Convertible Note Seed Financings: Econ 101 For Founders

What Is a Conversion Discount? In the context of a seed financing, a convertible note is a loan that typically automatically converts into shares of preferred stock upon the closing of a Series A round of financing. ?A conversion discount (or ?discount?) is a mechanism to reward the noteholders for their investment risk by granting to them the right to convert the amount of the loan, plus interest, at a reduced price (in percentage terms) to the purchase price paid by the Series A investors. In other words, the founders are saying to the investors, in effect, if you take this risk and give us money today, we?ll reward you by giving you ?20% off? at our Series A round down the road (20% being the usual discount, as discussed below). ?For example, if the investors in a $500,000 convertible note seed financing were granted a discount of 20%, and the price per share of the Series A Preferred Stock were $1.00, the noteholders would convert the loan at an effective price (referred to as the ?conversion price?) of $0.80 per share and thus receive 625,000 shares ($500,000 divided by $0.80), which is 125,000 shares more than a Series A investor would receive for its $500,000 investment and a 1.25x return on paper ($625,000 divided by $500,000). ?(The foregoing example does not include accrued interest on the loan, which is typically about 5%-7% annually, as discussed below.)

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