Of the various terms on a note, increasing the discount rate is *generally* a safe one to give on. The discount rate does not matter if your equity round is priced high enough. If the equity round is priced high enough, the note will just convert at the cap and the discount rate won’t really come in to play. Which is to say, that if an investor does want to price you at a valuation that would trigger the discount rate to matter, then our advice would be to structure that investor’s interest as a note / SAFE, and just delay pricing the company.
Let me give you an example to make this clear. Let’s say you got a note for $100k. And you have a note with a cap of $6 million, and a discount rate of 15%. What that means is that the $100K will convert into equity when you price the company. Now if the company is priced at $5 million, the note will convert at $5 million minus 15% of $5 million, or $5 million minus $750K, or $4.25m. That is the premium the note holder gets for taking the risk of investing in you early.
But if the company is priced at $10 million when you do the equity raise, not $5 million, the discount rate won’t come into play. Why? Becuase 15% off of $10 million is $8.5 million. And $8.5 million is higher than the note cap of $6 million. So the note will just convert at the cap of $6 million, since that is less than the price even after the discount.
And so if someone were to offer you money and want to price the company at a level where the discount rate would apply -- say $5 million -- we would urge you if possible to just structure their investment as a note, not a priced round, so you can delay the pricing to a point where the discount rate doesn’t matter.
What’s the point where the discount rate doesn’t matter? It’s the Note Cap Divided by (1 - the Discount Rate). In the example above of a $6 million cap and a 15% discount it’s $6 / (1 - 15%), or 6 / .85, or $7.06 million. If you raise at / above a $7.06 million pre money valuation, the discount rate doesn’t matter, the note will just convert at the cap.
Now, let’s say the discount rate was not 15% but instead 40%. Well then the price at which the discount rate doesn’t matter is $6 million / (1 - 40%), or 6 / .6, or a $10 million valuation.
So if you take a note with a very high discount rate, you just need to delay the pricing of the company until your price is high enough not be impacted by the discount rate.
The other factor here is that if your previous investors invested on Note terms that were worse for them than this, then you need to be prepared for the backlash. If you have a Most Favored Nation clause in your previous notes, they will get this discount. Even if you don’t, you may want or need to retroactively give it to them to avoid anger. Or you need to rationalize why the new investor is getting a higher discount -- and perhaps you can argue that the new investor will be doing more than just providing cash, they will also help advising, etc.
But all things being equal it’s better to increase the discount than decrease the cap, and it’s a place to give in on a note.