How Should the Conversion Discount for Convertible Notes be Determined?
Conversion discounts are often included in a convertible bridge note, specifying a discount rate that is applied to the company’s valuation for purposes of calculating the conversion price. The purpose of the conversion discount is to give the investor an appropriate return for investing in the startup before the Series A round (or any other later round), and the rates are set to approximate the amount of risk the investor is taking by funding companies in the beginning stages.
Depending on the circumstances, convertible note discounts typically range between 20% and 40%. Higher risk investments might call for a larger discount, and lower risk investors may command a lower discount. There are also conversion discounts that increase over periods of time, with a max discount cap. An example of such a discount might be:
- 10% if the Series A round occurs within 6 months of the convertible note investment;
- 20% if it occurs within 7-12 months after the investment; and
- 35% if it occurs 12 or more months after the investment.
I believe the concept of an increasing conversion discount does have merit and is a good deal for the company. As mentioned earlier, the discount is meant as a way to compensate the early-stage investor for the additional risk taken on by the investor that is not shares by the Series A investors because the Series A investors came in later, when more information on performance metrics should be available. If a startup needs just a few months of capital before the Series A, it makes sense the discount should be lower than a loan that is outstanding for many months or even years.