Raising capital in the early stages of a startup often involves using instruments like Convertible Notes or SAFEs. You are not selling equity directly at a fixed price. You are taking money now with the promise of giving shares later.
The mechanism that governs how that money converts into shares is critical to understand.
One of the two main levers in these negotiations is the discount rate.
In simple terms, the discount rate is the percentage off the share price that early investors receive during the next priced funding round. It serves as a financial reward for taking a risk on your company before it had a solidified valuation.
The Mechanics of the Math
#When your startup raises a priced round in the future, typically a Series A, the new investors will agree on a specific price per share. Let us say that price is set at $1.00 per share.
Your early investors holding a convertible note do not pay that full price. They paid you earlier when the risk was higher. Therefore, their money converts at a lower price based on the discount rate you agreed upon.
If the discount rate is 20%, the math looks like this:
- Series A Price: $1.00
- Discount: 20%
- Conversion Price: $0.80
Because their conversion price is lower, their original investment buys them more shares than the Series A investors get for the same amount of money. This effectively dilutes the founder more than the Series A money does, but it is the cost of accessing capital early.
Comparison to Valuation Caps
#Discounts rarely exist in a vacuum. They almost always appear alongside a Valuation Cap.
The cap sets a maximum effective valuation at which the investment can convert. The discount rate provides a percentage off the round’s price.
In most legal agreements, the investor gets whichever option results in a lower price per share. They get the better deal.
Consider a scenario where your company value explodes. If the Series A valuation is massive, the Valuation Cap will likely offer a much lower price per share than the 20% discount would. Here, the cap protects the investor from your extreme success diluting their ownership stake too much.
However, if the company grows modestly and the Series A valuation is close to your early estimates, the cap might not trigger. in this case, the 20% discount kicks in to ensure they still get a better price than the new money coming in.
Standard Market Rates
#Founders often ask what the number should be.
There is no law regarding this, but market norms usually settle between 10% and 30%. A 20% discount is the most common figure seen in early-stage term sheets.
If you offer a discount that is too low, perhaps 5% or 10%, investors may feel the reward does not match the risk of investing in an unproven idea. They might pass on the deal.
If you offer a discount that is too high, such as 40% or 50%, you create potential problems for the future. It creates excessive dilution for the founding team. It can also signal to future Series A investors that the early money got too good of a deal, which can complicate negotiations during the next round.
You must balance the need to attract capital now against the cost of equity later.