More and more, companies are turning to a convertible note structure when raising capital in the early stage. In a nutshell, a convertible note is a simple way for a company to give investors a “stake,” while giving the business time to grow and prove out value before its founders get diluted. The terms are relatively standard, and it cuts down on legal fees. Whereas issuing equity requires establishing a value on the business today, convertible notes offer a “kick the can down the road” option to entrepreneurs. And this is extremely important, as a new business needs time, whether for product development, proof of concept, or market penetration.
However, in today’s fundraising-friendly environment, entrepreneurs are getting extremely aggressive with the convertible note terms they offer to angel and seed investors. Having reviewed countless notes, here are some of the key terms I immediately look at when an entrepreneur sends me docs.
The purpose of this piece is to demonstrate the key levers a company can work with when negotiating terms on a convertible note and how they can be mindful of what is most important to the investor.
The Cap: As mentioned, the beauty of issuing a convertible note is that you, the entrepreneur, don’t need to establish a valuation for your business today, whereas issuing equity requires assigning a valuation up-front. This is valuable in that you have the opportunity to drive value a higher valuation in your business, thus minimizing the impact of dilution on your stake.
However, convertible note investors are taking equity-like risk, as these notes are not secured or guaranteed by anything (unlike a mortgage or car loan). As a result, such investors want to be compensated with a form of upside, which is offered primarily through a “valuation cap,” “discount,” or both.
- A valuation cap tells the convertible note investor the theoretical maximum valuation at which the dollars they lent the company will convert into equity. While this is not technically a “valuation” on your business, it is in fact a value that you should realistically be able to attain within a given period of time.
- A discount tells a noteholder the (unrealized) return they will see between investment and conversion.
The combination of both a cap and a discount is the optimal scenario for noteholders, as it protects against a high and a low valuation at the next round of financing. Be sure to choose the cap wisely – if it’s too high, investors will shy away for the same reasons as a high valuation in an equity round. If it’s too low, the better you perform, the more they will dilute you.
Qualified Financing: The term “qualified” is defined as an aggregate amount of equity raised in the future. When a company successfully raises such amount, outstanding notes will then convert into equity (typically the same class being issued). This value enables investors to approximate future dilution.
It’s important to think about how much you need to raise in your next round when defining this metric. The number is typically between $1 million and $3 million in the seed stage. Qualified typically refers to a stage at which institutions invest; thus anything less than $1 million is not particularly meaningful on any level.
Maturity: If notes remain outstanding at maturity, standard terms provide for either automatic conversion (typically into common equity), or optional conversion (the noteholder has the right to either get their principal plus accrued interest back, or to convert into equity – again, typically common). Some thoughts:
- If a note reaches maturity without converting, it’s unlikely (of course, there are exceptions) that a startup can afford to repay principal plus accrued interest to all of its investors without being forced into liquidation. Don’t offer investors that right unless it’s a deal breaker.
- Maturity dates should be reasonable, giving the company sufficient time to develop, while also being mindful that the investor wants to see some developments sooner than later. 18 months for maturity is typically a good starting point, depending on the product/technology.
- Entrepreneurs often choose to set the valuation cap as the valuation at which notes convert upon maturity. In my opinion, this is unfair to the investor who made an early bet on you. Notes converting at maturity should do so at a fraction of the valuation cap. Chances are, if you get to this point, you need more funding, and you won’t have leverage to set a high valuation.
Change of Control: One of my first angel investments was through a convertible note. The company took an early acquisition offer 11 months after I invested (maturity was 12 months on the note). The Change of Control provision stated that should notes be outstanding at the time of a change of control (e.g. acquisition, liquidation, etc.), noteholders would get 2X their principal. Now, a 2X (plus accrued interest) in 11 months is a fantastic return. However, had I converted into equity at the valuation cap, I would have received closer to a 4.5X (of course, had the acquisition transacted at a third of this value, then a 2X would have been the best outcome).
A fair change of control provision should provide noteholders the greater of (a) principal plus accrued interest, and (b) the amount had the notes converted to equity [at the cap] immediately prior to the transaction.
Most Favored Nations (MFN): Convertible note investors, and equity investors alike, should be offered and bound by the same rights as all other investors in that financing round. Exceptions typically arise when there is a highly valuable strategic investors, big-name VC, or investor writing a relatively large check. In those instances, such investors push for incremental terms or guarantees. As a deeply-involved, high-value investor, I want assurances that, for instance, no other investor in the round has a lower cap, greater discount, or any other preferential treatment.
The only exception I would approve of would be a strategic investor providing value to the company above and beyond its monetary investment. If you are concerned about giving away too much, set an investment threshold above which investors must commit in order to get such preferential terms.
Pro Rata Rights: Having existing investors re-invest in future rounds is a strong indicator to potential investors, and should also give you a good indication of how you are tracking. Larger VCs often dislike this being granted at the seed stage, over concern that their allocation in a future round may be cut back or diluted. If one of your early investors asks for this (provided they are investing a meaningful amount), give it to them.
Entrepreneurs will push for whatever they can get. When investors are flocking to get into a deal, deal terms will reflect this. Yet it’s said time and time again that it’s better for entrepreneurs to take an investment at a lower valuation from someone who can truly provide value than to go with the highest bidder. I’m all for an entrepreneur protecting his or her equity – the more they have the more incentivized they are to bust their tail. But it’s worthwhile to sacrifice a few extra percentage points to get the right partners involved because you will ultimately come out ahead.
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