Knowledge Is Power: Convertible Note Financing Terms, Part II

Antone Johnson , Founding Principal , Bottom Line Law Group

5 Oct 2011

Last week, we gave some attention to the “why” behind convertible note financing for early stage startups.  In this installment, I’ll dig into the “how” by dissecting an example term sheet based on a real deal.  For those playing at home, you may find it helpful to download the sample term sheet from my firm’s website and follow along with the commentary.

As with so many subjects in law and finance, mastering the jargon is half the battle.  A term sheet keeps things relatively straightforward by summarizing the most significant deal terms in outline form, whereas the deal documents themselves (often referred to as definitive agreements) — even for a relatively simple convertible debt financing — inevitably contain some densely written legalese.  Let’s dive in, taking it from the top:

• Type of Security:  Convertible Promissory Notes, bearing interest at a simple interest rate of 8%.

This may seem like a no-brainer now that you understand the basic structure of a convertible debt financing.  In fact, there is a recent variation on this theme.  At least one well-known Silicon Valley venture accelerator is using a document referred to as a “convertible security” rather than “convertible promissory note.”  Going back to Part I, recall that although a convertible note is technically a loan made to the startup, in practice these loans are rarely expected to be repaid.  That being the case, removing the whole concept of repayment in favor of a legal document that makes no claim of being a promissory note, yet retains the upside characteristics of a convertible note, makes logical sense from the entrepreneur’s perspective.  (Investors, of course, may disagree.) This is the structure that Adeo Ressi and others have dubbed “convertible equity.”

Assuming a conventional deal that is structured as a convertible note, the other term in this paragraph is the interest rate.  In case it isn’t clear by now, angel investors aren’t in the business of making risky early stage investments in order to earn 6% interest on their money, or even 10% — the upside is all in conversion to equity—so the interest rate isn’t a major point of negotiation.  Cash-strapped early stage startups also aren’t positioned to make interest payments on debt (except maybe for founders’ credit cards, but that’s another story), so unlike a typical home or car loan, where interest is amortized and paid over the term of the loan, interest on these notes usually accrues over the term of the loan and becomes payable only at the maturity date (or is converted in an eligible priced equity round or acquisition of the company).  Moreover, assuming an eligible equity financing takes place before the maturity date, the interest isn’t paid in cash, but rather is added to the principal amount of the note before converting it to equity.  New investors in a Series A round understandably would rather not have their funds used to pay interest to previous investors.

• Amount of Financing:  Up to $600,000 may be issued.
• Closing:  A first closing will be held on or before September 30, 2011, or such other date that the Company and the bridge investor(s) participating in such closing mutually decide upon (the “Initial Closing”). Additional closings may be held up to 90 days after the Initial Closing at the option of the Company.

These deal terms are simple but significant.  In most cases, an early stage startup will raise seed capital from more than one investor.  Theoretically everyone could cooperate to hold one grand closing at one time in one place, but in practice, life tends to be more complicated.  More often than not, multiple closings are held with different investors in the same round on the same terms using substantially identical documents.  These provisions establish the limits of what is considered to be the “same round,” setting investors’ expectations accordingly. Sometimes an additional incentive is offered to the “first penguin in the water” (to quote Dave McClure in a well-thought-out discussion with Fred Wilson and others that’s worth reviewing), with subsequent closings held not long thereafter.

• Mandatory Conversion:  The Notes and any accrued interest will be converted into the Company’s next issued series of preferred stock resulting in new money of not less than $1,000,000 (an “Eligible Financing”) at a discount to the per-share price of such preferred shares of 25% (the “Conversion Price”).

This paragraph is the heart of the whole deal.  The appeal of a convertible note financing to a new startup is that at its earliest, most uncertain stage, entrepreneurs and investors need not agree on all of the characteristics, terms, conditions, rights and preferences of a new series of preferred stock that would ordinarily produce an 8-page term sheet and a 100+ page stack of definitive legal documents.  As written, this mandatory conversion term (1) defines what kind of event will trigger conversion (a new priced equity round bringing in $1 million or more), (2) specifies generally what type of security the note will convert into (the “next issued series of preferred stock”), and (3) establishes a conversion discount (in this case, 25%) to compensate the convertible note holders for the increased risk associated with being the first to invest in a new venture.

This “uncapped note” example ignores the concept of a valuation cap, which we’ll take up in a future installment.  To use some concrete numbers, assume an angel invests $100,000 in a convertible note at 8% interest, and the Company raises a $2 million Series A round exactly one year later.  To keep the math simple without getting bogged down in share numbers and valuations, let’s assume the new investor pays $1.00 per share for 2,000,000 shares of newly issued Series A Preferred Stock.  Our angel fares as follows:  $100,000 + 8% interest = $108,000 that will convert to equity.  With the 25% discount applied to the $1/share price paid by new investors, the Note will convert to $108,000 / $0.75 = 144,000 shares of Series A Preferred Stock.

With this deal structure, the angel is relying on the Series A investors to negotiate fair terms of the Preferred Stock that he or she will ultimately receive in the conversion, but has no opportunity to directly negotiate those terms.  In practice, given that (1) investors’ interests are mostly aligned most of the time, and (2) Series A investors generally put a much larger amount of capital at risk, this approach seems to work relatively well.  Nevertheless, reasonable minds can differ among entrepreneurs, angels and VCs, particularly with respect to specific companies and investments, and we’ll examine some of those differences in a future post.

On to more specific terms next week.  Again, 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.

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