option. Before or after you get the deal? Before. Sometimes that's a catalyst for incorporation just so you don't have to pay for it, which is totally fine. I think there are certain scenarios where you could have an easier round raising a note as an LLC because at that point in time people aren't actually taking LLC shares, which most institutional VCs aren't able to actually take stake in LLCs. I might be getting a little bit technical in terms of corporate structure, but corporation's not that expensive. It is an expense. Part of the deal could be once we get this deal put together, we'll incorporate. What you're investing in, who you're taking debt with is a corporation. I've seen that happen before. I haven't seen it scare anybody away if you're not a corporation yet. I think a lot of people will want you to be by the time they sign a document. They want a corporation on the document. That shouldn't hold up a round. Right. It shouldn't be the focus of the round. What you're doing, your team, everything that Tim was talking about in the last speech, that has to be the focus. If it turns into some kind of corporate round structure conversation, not right for some reason.
