Thoughts on startups by investors that
fund them & entrepreneurs that run them

Knowledge Is Power: Convertible Note Financing Terms, Part III

Last week, we took the plunge and began dissecting an example term sheet for a convertible debt financing round piece by piece.  I’ll continue with more specific terms and wrap up next week with some thoughts about recent changes and trends for the future.  Readers may find it helpful to download the sample term sheet from my firm’s website and follow along with the commentary.In Part II, we looked at the mandatory conversion language that is at the heart of any convertible debt financing.  There are other conversion scenarios to be addressed in any thoughtfully drafted term sheet, one of which is as follows:

    • Voluntary Conversion: The Notes and any accrued interest shall be convertible, at the option of holders of a majority-in-interest of the outstanding principal amount of the Notes (“Majority Holders”), on the 18-month anniversary of the Initial Closing (the “Maturity Date”), into shares of Common Stock at a conversion price equivalent to a pre-money valuation of $3 million.

 

First, a word about the maturity date.  In my experience, a term of 12 to 24 months is common, with 12 months being on the short end.  Particularly when there are multiple closings taking place over a period of months, the fuse burns awfully quickly on a 12-month note given the many competing priorities of early stage entrepreneurs.  If you’re wondering why multiple closings would make a difference, the answer is that it usually makes sense to have all of the Notes in a given round mature on the same date (e.g., 18 months from the first closing), rather than on a rolling basis, to avoid administrative hassles and potential inter-creditor conflicts — or, in plain English, the prospect of newer lenders’ money being used to pay off earlier investors’ notes.  Some investors may say they face a 12-month limit based on lending regulations, as Yokum Taku has observed.

So what happens upon maturity?  Without any other language to the contrary, the Notes become due and payable in full, including principal and accrued interest.  That is obviously a challenge for the typical cash-strapped early stage startup that is seeking to raise more capital and is not in any kind of position to be repaying loans.  It’s worth mentioning two key attributes of convertible note venture deals here:  The debt is almost always unsecured, meaning there are no underlying assets to be seized as collateral in the event of default (unlike, say, a mortgage or car loan), and is not personally guaranteed by founders or shareholders.  Those deal terms reflect the relatively high-risk nature of this kind of early stage investment; a bank lending money to a small business would likely require collateral, a personal guarantee by the owners, or both.

In practice, if the notes mature and a startup has no cash and minimal hard assets, investors are left with little more than theoretical claims against an insolvent business entity (usually a corporation).  Thus, it’s in everyone’s best interest to see the startup raise more capital rather than declaring default and demanding repayment.  There are as many variations on this scenario as there are startups, but here are some common scenarios upon maturity:

  1.  The startup negotiates with the bridge lenders to extend the maturity date
  2.  The agreement contains language providing that, at the Company’s option, the notes may be converted to shares of Common Stock at a predetermined valuation
  3. Same, except at the option of the noteholders (per the term sheet example above)
  4. The company is unable to raise more financing and becomes insolvent (whether or not it formally files for bankruptcy)
  5. In rare cases where a startup is cash flow positive very early in its lifecycle, it may actually be able to pay off the notes without raising any equity investment.

Practically speaking, if the company is out of money, it’s out of money, so the difference between numbers 1 through 4 may not mean much.  Nevertheless, in some scenarios, a new influx of funding can resuscitate a startup, in which case there are meaningful distinctions between different classes of debt and equity holders.  For that reason, investors commonly insist on #3 (or nothing) rather than #2, giving them more flexibility.  Entrepreneurs generally prefer #2, provided it’s at a valuation that wouldn’t be absurdly dilutive given the amount of notes outstanding.

