Tag Archives: convertible note

Convertible Note Term Sheets

Just like the preferred equity financing process, the convertible debt financing process can start with a term sheet, rather than a full set of financing documents.

A convertible note term sheet is beneficial because it postpones a lawyer from cranking out a full set of docs until consensus is reached regarding the convertible debt offering’s material terms. It also makes any potential back-and-forth negotiation on such terms easier to manage.

On the other hand, if you are dealing strictly with friends and family on a convertible note transaction, adding this extra step in the process could be somewhat cumbersome. Thus, it’s usually prudent to go straight to the convertible note deal docs with friends and family.

Here are terms that are typically found in a convertible note term sheet:

Amount of the Offering: How much capital can the startup raise via the convertible debt offering?

Closing: Is there a specific date that the convertible debt financing will close, or will there be an open round of seed investment?

Interest Rate: What is the rate of interest on the convertible debt? Is the interest payable upon maturity or monthly/quarterly/yearly?

Term: When is the maturity date of the convertible notes?

Prepayment: Can the startup prepay the convertible notes without the consent of the convertible note holders?

Convertibility: What amount of equity financing is required to trigger automatic conversion of the convertible notes to equity (i.e., the determination of qualified financing)? What is the discount received by the convertible note holders relative to the price paid by the qualified financing investors? Is there a convertible note discount price cap? Do the convertible notes convert to equity on the maturity date, and if so, at what valuation">pre-money valuation?

Liquidity Event Payment: How much (e.g., 2X/3X, etc.) do the convertible debt holders receive if the startup gets acquired before a qualified financing and the maturity date? What is the definition of “Liquidity Event”?

Warrant Coverage: Do the convertible debt holders receive warrants to purchase “Series A” shares, and if so, how much percent coverage?

Security Interest: Will the convertible notes be secured by any or all assets of the startup?

Amendment: What is the manner how the convertible notes can be amended? Majority of the principal amount of the notes?

Legal Fees: Does each party pay for its own legal fees?

Keeping a Seed Financing Round Open

Startups don’t want to wait until every investor is ready before closing on a seed financing round. First, the roster of investors will not be identified and/or cutting checks on the same day. Second, what startup wants to wait on cash?

Therefore, most seed financings allow for an initial close (i.e., that first investor check) with an extension period for future investors. But in order to properly accomplish this, your startup will have to keep the round “open” via the deal documents.

Here’s what an open round mechanism might look like in a convertible note financing document:

The initial closing of the sale and purchase of the Notes (the “Initial Closing”) shall occur on [DATE], or such other date as is agreed upon by the Company and the Purchasers (the “Closing Date”). The Company may sell all or part of the remaining Notes in one or more subsequent Closings to be held on or before [X] days after the Initial Closing (each a “Subsequent Closing Date”). Each Purchaser at such Subsequent Closing Date shall become a party to this Agreement and shall have the rights of, and be subject to limitations applicable to “Purchasers” hereunder.

From the investor’s perspective, they don’t want the round to extend forever and let subsequent investors get in on the same terms several years from now. Thus, 60-90 days is a fairly common “final close date” and anything beyond that you probably need strong justification. But remember that while a lot of these deal structures are standard — each individual deal is unique. Additionally, there is a push to keep seed financing rounds open for longer than the “normal” open period.

The Convertible Note Discount and Price Cap

If you follow this blog, you know that I think convertible debt is a good structure for a startup’s angel round. The main feature of the convertible note is that the debt investment made by the angel investor will typically later convert into equity. For this article, let’s assume this equity is the Series A Preferred Stock purchased by a venture capital fund.

Convertible Note Discount

As a sweetener to the angel investor (i.e., compensate the angel for the early risk), the convertible promissory note will have an automatic conversion discount feature by which the angel investor will exchange the convertible debt for shares of the Series A Preferred Stock at a discount to the price per share paid by the venture capital fund at a Qualified Financing.

