The conversion premium (or preference) is the premium that is paid, usually in the form of equity, to the investor when their convertible debt investment “converts” to equity at a subsequent round of financing.
For some thoughts on what is an appropriate conversion premium, keep reading below!
What Is a Conversion Premium?
The conversion premium (or preference) is the amount above the actual investment amount that is given to convertible debt investors at the time of conversion.
So, uh, what exactly does that mean? Basically it means that very early stage convertible debt investors usually get a bonus on their investment in exchange for being involved before you’re ready to nail down a formal valuation. It’s usually a good bet for both parties (at least in the very early going) for a couple of reasons.
For the founders, it places a cap on what these first investors can get at the next round of financing and essentially serves to put a cap on the amount of dilution that the founding team will take when a formal valuation event does occur and gives some upside to your first investors — again, this assumes that you’d like to see your earliest backers make some money, which we think most entrepreneurs do.
For the investor, it ensures that they will be rewarded for their early stage investment at the next round of financing (assuming the company gets to that point) and maybe more importantly, it removes the risk of investing at an inflated early valuation and then getting hammered if the company completes the next financing event at a lower valuation. This is because if you own a percentage of an overvalued company your investment will be worth less than you initially thought, whereas convertible debt allows your investment to remain in dollar amount until a more accurate appraisal of the company can be made. At this point your total value, the initial investment plus the premium, is converted into equity ownership.
What Is a Normal Conversion Premium?
The very short answer: We’ve seen everything between 5% and 50% premiums used but like everything else this really depends on a lot of things.
The longer answer: Before getting into it, we’ll say that we have no data on this and if anyone has some please send our way. But there are a few things that will help frame the conversation with investors. First, some professional groups use this tool in the early stages so that’s a good place to start. YCombinator and CRV Quickstart are two who discuss it openly but other firms will use this on an as-needed basis — usually when they are more in the incubation stage than the series A phase. That being said, this is not usual VC territory so don’t expect this if this is who you are talking to right out of the gate.
For short term, smaller investments, the premium should be lower. For longer term, higher dollar deals, the premium should be higher.
As a very rough example — we very frequently see 20% conversion premiums on angel investments that are expected to convert to equity in the next 12 months.
We’d encourage you to set up what you think are realistic scenarios in the tool and just play with this term to get a feel for its impact. Hopefully the tool makes it easy to see and understand the impact.