Everything Startups Need to Know About Convertible Notes

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Everything Startups Need to Know About Convertible Notes

The traditional startup investment instrument remains popular with angel investors

Everything Startups Need to Know About Convertible Notes
The Convertible Note. Photo by Tyler Clemmensen on Unsplash

Last week I wrote an overview of the SAFE agreement. This week we turn to the other common startup investment — the convertible note.

The SAFE and the convertible note are shortcuts for early-stage startups that aren’t ready to bite off on the time and expense required to issue preferred stock. They provide two different ways for investors to put in money now and get stock sometime in the future.

The SAFE is a kind of pre-payment for stock. The convertible note is a loan that converts to equity. There are a lot of similarities, but some critical differences.

The biggest advantage of the SAFE agreement is that it’s a simple template that requires filling in only a valuation or discount before being ready to sign. The flipside is that it offers limited flexibility and investor protection. For this reason, many sophisticated angel investors, angel groups, and early-stage VCs prefer the convertible note instead.

This flexibility makes the convertible note useful, especially for complex situations, but there is more a startup founder has to understand to avoid making critical mistakes.

Also called convertible bonds and convertible debt, convertible notes have been around since the 1800’s. In their traditional use, they’re a loan with an option to convert the debt to stock under specific conditions at a set price. This makes them useful to hedge funds and distressed debt investors by adding a bit of upside potential to their loans.

Though the same documents, startup investors use the convertible note differently. Though legally a loan, nobody expects or wants repayment. They’re simply a holding device until the “equity round” when stock is issued.

However, because they’re loans rather than equity, this causes some complications that founders and investors need to understand.

First, like any loan, it has a maturity date by which it has to be repaid. For startups, that creates a hard deadline for the startup to complete the equity round.

Second, the U.S. government offers some amazing tax benefits for investing in early-stage startups, but they only apply to equity investments in C-corps. They do not apply to loans. And they require holding the equity for 5 years. So investors want to loan to convert to equity as soon as possible to start the timer ticking.

Third, as a loan it must include interest above an IRS defined minimum. Interest is paid in equity rather than cash, but the IRS considers that income on which investors have to pay tax. There’s very few things more painful than paying income tax on stock which can’t be converted to cash for many years if ever.

Lastly, while the convertible note is far simpler than stock documents, there’s still plenty of complex details to negotiate. Before creating the loan documents, the startup and investors create a simple a term sheet.

The term sheet is a 2–3 page document that lists the terms of the agreement in (mostly) plain English. While non-binding, the term sheet is easier for everyone to review and negotiate.

The term sheet is negotiated between the startup and the lead investor. The lead investor is usually the largest investor in the round.

Once the term sheet is agreed, all other investors use the same documents with the same terms. Occasionally, though, there are “side letters” giving specific investors additional rights such as a guarantee of being able to invest in the following round.

Once the term sheet is complete and signed, the lawyers draft the actual convertible note.

The point of the convertible note is to make an investment in an early-stage company now and receive stock when the company does a “priced round” or “equity round” later.

If everything goes according to plan, the conversion to stock happens when there is a “qualified financing.” To avoid triggering this conversion when giving a small amount of stock to advisors or selling a small amount of stock, the qualified financing when the conversion occurs is usually defined by the sale a minimum amount of equity, typically $1M.

The price of the stock is defined in the convertible note by a valuation cap and/or discount.

The valuation cap is a maximum valuation. The investor gets the lower of this cap or the actual valuation in the equity round reduced by the discount.

For example, if the valuation cap is $10M and the price round valuation is $20M, the note is converted to equity based on the $10M valuation. If the priced round valuation is $5M and the note includes a 20% discount, the note will convert at a $4M valuation.

It’s important to note that this valuation cap is a pre-money valuation. The post-money valuation from which the stock price is calculated is:

post-money valuation = pre-money valuation + all investment converting at the same time

If this convertible note is the only investment prior to the conversion, the calculation is simple. If I invest $1M at a $10M pre-money valuation cap, the post-money valuation is $11M.

If the company raises another round of $5M in convertible notes or SAFEs before the equity round, the post-money valuation rises to $16M. See this article for the bad things that can happen using a pre-money valuation.