For example, if a venture capital fund purchases Series A Preferred Stock at $1.00 per share, the discount may allow the angel investor to purchase the same Series A Preferred Stock at $0.75 per share. (For more background, check out this post for an example of how convertible debt and the conversion discount works.)

Incentive Misalignment

Convertible notes have drawbacks — they aren’t perfect. The main drawback is the quirk that the lower your pre-money at Series A, the more equity your angel investor gets.

EXAMPLE 1: If a VC invests $2,000,000 at a $5,000,000 pre-money valuation and an angel investor has a $100,000 convertible note with a 25% discount, the angel investor will own 1.9% of the startup immediately after the Series A round.

EXAMPLE 2: But if the VC invested at a $15,000,000 pre-money, the same angel investor would own 0.78% of the startup right after the Series A.

Because of this quirk, an angel investor may not have much incentive to help increase your pre-money valuation before a Series A…regardless of the conversion discount. Meanwhile, you and your co-founders are doing everything possible to increase the startup’s valuation.

Convertible Note Price Cap

To provide upside protection, angel investors like to put a “price cap” on the convertible note discount. This price cap is expressed in terms of a pre-money valuation and effectively acts as a share price ceiling. Thus, an automatic conversion discount with a price cap might read something like this:

“The conversion discount shall be the lower of (i) a 25% discount to the Series A Preferred Stock share price, or (ii) the price per share if the Series A premoney valuation was set at $[6,000,000].”

Using the hypothetical in Example 2 above, an angel investor using this $6,000,000 pre money price cap would receive 1.45% instead of 0.78% as of right after the Series A.

Price Caps as a Weapon

The original idea was that price caps would provide upside protection for an angel investor. But occassionally I’ll see an angel throw in a really low price cap (<$400k) in the automatic conversion section. How many Qualified Financings are going to take place lower than $400k (and make the conversion discount percentage even a legit term)? Lowball price caps are essentially a “#$!@ you” to the startup.

How to Set Conversion Discounts in Convertible Notes

Convertible promissory notes do not include a stated pre-money valuation. Instead, the convertible note seed investor and startup agree that the pre-money valuation for the convertible note investment will be determined by the pre-money valuation the startup receives at the Series A round. However, the convertible note investor does not receive the Series A pre-money valuation, but rather a lower pre-money valuation as determined by the conversion discount.

The convertible note seed investor gets a lower pre-money than the Series A investors for investing in the startup before the Series A round. Since the convertible note investor made the higher-risk investment in the startup, the seed investor’s reward is the ability to purchase (not by investing new cash, but by exchanging the debt) Series A shares at a price per share lower than the per share price paid by the other Series A investors.

So how do you set the conversion discount in a convertible note?

Conversion discounts are set to approximate the amount of risk the convertible note investor is taking by investing in the startup. In addition to the general risk of investing in an early-stage startup, other factors include time and the likelihood of the startup’s valuation increasing between the convertible note investment and the Series A round,

The majority of convertible note deals I see have the conversion discount set at a fixed percentage somewhere between 10% and 40%.

Occasionally, I have drafted conversion discounts that increase over periods of time. For example the conversion discount may be:

(i) 15% if the Series A round occurs within 6 months of the convertible note investment;
(ii) 25% if the Series A round occurs within 7-12 months after the convertible note investment; or
(iii) 40% if the Series A round occurs 12 or more months after the convertible note investment.

How Convertible Debt Works

Convertible debt is a type of security frequently issued by startups when raising seed capital. With convertible debt, the startup issues the seed investor a promissory note, for the investment amount, that contains a conversion feature. The conversion feature is the mechanism by which the debt (the promissory note) will convert to equity (new shares for the investor) upon a future event.

The Qualified Financing

Most (if not all) convertible promissory notes contain an Automatic Conversion clause that dictates the automatic conversion of the convertible debt upon a “Qualified Financing.” The Qualified Financing is typically defined as an equity financing by the startup, for the purpose of raising capital, in which the aggregate of $1,000,000 (this amount can vary per deal) is purchased by investors. Thus, the Qualified Financing event is the trigger by which the convertible debt will automatically convert to equity. The conversion is considered “automatic” because it does not require the vote of either the startup or the investor.

