Convertible notes are one of the most common ways investors invest in early-stage startups. And yet, even with their popularity, they are still quite confusing to many founders. If you've looking for a greater understanding of convertible notes, check out this presentation from Kevin Smith from SEEDCHANGE (www.seedchange.com) and Gadiel Morantes from Early Growth Financial Services (www.egfs.co). This presentation explores how convertible notes really work, including: - Why convertible notes vs. shares of common or preferred stock - Convertible note terms - and the terms that REALLY matter - Conversion mechanics - Valuation cap - Safe alternatives to convertible notes - and more....!

1. 1
How Convertible Notes Work
#ConvertibleNotes
SEEDCHANGE

2. About Your Hosts
Kevin Smith
Founder and CEO
Gadiel Morantes
Partner
SEEDCHANGE

3. What’s a convertible note
(and why should you care)?
3www.seedchange.com www.earlygrowthfinancialservices.com
• Historically used for bridge
rounds
• Now standard for early stage
funding (unless you’re in
ROW)
• When to use convertible
notes:
– Seed
– Bridge
– Supplement

4. Startup funding cycle
4www.seedchange.com www.earlygrowthfinancialservices.com

5. Looks like a fish, flies like a bird. . . .
5
• Debt / equity hybrid
• Technically debt (interest and terms)
• Behaves (mostly) like stock: will convert when
the company does a sizeable equity
investment round
www.seedchange.com www.earlygrowthfinancialservices.com
IOU

6. The FAB of convertible notes—
Features
6
• Short agreement
• Simple
• Flexible
• No company valuation
• (Largely) standardized terms
www.seedchange.com www.earlygrowthfinancialservices.com

7. Advantages of convertible notes
7
• Short  Quick close(s)
• Simple  Low legal fees
• Flexible  Close any time
• No valuation  No negotiation
• Standard terms  No negotiation
www.seedchange.com www.earlygrowthfinancialservices.com

8. Benefits of convertible notes
8
• Short  Quick close(s)  Save time
• Simple  Low legal fees  Save $
• Flexible  Close any time  JIT funding
• No valuation  No negotiation  Save $/time
• Standard terms  No negotiation Save $/time
www.seedchange.com www.earlygrowthfinancialservices.com

9. How it works: a 1-page manual
9
• Decide amount of round and minimum investment
• Provide note terms to (accredited) investor
• Agree terms
• Sign and date
– the note purchase agreement (company and investor) and
– the note (company)
• Exchange executed note purchase agreement and
note for check/wire
• Add noteholder to cap table (debt page)
Convertible note is classified as debt
until it converts to equity
www.seedchange.com www.earlygrowthfinancialservices.com

10. All the terms that matter
10www.seedchange.com www.earlygrowthfinancialservices.com
• Interest rate
• Note term (Maturity date)
• Discount
• Note cap

11. Interest rate
11
• All convertible notes include interest rate: IRS says so
• Methods for determining the interest rate:
– Round number: 5%
– Tied to accepted standard: LIBOR
• Interest is paid in shares, not cash
• Interest begins to accrue on the date the note is signed
• Interest is paid when the note converts to stock
www.seedchange.com www.earlygrowthfinancialservices.com
Use 5%

12. Term (Maturity date)
12
• Date of conversion/repayment
• Typically converts after 12 or 18 months
• On maturity
• Convert or repay
• If neither, talk to your investors about amending
the note purchase agreement
www.seedchange.com www.earlygrowthfinancialservices.com
Use term = 18 months

13. Discount
13
• Discount on share purchase at time of
conversion to stock
• Compensates early investors for greater
risk
• 20% is standard
• Recent trend in Silicon Valley toward
15%, 10%, 0% discount
www.seedchange.com www.earlygrowthfinancialservices.com
Use 20%

