Hidden Danger of Interest and Discounts in Convertible Notes

It seems that more and more early stage investors are using convertible debt as an investment form (convertible note, subordinated loan agreement, etc) so it’s worth taking a look one of the least discussed portions of the loan: the interest.

Interest on loans has historically been intended as compensation to the loaner for the cost of capital of the loan. This makes sense in banking and financial services where the interest is the primary source of revenue and loaning is the main business activity of the bank. Keeping interest in the loan for angel and venture capital investing also makes some sense for the simplest of convertible loans, in particular if it is not clear if there will be a further financing in the future (but instead an exit or insolvency). In these two cases the conversion event never takes place, so the loaner never has the opportunity to benefit in the upside of a higher valuation through the increase in value of his shares (for insolvency that is a good thing, his loan now has a higher priority of payment than the shareholders). To compensate for the risk of there being an exit before the next financing or insolvency before the next financing (particularly common with bridge loans), the interest becomes an important component incentivizing the loaner.

However, convertible debt has become so common that many additional clauses have snuck in over time, namely Forced Conversion, Discount, and Caps. I’ll be talking primarily about the Discount clause and its effect on Interest in this post.

The “Discount” in Discounted Convertible Note is meant to compensate the investor for the massive risk he is undertaking by investing without setting a fixed valuation on his investment. Instead, the investor receives a discount to the next financing. (For example, if the next financing round has a $ 10 million pre-money valuation and he has a 20% discount, then he invests at a $8 million pre-money valuation).

Where it gets interesting is if the convertible loan contains both a discount as well as interest. In this case, the interest accumulates over the life of the loan (until the next financing) and also converts. So if a $ 1 million loan with 10% interest (for simplicity let’s say it is non-accumulating interest –i.e., “bullet loan”), then after a year $1.1 million is converted. Remember: interest is also discounted. So in the example above with 20%, the $1.1 million is converted not at the round’s $ 10 million pre-money valuation but rather at the discounted $8 million pre-money valuation.

So let’s compare:

(Assuming a $ 10 million pre-money Series A, in which $ 1 million was invested as a loan 1 year before.)

(The loan without interest or discount might as well be thought of as an equity investment now – it doesn’t get any special economic effects so it is the same as $ 1 million investing in this new round).

Obviously the presence of the discount and the interest are beneficial to the investor, but what most founders forget is that they are compounding. Even with numbers as low as these and with only 1 year interest, we see enough change for it to be a discussion point. The final results of the negotiation depend on many factors of course, but a founder should recognize that the “interest plus discount” combination can lead to more dilution than he was expecting.