The Qualified Securities

The equity raised in the Qualified Financing (the $1,000,000 above) is typically termed “Qualified Securities.” Think of this as the Series A round. The convertible debt held by the investor will convert to the Qualified Securities. The amount of shares of the Qualified Securities issued to the convertible debt investor is dependent on the conversion discount per the terms of the convertible promissory note.

The Conversion Discount

As a sweetener to the convertible debt investor, convertible promissory notes have a conversion discount feature by which the convertible debt holder will exchange the debt for Qualified Securities at a price per share equal to 80% (this amount can very per deal) of the price per share paid by the Qualified Financing investors (the investors with the new $1,000,000 above).

Example

Here’s the basic outline of how convertible debt works:

(1) Joe Angel invests $100,000 in Startup.

(2) Startup issues Joe Angel a convertible promissory note for $100,000. The convertible promissory note has an automatic conversion feature at $1,000,000 (the “Qualified Financing”) with a conversion discount equal to 20%.

(3) Startup closes $1,000,000 Series A Preferred Stock round (the “Qualified Securities”) by a VC at a Series A Preferred Stock price of $1.00 per share.

(4) Since the Automatic Conversion feature in Joe Angel’s convertible promissory note is triggered by the Series A round, Joe Angel’s convertible debt will be converted to Series A shares at a per share price of $0.80.

(5) The Startup issues Joe Angel 125,000 shares ($100,000/$0.80 per share) of its Series A Preferred Stock. The convertible promissory note is cancelled.

Selling Your Startup with Convertible Debt

I previously mentioned that convertible debt is a good way to raise capital for most startups. The main reason why convertible debt is beneficial for startups is that it delays coming up with a valuation figure at the seed stage–the valuation conundrum is essentially punted to the Series A (or “qualified financing” stage).

But what happens to the convertible debt if you sell rather than raise capital?

In most situations, the investor will receive more than the interest due + principal balance of the loan. I’ve seen anywhere from 1.5X-3X the outstanding principal amount of the loan due the investor upon the closing of the “change of control” event. This 1.5X-3X payment is, of course, made in full satisfaction of the startup’s obligations to the convertible debt investor.

In this unique situation, your startup essentially skips the “qualified financing” and goes straight to the exit. If the convertible debt investor wasn’t able to enjoy the upside in the event of an acquisition, such investors would be more reluctant to invest this way (and you’d be left to grapple with the valuation debate). Or worse, the investor would demand a higher interest rate. Or much worse, they would require their consent to prepay the convertible note before the qualified financing or maturity date of the loan.

The Basics of Convertible Debt Financing

Selecting the optimal structure when raising capital for your startup can be a challenging task. When clients ask me for my recommendation, I find myself recommending the convertible debt financing route more often than traditional equity financing (i.e., I’ll give you $100k for 20% of your company’s stock).

So what is convertible debt?

Convertible debt financing is basically an investor loan to your startup that has a future conversion-to-equity feature. That is, your startup’s investor gives your startup a loan like a bank would, but the outstanding balance of this loan will convert to shares in your corporation at a future date.

When does convertible debt convert to equity?

Convertible debt typically converts to equity the next time your startup raises capital (think venture capital or similar large investor). Technically, this large raise is called a “qualified financing” per the convertible debt agreements (note and note purchase agreement).

How does convertible debt convert to equity?

Convertible debt converts to equity based on the valuation your startup receives from the venture capital firm in the “qualified financing.” For example, if your venture capital investor ends up paying $1 per share for your startup’s preferred stock and you have $800,000 of convertible debt, the investor will receive 800,000 shares of preferred stock. The loan will then be cancelled. (Note: Convertible debt often converts to preferred stock at a discount than what the venture capital investor pays for the preferred shares.)

So why do I recommend convertible debt so much?

Simple: It delays the valuation discussion. I see many founders struggle with their investors over a valuation to do a straight up cash-for-shares equity investment. And this struggle can last for months and eat up development time.