STARTUP FINANCING: Convertible Notes. Part II.
Updated: Jun 28, 2020
Convertible notes are loans that (ideally) convert into equity, typically in conjunction with a future financing round. Noteholders, or investors, prefer to convert their notes into preferred stock which has additional rights, preferences, and privileges compared to common stock. Companies, or startups, prefer the notes to convert into common stock.
A convertible note combines debt and equity features. Convertible notes include the following debt features:
(1) Principal amount. Typically ranges from tens of thousands of dollars to upwards of $1 million.
(2) Annual interest. Typically 3-10% interest that accrues on the principal balance.
(3) Maturity date. Usually, 1-2 years. Some convertible notes provide that an entire series of notes becomes payable upon the demand of the majority-in-interest of the noteholders in that series on or after the maturity date. This provision is beneficial for the companies, as it leaves the decision to demand repayment with the largest noteholders.
(4) Priority in a Liquidation. Upon a dissolution or winding-up of the company (which is not in connection with a sale of the company), the noteholders’ claim is superior to all equity holders of the company and typically pari passu with all other unsecured non-senior debtholders. These notes are usually unsecured because the cost of documenting and perfecting a security interest for a seed-stage startup company with little to no assets is rarely worthwhile from an investor's perspective.
Convertible notes include the following equity features:
(1) Conversion Events. Convertible notes may convert into different types of equity on the occurrence of any of the following events:
The closing of a subsequent equity financing (the “Next Equity Financing”). A preferred stock financing is the most common conversion trigger;
The closing of a sale of the company or substantially all of its assets (the “Corporate Transaction”); and
Reaching the maturity date before the Next Equity Financing or the Corporate Transaction.
(2) Conversion Price which includes:
Conversion Discount rewards noteholders by granting them the right to purchase stock upon the closing of the Next Equity Financing at a reduced price (e.g., 10% to 35%). Sometimes the conversion discount is increased based on how long the notes have been outstanding. For example, a 10% discount if the Next Equity Financing occurs within the first six months of the term, 20% if the Next Equity Financing occurs during the following six months of the term and 30% if the Next Equity Financing has not occurred within the first year of the term.
Valuation Cap protects investors from an inflated company valuation by setting a “ceiling” on the pre-money valuation at which the notes may convert in the Next Equity Financing. For example, an investor takes a 20% discount on the stock price of the next round up to a valuation of $X. If a company gets a valuation above $X, the investor’s valuation is still $X. This provision is beneficial for investors to ensure they still have a meaningful stake in the company if it achieves an unusually high valuation in the Next Equity Financing. When notes contain a discount and a valuation cap, they convert at the lesser of the price: calculated based on the discount and implied by the valuation cap.
(3) Conversion Threshold protects noteholders from having their note converted to equity prematurely by setting a “floor” on the amount of funds raised in the Next Equity Financing at which the notes may convert (e.g., $1 million). Also, this provision prevents the investors from gaining significantly more equity than expected.
If the company goes through the Corporate Transaction before the maturity date and the Next Equity Financing, then there are a couple of scenarios that could play out: (a) the noteholders get back their principal investment amount, interest, and, if applicable, an additional multiple of the principal, or (ii) some sort of conversion occurs (e.g., the debt converts into stock of the acquiring company at a valuation subject to a cap).
If the note reaches the maturity date, and there is no Next Equity Financing or the Corporate Transaction, noteholders typically have the following options to (a) convert their notes into shares of common stock (which rarely happens), (b) demand repayment (although the company would not usually be able to comply, having likely spent most of the note proceeds on building the business), or (c) leave the notes outstanding. Investors usually continue to hold the notes, because they have priority in a liquidation and leave open the possibility of receiving preferred stock.
Advantages of Convertible Notes for Companies:
Postpones startup valuation while maintaining ownership control.
Using convertible notes as “bridge notes” to get funds needed until the Next Equity Financing or the Corporate Transaction.
Traditionally low cost, may be issued in mere days reducing legal fees.
Simple, efficient and fast financing instruments. Although, fixed price financing has gotten faster and cheaper (e.g., SAFE and KISS).
Disadvantages of Convertible Notes for Companies:
In case of a lower than expected fixed price round, the noteholders will be gaining significantly more equity than expected.
Venture capitalists in future financing round may refuse to invest unless the valuation cap is removed or offer funding only within the cap.
Threat of bankruptcy (if at maturity the startup cannot pay back, the noteholders can bankrupt the company by demanding repayment).
Threat of bankruptcy gives the noteholders some leverage to renegotiate the terms of the note.
The interests of the startup and investors can be “misaligned” because investors will get a higher ownership stake in a startup with lower valuation.
Early-stage companies prefer using convertible notes instead of a priced equity round in order to defer startup valuation until proof-of-concept, data points, and other key metrics have been established. Those metrics would come handy to negotiate higher valuation with investors while maintaining ownership control. The higher the valuation, the less dilution the startup will encounter. The lower the valuation, the higher ownership stake investors will obtain. Investors dislike convertible notes because they want to know how much of a company they have purchased and do not like taking equity risk and getting debt returns. Also, executing convertible notes is usually faster and cheaper than a priced equity round.
When do you Need an Attorney?
When attempting to raise money, you may need an attorney experienced in financing rounds to advise you on the different types and stages of startup funding, the best strategies to attract investors, and to evaluate deal terms, prepare the company for due diligence and, hopefully, draft and negotiate term sheets and closing documents. You will also need an attorney to comply with securities laws because every security sold, including convertible notes, must either be registered with the Securities and Exchange Commission or exempt from registration. For more information about compliance with securities laws see Startup Financing: Sources and Rounds.
This article is not legal advice, and was written for general informational purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Kristina Subbotina. Ms. Subbotina is a New York-based attorney specializing in advising individual and corporate clients on aspects of corporate and securities law.