How do convertible securities work?
Convertible securities like convertible debt/notes and convertible equity are commonly used to provide both seed and venture funding to early stage startups. In convertible securities the investment is given right away to the startup but conversion to equity happens during the next round of financing or as described in the terms of the security agreement. To compensate for the added risk in investing in early stage startups, convertible securities have features like:
i) Discount rate
ii) Valuation cap
iii) Return Provision
Discount Rate:
Discount rate is the discount on the Series-A, or other relevant valuation at which the convertible security investment is converted to equity. Discount rate determines how much the investor is compensated for taking the early risk.
Example:Investor A has a convertible note of $100,000 with a discount rate of 20%. If a qualified funding round, like Series A generates a price/share of $1, other investors get shares at $1/share while the investor A gets to purchase shares at 20% discount hence at $0.80/share. Number of shares owned by investor A = $100,000/$0.80 = 125,000 shares.After the conversion of the convertible note to equity, the convertible note is cancelled.
Any ‘new’ investor who contributes $100,000 as investment will receive 100,000 shares @$1/share.
Valuation Cap:
Valuation Cap refers to the pre-money valuation limit set in the convertible security agreement at which the convertible security investment is converted to equity. It does not imply that the company’s pre-money valuation is equal to the cap. It just implies that the actual pre-money valuation will be determined later but in no case would it be higher than the cap. The cap thus helps to set the conversion price at which the investors security would be converted to equity.
In a qualified round of financing, say Series A, if the actual valuation is greater than the cap mentioned in the agreement the investor will convert to equity at agreed cap in the agreement even though it is lower, else it will convert at the valuation.
*Price/share calculated as Pre- Money Valuation Cap/ Outstanding shares
Return Provision:
A return provision is basically repayment of the investor’s principal “x” times. It could be 2x,5x or any other multiple negotiated with the investors.
Raising funds is all about negotiation. To raise money successfully both investors and founders can agree on one or more than one of the above stated provisions (discount, price cap or return provision).
Do convertible note investors receive IRS form 1099-INTs from the company after their note converted to equity?
If the note pays interest periodically (could be annually or semi-annually as specified in the agreement), the investor must recognize interest income when it is received. If the note requires interest to be accrued and not paid till maturity, it is still treated as paid. Per the requirement under federal tax rules, the company must still issue Form 1099-INT to the investor. There are numerous tax issues on convertible notes most of which largely depend on whether the note is characterized as debt or equity instrument.
About The Author
Arushi Bhandari is an MBA and a licensed CPA in the state of California. She has helped several Silicon Valley startups at different stages with their accounting and tax related issues. Her publications eBooks - STARTUP Financing, Equity and Tax and Introduction to Equity Compensation are available on Apple iBookstore, Amazon Kindle and Google Play. She maintains a public blog at www.startuptaxaccounting.com especially aimed at startups, and has guest blogged at different startup platforms such as The Startup Garage and Belmont Acquisitions.
DISCLAIMER: The information provided is intended to educate the readers and a more definite answer should be based on a consultation with a lawyer or CPA.It should not be relied upon as legal advise because the information might be incomplete and answers could change depending upon circumstances and if all facts were known.