The advent of convertible notes have made it more simple to invest seed money into a promising company. Convertible notes act as loans with certain provisions to protect the company. As well, they incentivize the risks involved for an investor, without requiring a lawyer, as one would with a real equity investment.
Instead, a convertible note carries with it a means of investment, which accrues interest (somewhere between 4% and 8% depending on where the investor and founder land), sometimes a cap (a maximum valuation that has been set to protect the investor against potential equity dilution, in the case of an unexpectedly large next round funding).
Why Offer Discounts at All?
Making any investment at all in a company this early carries more risk than any other subsequent phase. A discount is built into the agreement to make the deal a little more amenable to the aims of investors. The agreement allows early investors to purchase shares upon conversion with their investment plus accrued interest. All of the while, at a lower price than later stage investors.
If a company sells their equity at a $1.00 per share but the discount rate on their convertible note is 20%, new investors would have to pay that rate. However, the convertible note holder would be able to purchase shares at $0.80.
Discounts Vary Based on Maturation & Risk
Most discounts range between 15% to 40%, with a concentration around the lower end of that scale. However, more perceived risk associated with the company may justify or even require a higher discount. For instance, a longer maturation date or any specific concerns regarding the company.
Typically, a maturation date within the first six months will carry with it a 15% discount on shares upon conversion; the discount should be upped to 25% between 7 to 12 months. A year or more would call for a 40% discount for shares.
