Knowledge Is Power: Convertible Note Financing Terms, Part I

Antone Johnson , Founding Principal , Bottom Line Law Group

29 Sep 2011

The most successful serial entrepreneurs in the world may found three or four, perhaps even eight or ten venture-backed startups over the course of their careers. By contrast, venture capitalists and angel investors typically make scores or even hundreds of investments over the course of their careers. It should therefore come as no surprise that an asymmetry of information exists, mostly gleaned from experience, between founders and investors in a venture financing deal. In recent years, startup accelerators such as Y Combinator, TechStars or 500 Startups, blogs including Venture Hacks, Fred Wilson’s A VC and Mark Suster’s Both Sides of the Table, and other resources have contributed to closing this knowledge gap. (See my blogroll for links to many of the best resources.) Nevertheless, a key advisory role of startup lawyers in my opinion is to level the playing field by bringing our own perspectives to bear, having gone through the twists and turns with many clients over the years. Knowledge is power. (For more on working with startup lawyers, see Mark Suster’s classic post, How To Work With Lawyers At A Startup.)

For a traditional VC financing round structured as a sale of preferred stock, the best resources I can recommend are the Term Sheet Series by Brad Feld and Jason Mendelson and Startup Company Lawyer by Yokum Taku. Every installment or post in those series is a good read, and I won’t attempt to reinvent the wheel here. Given that convertible debt financing has become the de facto standard for small (<$1MM), early stage deals in recent years, I thought I would write a primer on the elements of a term sheet and definitive documents for entrepreneurs looking at the earliest stage financing rounds.

Let’s take it from the top: Why convertible notes? There are two principal reasons. The first is that they are the easiest deals to bang out quickly and cost-effectively, keeping the amount of legal work and negotiation on both sides to a minimum. Experienced investors often don’t feel the need to involve legal counsel in most typical convertible debt seed or angel round investments. A term sheet for a convertible note deal may run two or three pages, versus 8-10 pages for a typical Series A Preferred Stock financing. (I’ve posted a sample convertible note term sheet on my website.) The definitive deal documents are concise (at least by lawyer standards), whereas a full Series A deal will generate a stack of new paperwork of a hundred pages or more.

The second reason, perhaps nearer to both entrepreneurs’ and investors’ hearts, is the ability to punt on valuation at a stage in which it is hardest to determine using any objective criteria. A quick historical explanation is in order here: For decades, the convertible note structure was commonly used as a bridge financing to an upcoming priced equity round — for example, a VC firm that invested in a startup’s Series A round would make an additional investment on a bridge basis to help keep the lights on while the company went out and raised a Series B round led by another investor, a process that could take several months. Another use of convertible note bridge financing is to make a quick injection of seed capital into a new startup when the investor and entrepreneur already know and trust each other; it’s better than a handshake, but far quicker and easier to complete than a real Series A round. In a convertible debt financing, the investment is made without placing an explicit valuation on the startup; instead, the investor makes the company a loan, which will convert as part of the next priced equity round into the type of security issued to investors in that round, whomever they may be.

In recent years, particularly as the amount of seed capital needed to launch new Internet and software businesses has decreased, deals have gotten smaller and a whole new class of “super-angels” and “micro-VCs” has emerged; this existing bridge structure was adapted to become what is now the most common type of deal for seed rounds of less than $500,000. (A group led by Ted Wang is trying to change that with the innovative Series Seed documents, which I’ll discuss in a future post.) Others have discussed in detail the pros and cons of convertible debt vs. seed equity rounds. For my own perspective on why convertible notes have become the de facto standard for small deals, see this post at Mashtag. For better or for worse, most entrepreneurs and angels are likely to encounter a convertible debt term sheet—if not many of them—sooner or later.

We’ll get into specifics and begin dissecting a sample term sheet for a convertible note financing next week. Until then, here is a brief outline of how these deals work for a typical startup:

• An investor lends the company some amount of principal, say $100,000, documented as a convertible promissory note. The note is one of a series issued under a note purchase agreement entered into between the company and each investor.
• The note is similar in many respects to a promissory note for any kind of loan, with the corresponding terms: Term, interest rate, repayment terms, and so forth. A typical bridge note doesn’t require any payment of interest or principal until the maturity date, which is commonly between 12 and 24 months.
• Unlike a mortgage or many types of conventional business debt, the note is usually not secured by any kind of collateral. This is not the kind of loan that is expected to be repaid; early stage startup investments are risky, and there typically isn’t much to go after if the business fails. Investor and entrepreneur alike are betting on success, in which case the note will convert to equity .
• Conversion terms are where the money is, literally and figuratively. In brief, criteria are set for an eligible equity financing, such as a preferred stock financing round of $1 million or more — a conventional “Series A.” Assuming such an eligible financing round is completed before the maturity date, the loan will convert into the type of security issued to investors in that financing round (such as Series A Preferred Stock), at a price per share equal to the price paid by the new investors, subject to a conversion discount, such as 25%, to compensate early investors for their risk.
• There are other bells and whistles that I will cover in the next installment, including a valuation cap, which places an upper limit on the price per share at which the note will convert, provisions dealing with a sale of the company prior to maturity, and more.

If you have any specific questions, please leave them in comments! This is intended to be an interactive forum for entrepreneurs and investors alike.

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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