What should the conversion discount be for a bridge note into preferred stock?

April 28, 2007

The conversion discount refers to the discount from the price per share price paid by investors in the VC Series A that is used to calculate the number of shares of Series A issued upon conversion of the note into Series A. The discount generally seems to range between 20% to 40% depending on the situation. I’ve recently completed an extremely early stage high risk deal where the discount was 50%.

If the conversion discount was 20% and the price of the VC Series A was $1.00 per share, then each $0.80 of note would convert into one share of Series A.

Charles River Ventures announced a QuickStart seed funding program where the conversion discount increased monthly, but capped at a maximum discount. In my opinion, this seems like a good deal for founders.

The purpose of the conversion discount is to give the investor an appropriate return for investing in the company before the VC Series A round.  The other way for the investor to receive an extra benefit is to receive warrant coverage.  In some situations where there is only a short time between the bridge loan and the Series A, no conversion discount and some amount of warrant coverage seems more appropriate.

The concept of the discount increasing over time seems to make sense to me. If a company only needs 2 months of bridge loan before a VC Series A, then the discount should be lower than a bridge loan that may be outstanding for 12 months. A bridge investor needs to be compensated for the potential valuation increase during the time period that the bridge loan is outstanding, plus compensation for risk. I think the amount of discount needs to factor in (i) the length of time until milestones or other metrics are achieved that would enable the VC Series A round, (ii) the length of time that the funds will last, and (iii) general risk.

Comments

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  • Carl Loeffler

    What are the tax consequences of conversion discounts? Does the investor have realized gain equal to the discount at time of conversion, or just a lower basis? What about interest on a convertible note? Is it taxed upon conversion, even if the interest converts into stock?

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  • Jake

    My company is small an cashflow positive but needs investment to grow. We’ve been offered a bridge note of ~$1million by a strategic partner. The terms do not include warrants but have an interest rate of 20% and a discount of 20% on conversion at the A-round. This interest rat seems very high to me. Do you have any perspective on this?

  • http://www.startupcompanylawyer.com Yokum

    The interest rate is high, but a 20% conversion discount seems company favorable. Whether the conversion discount is high or low depends on the amount of time that the note will be outstanding/when the next round of financing will occur.