A convertible (also known as a convertible instrument) is a contract that your startup can sign to raise money. When you sign a convertible, your startup receives an investment, but does not need to issue any shares at that time. It’s called a convertible because the contract can convert into shares in your startup in the future (typically at the time you do an equity funding round). A convertible is typically signed by your topco.
Clara Tip: There are many types of convertibles and you may have heard a number of different names like convertible note, SAFE or KISS. See below for more details on the different types of convertibles.
Key features of a convertible
No shares are issued at the time a convertible is signed and money is received.
Investor typically receives a discount to the valuation of your startup at the next equity funding round. This is typically around 20%, though it can vary from 10% to 30% in some cases. This is essentially compensation for the investors taking a risk by investing in your startup early and not receiving shares (and the enhanced investor protections that come with holding shares) at the time of the investment.
In addition to the discount, the valuation may also be subject to a valuation cap. A valuation cap is the maximum valuation of that startup when calculating the conversion of the investment amount under a convertible into shares. It can work instead of or alongside a discount (in which case, it is whatever valuation is lower between the discount and the cap). So, if an investor invests with a 20% discount and a USD 3 million valuation cap, if at the next equity funding round the startup is valued at USD 6 million, then the investor will convert at the USD 3 million valuation (i.e. an effective discount of 50%). If the startup is valued at USD 3 million, the investor would convert at USD 2,400,000 (a 20% discount) because that is lower than the cap.
The valuation can be on either on a pre-money or post-money basis.
Some convertibles may carry interest. This is typically an annual interest rate that is added onto the investment amount. Unless the convertible has a maturity date with repayment obligation (see below).
Some convertibles may have a maturity date. This means that if you do not do an equity funding round and convert the investment amount into shares by certain date (e.g. 18 months from the date of the investment) then the investor has the right to either require repayment (this is increasingly rare since it’s widely acknowledged that startups will not have the money on hand to repay) or force a conversion into shares.
Other rights may include:
a “most favoured nation” (MFN) right, which grants the investor the right to upgrade their rights under the convertible to any more favourable rights that are granted to other investors in future convertibles (e.g. a higher discount or lower valuation cap);
a participation right, which grants the investor the right to invest additional money in the startup’s next equity funding round, typically either an amount equal to their investment amount under the convertible or an amount proportionate to what their percentage shareholding would be in the startup once converted; and
information rights, which require the startup to provide certain information to the investor about its business and financials (e.g. quarterly management accounts, annual audited accounts, right to inspect books and premises).
None of the key rights of an investor need to be discussed or agreed at this stage. They will be negotiated as part of the next equity funding round that will be carried out by your startup.
Most common types of convertibles
A convertible note is the traditional format, though one that has become less popular in recent times (losing out to the SAFE – see below). A convertible note typically: (i) carries an interest rate on the investment amount (although this interest is usually added to the investment amount when it is converted) and (ii) has a maturity date and so may sometimes need to be repaid by the startup (although sometimes the repayment is replaced with a mandatory conversion instead, but that also has some difficulties because converting with a normal equity funding round can be tricky – e.g. how do you set the terms, if it’s the first equity round, what documents do you use etc.). Neither of those features are ideal for an early-stage startup and that’s why SAFEs have become the dominant convertible in the market these days.
The most common and popular type of convertible for startups today is the SAFE (which stands for Simple Agreement for Future Equity). It was originally created by Y Combinator. A typical SAFE sets out an investment amount, a valuation cap and a discount, but does not include a maturity date or interest. This means that it is possible that a SAFE investment may never be repaid if an equity funding round doesn’t happen. It also typically does not carry any additional investor rights, such as an MFN right, participation right or information rights, but these can be agreed to separately in a side letter with the investor.
Clara Tip: It's always better to try and keep all the SAFEs you sign on identical terms (other than investment amount). If there are any special rights that you feel you have to give to one of your investors (e.g. a large investor leading your SAFE round), then it’s better to give those terms in a side letter and keep the format and terms of the SAFE as consistent as possible with all investors. This doesn’t mean the side letter terms would not be known to your other investors (it’s always a good idea to be as transparent as possible and disclose all terms), but it keeps the process for reviewing and signing the SAFEs easier and highlights that any special terms are only given to specific, large investors and are not to be expected by most of your SAFE investors. Keeping all the conversion mechanics the same will also help you a lot when you come to convert all the SAFEs and run the calculations needed to figure out how many shares to give to each investor.
A KISS (which stands for Keep It Simple Security) is a type of convertible created by 500 Global. It has many of the same elements of a SAFE, although in its traditional form it always carries an MFN right and the right to receive 2x the investment amount if there is a sale of your startup before it is converted. There are other variations that may also include a maturity date and/or carry interest.
Fixed Percentage Convertible
A fixed percentage convertible is a type of convertible that guarantees a fixed amount of equity (expressed in percentage terms) in your startup upon conversion. For example, the convertible could state that at the next equity funding round the holder would receive a number of shares representing 4% of your startup’s share capital. This sort of convertible is rarer, but is popular with accelerator programmes, in particular. The rest of the structure of a fixed percentage convertible is typically similar to a SAFE (including the lack of a maturity date or interest).
Clara Tip: With every type of convertible, one of the most important things for you to look out for is what is included and excluded when calculating your startup’s share capital, often referred to as your company capitalization or your fully diluted capitalization. This will have a material impact on your dilution. It’s a complex area and related to the concepts of pre-money or post-money valuations, so take the time to understand it and speak to advisors, mentors etc. (and your investors) about this.
Convertibles are a quick and simple way for your startup to raise funds.
You’ll typically avoid a discussion on your startup’s valuation (other than agreeing a cap) and what investor terms you have to give (other than any agreed at the convertible stage, such as MFN right, participation right or information rights).
There are many types of convertibles. The most common is the SAFE. Others include a convertible note, KISS or fixed percentage equity convertible.
Try and keep the terms of all your convertibles similar as much as possible.
Take a hard look at your company capitalization (or fully diluted capitalization), including whether it’s one a pre-money or post-money basis.