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What they mean
Convertible notes are debt instruments that convert into equity. Someone gets diluted by these notes and it is not always clear whom. If you don’t know the three ways that this debt will convert, then you need to read this nerdy article: Key convertible note terms that no one understands and cost you big. We will go through the:
- Pre-money method
- Percentage ownership method
- Dollars invested method
Investors are asking this to understand your capitalisation table and what the potential impacts are of any convertible instruments.
There is typically nothing sneaky about this question. If they are asking it, it means they are ticking off the mental boxes before maybe pulling the trigger on the deal. This is typically not a question to be asked in the first meeting. It can also be an off the cuff question you just gets asked out of interest.
Now, we need to deal with the ‘terms’ part.
It is not commonly known by founders, but once you agree to terms in deals, they become a watermark for future investors. If you were stupid enough, or desperate enough to have to accept a 2x liquidation preference, then future investors will want the same or more. They will use the terms against you.
When investors are asking what the terms are, they want to know:
- If you accepted bad terms and so were either dumb, naive or desperate
- If you have screwed yourself
- If they can get the same terms
You don’t need to say each and every term, but you will need to say the main ones. You can also say ‘here are the key terms, 1, 2 and 3. The note agreement will be in the dataroom, for you to review once we have signed a term sheet.‘
What you need to say
“Yes, our seed round was done as a $2 million convertible note converting at the next qualified financing round, which would be the series-A we are discussing now. The terms are pretty standard, but for headlines, there is a 20% discount and $6 million cap. We also negotiated to mitigate phantom preferences (Read this!)”
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