Discount rate, convertible debt and the effect of time

Question

The way I understand it is that there are three main parameters to a convertible debt investment.

1. An investment amount
2. A discount rate
3. A trigger event

Now under most of the examples I have seen, a trigger event for a given investment will occur, a post money valuation will be made based of the subsequent investment, at that point the convertible debt will be converted and a discount rate applied to it to calculate the initial investors final equity amount.

However I have on numerous occasions seen the discount rate being referred to as an "interest rate" and I stand confused in trying to understand if the length of time till the trigger event somehow effects the final discount rate of a convertible debt investment.

So say for example you negotiate a convertible debt investment with a 12% discount rate, does this mean that if the trigger event occurs in 1 month you might only have a 1% discount rate?

Fundamentally what I am asking is, does time have an effect on the discount rate or is this a set value regardless of the period of time elapsed till the trigger event? If the value is set, why is it often referred to as an interest rate?

Answer 1

You are mixing terms here.

The definition of an "interest rate" is typically a simple interest rate as applies to the Principal of a loan. The unpaid interest rate is not compounded. This is owed at the conclusion of the loan or when converted to debt. Typically rolled into the equity stake.

The definition of "discount" is what the convertible debt holder would be rewarded as an early investor. If the Priced round comes in @ $\$1.00$ per share and the convertible debt holder has a 25% discount then they would convert their loan at $\$1.00 \times (1-0.25)$ or $\$0.75$ per share.

There is another major term called "the Cap" which sets a ceiling at the first priced round. This is critical to the deal terms. More on this later.