It’s worth pausing on the definition of the phrase “at the noteholders’ option.”  The sample language above includes the term “Majority Holders” defined as holders of a majority-in-interest of the outstanding principal amount of the Notes.  This is a helpful construct because if the company has to negotiate with lenders or investors, particularly under financial duress, it’s much better to only have to deal with one or two of them on behalf of all noteholders rather than having many simultaneous discussions and running the risk that one minority investor could derail the whole thing.  The “Majority Holders” concept also appears elsewhere in the financing documents, most commonly in the section regarding amendments and waivers, for similar reasons.  From the investor perspective, you are being asked to give up individual rights as a creditor of the Company for the greater good; assuming others are behaving rationally, you can reasonably expect that the Majority Holders, with the most skin in the game, holding notes identical to yours, will have interests aligned with yours in maximizing the return on their investment (or minimizing loss).

    • Prepayment.  The Notes may be prepaid only upon prior written approval of the Majority Holders. Any prepayment must be made in connection with the prepayment of all Notes issued under the Note Purchase Agreement, as amended.

 

To angels, prepayment defeats the entire purpose of making a convertible note investment in an early stage startup:  A 6% or 10% return within a year or two isn’t worth the risk associated with making an unsecured, non-recourse loan to an unproven, development-stage company with little or no revenue.  Investors want to see the company hit a home run, achieve an exit at a hefty valuation, and ultimately generate a 10x or greater return on their capital.  Therefore, it’s unusual for the company to be permitted to prepay the Notes without the holders’ consent (again, typically a decision the Majority Holders can make on behalf of all noteholders).  The one exception, which we’ll get to in Part IV, is if the startup is acquired before it closes a priced equity round; the company needs a way to retire the Notes in connection with a merger or acquisition, and investors will expect a decent return in that scenario.

Next installment will cover “Change in Control” provisions and some meaningful items hidden away in the “boilerplate” sections at the end of a term sheet that most people skip over.  As always, feel free to ask questions or give feedback in the comments below.
This article is for general informational purposes only, not a substitute for professional legal advice. It does not result in the creation of an attorney-client relationship.

Written by Antone Johnson

user Antone Johnson Founding Principal,
Bottom Line Law Group

Antone is a business lawyer and executive advising technology and media companies, entrepreneurs and investors in corporate, commercial and intellectual property matters. Johnson is Founding Principal of Bottom Line Law Group, a business and IP law firm and was the former VP and head of worldwide legal affairs at eHarmony.

prev next

You might also be interested in

The Discipline of Execution Defines an Entrepreneur

When entrepreneurs come to me with that “million dollar idea,” I have to tell them that an idea alone is really worth nothing. It’s all about the execution, and investors invest in the people who can execute, or even better, have a history of successful execution. Execution is making things happen, and for startups it usually means making change happen,

Read more >

10 Incentives For Entrepreneurs To Bootstrap Their Startup

Image via Pixabay

I’ve always wondered who started the urban myth that the best way to start a company is to come up with a great idea, and then find some professional investors to give you a pot of money to build a company. In my experience, that’s actually the worst way to start, for reasons I will outline here,

Read more >

The Right Startup Advisors Are As Valuable As Money

Warren Buffett advises President Obama, image via Wikipedia

If you are a new entrepreneur, or entering a new business area, it’s always worth your time to assemble an Advisory Board of two or three executives who have travelled that road before. You need them before you need funding, and if you select the wrong people, or use them incorrectly, no

Read more >

Surround Yourself With People Smarter Than You

Einstein image via Flickr by Sebastian Niedlich

Helpers do what you say, while good help does what you need, without you saying anything. People who can help you the most are actually smarter than you, at least in their domain. Top entrepreneurs spend more time putting the right team in place to accomplish their objectives than they spend on any

Read more >

The Planned Iteration Startup Launch Minimizes Risk

Eric Ries on Lean Startup methodology, via Wikipedia

The traditional mode of starting a company has been to plan a serial process, where you complete once all the steps, leading to the “big bang” launch of the company. I strongly recommend a dramatic departure from this model, called “planned iteration” or Lean Startup methodology, where you assume you won’t get

Read more >

One thought on “Knowledge Is Power: Convertible Note Financing Terms, Part III”

Comments are closed.