Valuation of Convertible Notes

After you have operated your business for a while and distributed your company shares, you may have considered taking on new investments in the form of a convertible note. These notes are special loans that can be converted into shares of a company. They are the go to investment instruments for new startups looking to get funding to build their company.

But before we discuss how to find out the convertible note valuation, let’s cover what a convertible note is.

What is a Convertible Note?

A Convertible note is a form of a loan that contains both a debt feature and equity feature. The main advantage of this loan is the dividend (like loan interest) paid back to the note holder for their initial investment. This special type of loan also allows the holder to convert the debt into equity of the company, usually upon a triggering event, such as the sale or liquidation of the company.

Convertible notes can come in many different forms, but the most common are the 500 Startups KISS (Keep it simple security) and Y-Safe Combinator SAFE (Simple agreement for future equity. These types of notes mainly differ in terms of the interest, valuation cap and discount rate.

Things to consider for convertible note valuation

The basic concept for valuing a convertible note is the same in theory as the valuation of any other financial asset. The value of the note is equal to the present value of the future income that the convertible note will receive, discounted to the present value based on its associated risk.

This process requires identifying the expected future cash flow, and also the required rate of return to use when discounting the convertible note. The required rate of return can vary from company to company, but a benchmark for this can be on a return on similar notes in the public market.

Before we dive into the details of the valuation of convertible notes, let’s summarize the main features of a note:

• The principal amount (or par value) which is the total amount loaned from the borrower to the company, to be returned on the maturity date.
• A coupon rate (interest rate), which is the interest generated and to be paid periodically to the note holder. This interest is commonly in cash, but can also come in the form of equity.
• There are also zero coupon bonds, or convertible notes that do not generate any interest. This simplified type of note is often purchased at a discount of the par value.
• Option to convert the debt amount into shares of the company, depending on the agreement of the convertible note. This can also include other factors such as the conversion trigger amount, valuation cap, early exit multiple, conversion discount, and others.

Convertible Note Valuation

In order to find out the valuation of convertible notes, its essential to understand the relationship between interest rates and the value of the note. In general, the valuation of a debt security goes in the opposite direction of the current market interest. That is, when the market interest rates rise, older convertible notes become less valuable as newer investments will offer a higher yield. On the other hand, when market interest rates fall, existing convertible notes become more valuable, as newer investments have less to offer. This relationship between the coupon rate, principal amount and market rate can be summarized as below:

This theory is also commonly studied in the bond market, where these financial assets also contain interest rate (coupon rate). In the above graph, YTM is Yield to Maturity, or the market rate.

In this graph we see that:

• If the coupon rate is less than the required market rate of return, the price of the convertible note is lower than its par value. (the note is selling at a discount)
• If the coupon rate equals the required market rate of return, the price of the convertible note is equal to its par value (the note is selling at par)
• If the coupon rate greater than the required market rate of return, the price of the convertible note exceeds its par value (the note is settling at a premium)

To demonstrate the relationship between these note price and interest rates, let’s take an example with some numbers.

Convertible Note Valuation Example

Let’s say there is an investor who buys a convertible note from the company with a par value of $1,000, a coupon rate (interest rate) of 10% with 5 years to maturity (assuming the company is willing to accept 10% interest payments over 5 years).

The future cash flows of this note would be:
Year 1-$100
Year 2-$100
Year 3-$100
Year 4-$100
Year 5-$1,100

Based on these cash flows, we can create three scenarios with differing interest rates to show how the market value changes with each one. In this example, we take the interest rates of 8%, 10% (par value) and 12%, as below:

The figures in the table show the relationship between the interest rates and the market value of the note. If the interest rate is 8%, the value of the note will exceed the par value. If it is at 10%, it will be at par value. And if the interest rate is at 12%, it will fall below the par value. These interest rates can be calculated quite easily with the right equations. However, determining the appropriate interest rate for a particular convertible note can be the most challenging part.

Applying a Discount Rate for Convertible Notes

Once the interest rate and market value is determined,a discount rate should be applied to find a more accurate convertible note valuation. This is normally determined after the appropriate valuations methods (income approach, asset-based approach, market approach) are used to find the value of the note.This discount rate will serve as a way to lower the valuation of the convertible note based on its risk and how it compares to other similar notes in the market.

The common risk factors for debt securities include:

• Default risk: The risk that the borrower will not be able to pay back the interest or principal payments. The risk of default can be determined after analyzing the company’s financial statements to see if it can fund its outstanding convertible notes.
• Interest rate risk: The risk that a change in interest rates in the market may reduce the value of the note. This creates an inverse relationship between the market rate of interest and the price of the note.
• Reinvestment risk: The risk the note will be refinanced or called back. If interest rates decline, and the borrower refinances, calls back or pays off the loan (in accordance to the agreement), the note issuer is forced to reinvest at a lower interest rate.

These risks should be considered when finding the valuation for a convertible note. Often the most challenging part is quantifying each of these risks. On the bright side, there are a lot of sources of information online to help with finding the appropriate interest rates, such as the U.S. Treasury Department. They have rates for many instruments such as treasury securities, bank loans, corporate loans, and many others. In addition to this, credit rating agencies like Moody’s and Standard & Poor’s have bond rating reports that contain the interest rates for various instruments. Both of these can help with finding the right valuation.

Another thing to consider is the current market for interest rates, as this may affect the risks to consider. When forecasting future cash flows, consider building a forecasting model close to the predicted economic forecasts for the valuation. This may help in getting better figure in the end.

How to record Convertible Notes on Eqvista

If you are considering incorporating convertible notes for your company or have already issued them, you can record these on the Eqvista app. This will help you with organizing the details of these notes, and how they will ultimately affect your company’s cap table.

Once you login to your account on Eqvista, head over to the “convertible instruments” section on the side menu under “Securities”. Once there, click on “issue instrument” to record your convertible note.

The first page for issuing convertible notes will contain all the basic information, such as: the instrument holder, the convertible note name, issue date and Note Type. It’s important to specify which type of note you are issuing, as these will differ based on their interest rates.

You will also enter in the principal amount (total amount of the note), interest rate, maturity date, and accrual frequency of the interest, as below:

After you have entered in the basic details of the note, you will also have to add in how this note converts to shares. This will include: which type of shares the notes converts too, the conversion trigger amount (minimum value of the company before converting to shares), valuation cap (maximum amount of the company value for calculating the number of shares to convert to), early exit multiple (multiplier of principal upon conversion) and the conversion discount(discount on the share price).

These terms for how the note converts to shares should be outlined in the agreement of the convertible note, as it will affect the convertible note valuation in the end.

Once the convertible note is created, the details of the note will appear on the app as below.

Later on, you can explore other options such as converting the notes to shares, or canceling the note in case it expires.

Visit our support page to learn more on how to create a convertible note on Eqvista.

Conclusion

In this article we have covered the many factors that go into a convertible note valuation and how to create one on the Eqvista App. These types of debt instruments can be crucial for growing your company and getting the necessary funds to expand.

Remember once you have set the dividend rate on your convertible notes, you should also take into account the other factors that can affect the valuation, such as the discount rate and valuation cap.

If you are looking for more information on convertible notes or have questions on how to create on on our app, let us know. You can also manage all your company shares on our App as well.