This week we move on to something near and dear to the hearts of entrepreneurs and investors alike: The exit, more formally known as a “liquidity event.” For convertible notes, the only liquidity event we need be concerned with is an acquisition of the startup in the near future, before the maturity date; otherwise, the notes will convert to equity of one kind or another, and the eventual sale of that equity (in a public offering, acquisition, or private sale) is a different subject for another day. Readers joining this series in progress may find it helpful to download the sample term sheet from my firm’s website and review the earlier posts covering the basics.
In Parts II and III, we looked at commonly used mandatory and voluntary conversion language in convertible notes. To account for scenarios in which the startup is acquired before it has a chance to complete a priced equity financing round, most term sheets and deal documents contain a “change in control” provision. Entrepreneurs generally don’t ask for this kind of language, but most sophisticated investors will insist on it in one form or another. To understand why, consider what would happen without such a provision if the startup turned out to be an overnight sensation acquired by Google for $30 million six months later. What happens to the outstanding convertible notes? In descending order of preference from the founders’ point of view:
1. The company pays off the notes immediately according to their terms, with prorated interest. Assuming a hypothetical $100,000 investment at a 10% interest rate, this kind of payoff would yield a return of $5,000 (5%) six months later – not exactly the kind of return angel investors are looking for when they make risky early stage investments.
2. If the notes contain a “no prepayment” clause, which is usually the case, another option might be to wait out the clock and repay the principal and interest upon maturity. Using our hypothetical numbers, assuming the notes have an 18-month term, the return would be $15,000 (15%) – again nothing to write home about.
3. Suppose the notes converted as if the acquisition were an eligible financing round. Investors would be repaid their principal, plus accrued interest, divided by the conversion price (let’s say 30% discount, so 1 – 0.3 = 0.7). Again using the numbers above, the return is $50,000 (50%) in six months – a good investment to be sure, but still a relative pittance for a startup making such a successful early exit.
What these approaches have in common is that they cap the investors’ upside such that even in the most spectacular of liquidity events, unless the notes convert to equity first at a lower valuation, angels don’t get anywhere near the payoff awarded to equity holders. Most would agree this is not a fair outcome.
Returning to our sample term sheet, here is one flavor of change-in-control provision that I like to use:
Change of Control: If an acquisition or similar change of control transaction occurs prior to the Preferred Financing, then upon the closing of such transaction, the Notes will, at the election of the Majority Holders, become
(a) payable upon demand as of the closing of such transaction; or
(b) redeemable for a payment equal to the amount each Note Holder would have received had the Note converted immediately prior to the transaction to
(i) Preferred Stock (if a Preferred Financing is pending at the time of the transaction) or,
(ii) if no Preferred Financing is pending, to Common Stock at a price per share equivalent to a fully diluted pre-money valuation of $3 million,
to be paid in the same form of consideration (e.g., a mix of cash and stock) received by other equity holders in the transaction.
Thanks to Gil Silberman for reminding me of this formulation in his Quora post. The language is a mouthful, so bear with me as we review the salient points:
- “…at the election of the Majority Holders…” is helpful to the company because if there are any decisions to be made regarding the payout, it’s more expedient for the company to deal with one majority investor (or a small control group) rather than with each of many small investors. This is particularly true under the severe time pressure that tends to accompany M&A.
- “Payable upon demand as of the closing of such transaction” is the fallback position described above as #1. In a “fire sale” of a distressed company at a very low valuation, this can be the best option for investors.
- “Redeemable for a payment equal to the amount each Note Holder would have received had the Note converted immediately prior to the transaction to…” is the language that enables investors to share in the upside of a successful exit. The simplest possible formulation is to state a multiple (i.e., if the startup is acquired before the notes mature or convert, investors will be paid 2X or 3X their investment). The downside to that approach is that it bears no relationship to the purchase price paid by the acquirer. Hence:
- “Preferred Stock (if a Preferred Financing is pending at the time of the transaction)…” reflects the notion that a financing offer on the table at the time of acquisition is one of the most reliable indications of valuation for an early stage, privately held company. This is not uncommon in practice; rapidly growing, successful startups tend to attract both buyout and investment offers around the same time. Including this language in a change-of-control provision essentially turns the clock forward a little, assumes for the sake of calculation that the imminent financing round actually closed, and applies the conversion discount (30% in our example).
Using some sample numbers, let’s assume the startup has a term sheet on the table from a VC to invest $3 million at a $10 million pre-money valuation when our hypothetical $30 million acquisition offer materializes. The noteholders essentially triple their money (ignoring interest), but if the conversion discount also applies to this scenario (a drafting subtlety in the documents), they actually do better. Nevertheless, this is the variant most favorable to founders, and is often omitted in favor of the next clause:
- “…to Common Stock at a price per share equivalent to a fully diluted pre-money valuation of $3 million” gives investors the best shot at participating in the upside of a highly successful early M&A exit. In our hypothetical example, the angels would get a 10x return on their convertible note investment six months after making it. Not too shabby. As above, this can get even better if the conversion discount also applies.
It’s worth noting that the $3 million figure here is not the same thing as the valuation cap investors and founders regularly negotiate in convertible note deals, but it is a related species of cap that serves a similar purpose of protecting investors in a scenario in which the company achieves a stratospheric valuation. To make things extra confusing, there can be three distinct places where these figures appear in a convertible debt financing term sheet or deal documents, which may or may not be the same valuation: (1) The valuation cap that applies to conversion of the notes in a priced equity round; (2) the agreed-upon price at which the notes may convert to equity if the maturity date is reached without an equity round that triggers conversion; and (3) this figure that applies if the company is acquired before conversion.
- “…to be paid in the same form of consideration (e.g., a mix of cash and stock) received by other equity holders in the transaction.” Mergers and acquisitions come in many varieties. This language allows for the possibility that the startup may be acquired for stock, or a mix of cash and stock, of the acquiring company.
Having covered just about every path a convertible note can take, we’ll finish up the series by looking at a few miscellaneous term sheet items and revisiting the pros and cons of different deal structures.