14. Convertible note cap
14
• Dilution protection, not company valuation
• Allows conversion to stock at a ratio
guaranteed not to fall below $_____
• Aligns incentives between investors and
founders
• Investor chooses to convert using either note
cap or discount – not both
Median note cap = more or less approx.
something like $4.5 million
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15. Conversion example #1
15www.seedchange.com www.earlygrowthfinancialservices.com
Assumptions:
Note converts after equity investment of $1.5m.
Excludes 5% interest paid to noteholders in the form of shares issued at the time of conversion.
Assumes no post-money option pool (the last worksheet adds an option pool to this scenario)
Company (pre-funding): DISCOUNT CAP
Shares outstanding* 8,500,000 Series A at conversion Series A at conversion
Effective valuation $3,781,250 Effective valuation $3,925,000
Convertible note terms: Share price $0.44 Share price $0.46
Note Size $575,000 No. of shares 3,371,901 No. of shares 3,248,408
Note Cap $4,500,000 Equity 25.00% Equity 25.00%
Note Discount 20%
Note Holder at conversion Note Holder at conversion
Series A terms: Share price $0.36 Share price $0.46
Series A investment $1,500,000 No. of shares 1,615,702 No. of shares 1,245,223
Series A valuation $4,500,000 Equity 11.98% <----- Equity 9.58%
Return 1.25x Return 1.00x
Note holder converts via DISCOUNT -----> CONCLUSION
At this Series A valuation, the note converts
using the DISCOUNT, creating 2.4% more
equity for the note holder compared to a
CAP. The note holder's return on the Series A
is 1.25x.
Cap Table (Ownership) shares %
Team 8,500,000 63.02%
*Shares issued to founders and
employees
Series A 3,371,901 25.00%
Note holder 1,615,702 11.98%
13,487,603 100.00%

16. Conversion example #2
16www.seedchange.com www.earlygrowthfinancialservices.com
Assumptions:
Note converts after equity investment of $1.5m.
Excludes 5% interest paid to noteholders in the form of shares issued at the time of conversion.
Assumes no post-money option pool
Company (pre-funding): DISCOUNT CAP
Shares outstanding* 8,500,000 Series A at conversion Series A at conversion
Effective valuation $12,781,250 Effective valuation $11,775,000
Convertible note terms: Share price $1.50 Share price $1.39
Note Size $575,000 No. of shares 997,555 No. of shares 1,082,803
Note Cap $4,500,000 Equity 10.00% Equity 10.00%
Note Discount 20%
Note Holder at conversion Note Holder at conversion
Series A terms: Share price $1.20 Share price $0.46
Series A investment $1,500,000 No. of shares 477,995 No. of shares 1,245,223
Series A valuation $13,500,000 Equity 4.79% -----> Equity 11.50%
Return 1.25x Return 3.00x
Note holder converts via CAP -----> CONCLUSION
At this Series A valuation, the note converts
using the CAP, creating 6.71% more equity
for the note holder compared to a
DISCOUNT. The note holder's return on the
Series A is 3x.
Cap Table (Ownership) shares %
Team 8,500,000 78.50%
*Shares issued to founders and
employees
Series A 1,082,803 10.00%
Note holder 1,245,223 11.50%
10,828,025 100.00%

17. The down sides of convertible notes
(and an alternative)
17
• It’s still debt—and investors really want equity
• Debt incurs interest—and investors really don’t
care
• Debt has to be repaid---but what if you can’t?
Why not create something that looks and acts
more like stock?
Someone did: SAFE (Simple Agreement for Future Equity)
www.seedchange.com www.earlygrowthfinancialservices.com

18. Q&A and Thank You!
Kevin Smith
415 Jackson Street
San Francisco, CA 94111
www.seedchange.com
info@seedchange.com
1.877.711.9883
@seedchange
Gadiel Morantes
www.earlygrowthfinancialservices.com
contact@earlygrowthfinancialservices.com
415.234.3437
@EarlyGrowthFS
SEEDCHANGE