Not knowing the actual valuation is the primary reason many early-stage investors including me prefer a post-money SAFE over a pre-money convertible note.

These are the primary terms of the convertible note:

Financing Amount: The total amount the company is raising in this round. This is usually specified as a minimum and a maximum. Until the minimum is met, any money collected goes into escrow rather than directly to the company, protecting investors if the company can’t raise a sufficient amount. The maximum limits the amount of dilution in this round.

Maturity: As a loan, the convertible note has a maturity date at which time it is, in theory, supposed to be repaid. Startups want this to be as long as possible; investors want it to keep it short. 18–24 months is typical.

Valuation Cap: The pre-money valuation cap at which the note will convert to equity.

Discount: a discount from the priced round valuation. A typical value is 20%, though it can be higher if the maturity is longer, or lower for a short maturity.

Interest: the interest paid on the loan, typically set to 6% or 8%. The interest is paid in additional stock when the conversion occurs. i.e. if I invest $1M with an interest rate of 8%, and the conversion occurs exactly 1 year later, I get $1.08M of stock.

These are the headlines terms, and would like stated on a pitch deck as: raising $1M on a $10M pre, with a 20% discount and 8% interest.

Beyond these headline terms, there are other critical terms that can make a huge difference.

Liquidation Preference: In the case of a successful exit, note holders can convert the note to stock at the valuation cap and share in the upside. Hurray.

In a less successful exit or liquidation of assets, as a loan, note holders are entitled to their money back prior to equity holders (including SAFEs) getting anything.

With a 1x liquidation preference, I get my money back with interest. But I don’t need to settle for just a return of my money. We can set a 1.5x, or 2x, or even a 4x liquidation preference, giving me a guaranteed return (if the exit is large enough) before anyone else.

More details on the liquidation preference here.

Board Representation: Investors want to be involved in the business to provide both guidance and oversight. The lead investor is usually given a seat on the board of directors, and 1 or more other large investors may be given board observer rights. Legally, as a loan instead of equity, noteholders have no voting rights in the company until the note converts.

Options Pool: The company to usually required to reserve an options pool for new hires. This dilutes the common stockholders, so founders prefer a smaller pool. Investors want to ensure sufficient equity is reserved to grow the team. A typical options pool size is 20%.

Minimum Investment: To avoid cluttering the cap table with lots of small investments, founders may require a minimum investment amount. A $25K minimum is typical for pre-seed/seed rounds with $10K minimums at the earliest stages and up to $100K minimums by Series A.

Revesting: Possibly the most contentious term, some investors insist that stock held by founders be subject to a fresh 4 year vesting schedule. If that seems unfair, I don’t disagree. On the other hand, at one startup I invested in, the founder/CEO quit soon after closing the round to take a high-paying corporate job, leaving us scrambling to find a new CEO. And she got to keep all her shares. As investors, we want guarantees that the founders will stick around, or in the worst case, make their shares available for a replacement.

Qualified Financing: The note automatically converts to shares in the priced round when equity is sold to other investors. The term sheet defines the minimum size of that priced round. Some convertible notes give the investors the option of converting with any equity financing, but only the requirement to convert with an investment over the minimum.

Information rights: Investors want regular updates on the status of the business, including financial reports. Some startups limit this to the largest investors. As a small investor, I beg you to make this information available to everyone. We invested because we want to join your journey. Please keep us updated on not just your successes but your challenges so we can help.

Security: Most convertible notes are unsecured investments, but some investors may require the agreement be secured by intellectual property, or for a hardtech startup, facilities and equipment.

Legal Fees: it common for the startup to pay the legal fees of the lead investor to draft and negotiate the documents. This amount should be taken out of the investment and capped to a reasonable amount — $10K or $20K. Beware of scammers posing as investors asking startups to pay for their legal fees upfront.

Other terms: A convertible note is a flexible legal document that can incorporate any terms negotiated between startup and investors. Additional terms may include:

  • Warrants to reduce the valuation for anyone who invests before a deadline.
  • Covenants that the startup guarantees particular statements
  • Use of funds limitations
  • Insurance requirements if an investor is on the board

Once the terms sheet is set and signed, the lawyers can get started drafting the actual convertible note document.

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Entrepreneur's Handbook – Medium


Author: DC Palter