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To: Entrepreneur Seeking Capital
From: Spartina.com & CoolBizApps.com
Re: Considerations for raising money using a Convertible Note
Disclaimer: This article is for discussion and educational purposes only and should not be construed as
legal advice. Legal advice can only be given by legal professionals. Please seek the advice of a lawyer
before proceeding on Convertible Notes.
What is a Convertible Note?
For an early stage company seeking to raise money, there are two main routes. One is to issue equity (a
share in the company) to an investor in exchange for a cash investment. However, in order to defer
putting a valuation on the company’s stock, another way is to borrow the money, with the intention
that the loan eventually converts into equity. This is the essence of what is called a “Convertible Note.”
A Convertible Note is debt that the company incurs, that can be converted into stock based on certain
conditions. A Convertible Note is commonly used for a small first angel round ($100k‐$500k) to provide
financing on terms that will be decided at a later date when additional, often professional investors
participate. Thus it's often called a Bridge Financing.
A Convertible Note is also known as a debt offering since the company literally goes into debt to the
investors until the price of the Note is paid back, plus interest, or until it is converted into stock.
Why do it (the Company)?
You want to raise capital to grow your business and you need to be efficient from a time perspective and
keep legal costs to a minimum. There is a great deal of work, which costs time and money, to create a
stock offering. If you are only looking for a relatively small amount of funding, for example, under $500k,
then a Convertible Note is much simpler. For example, the legal fees for a Convertible Note might be in
the range of $2,000‐$5,000, while the fees for a Series A could be $5k‐$50k, as you might also pay for
the fees of the investors.
In addition to being quick and relatively straightforward to execute, these funds will allow you to make
progress and improve your valuation for your subsequent financing.
Another benefit for the company borrowing the money is that you might get the cost of the Convertible
Note at a lower interest rate, since the lender/investor has the option of converting it into stock.
The company must record the Convertible Note as a debt in its balance sheet. If bankruptcy occurs, the
Note holders are considered creditors and must be paid back by the company’s remaining assets.
Why do it (the Investor)?
The investor wants to invest in the Company today and believes a subsequent financing is around the
corner. The investor is seeking to benefit from the same terms (e.g. Liquidation Preference) as the next
investors, who also might be better equipped to price the round. The investor seeks to be compensated
for the risk of investing early through terms in the Note.
Investors sometimes object to convertible debt financing because they don’t know how long it will take
for the next financing to occur, and the company’s value could increase much more than the discount
their Note provides them. This leaves them having taken a much larger risk than the next‐stage
investors, and enabled the company to significantly increase its value, yet they pay a price close to that
of the next‐stage investors. One way to mitigate this concern is to cap the valuation that will be used to
calculate the share price for the Note conversion.
In general, if there are sufficient protections in the terms of the note, (see below), then angel investors
will be willing to work with this method of investment. It is a way of getting cash to a company quickly
so it can grow sufficiently to make it to the next round of equity investment. Once that first round is
done, the investors’ loans convert, and then they are holding equity.
In the table below, common terms are explained, including the incentives to the investor, as well as the
protections they will need. A quick review will help you optimize your time with company counsel.
Variables and Levers:
Interest Rate What Interest rate will you offer?
Only the relatively low AFR (Applicable Federal Rate) is required by the IRS to avoid
imputed interest. (In other words, if the interest rate is below this, the IRS will tax you
as if the interest rate were higher, or, as if this were a gift.) However, typically a “high”
rate is necessary to get investors, for example, 6%‐10%, (and usually above the
minimum AFR). You’ll need to adjust based on market conditions and other terms of
the Note. You can make the determination if the interest is simple or compound.
Tip: Leave yourself the flexibility to pay off the interest earned to minimize the dilutive
impact on conversion of the note and/or have the interest not subject to the
convertible discount, if offered.
Tip: Remember to collect a W9 for tax reporting on the interest earned.
Duration & How long is the Note for? 1 year?
Maturity Date
What happens if the Note matures and an equity financing has not occurred? Does it
automatically convert to common stock if a financing did not occur, or roll over into a
term Note payable over time?
One option is to set a conversion at maturity date if no equity event took place, using a
pre‐determined valuation and terms. You might have the note convert to a term note
at maturity.
Tip: In general, investors don’t want to call the note in. Rather, set the date with an
understanding of how much time you need before you will can secure a Series A round
of financing.
Tip: It is in your interest to push the maturity date out to give yourself enough time to
attract a Series A investor.
Conversion & Will there be a mandatory conversion at a set price? How is price determined?
Automatic Typically conversion of the note into equity takes place at the “Next Equity Event.”
Conversion
Tip: Try to ensure that all Note holders have the same conversion terms and that any
amendments are done on a majority of class basis, to avoid "outlier" investors from
disrupting future events.
In some Notes, there is a minimum amount or threshold to be raised in a subsequent
financing that will trigger the automatic conversion, for example, an equity event that
is greater than $1 million being raised.
Conversion What discount will you offer to make this attractive to investors?
Discount
Investors need incentive to make an early investment. A discount is the most common
incentive to provide a prospective Note holder. The discount lowers the per share price
that the investor will pay when the next financing occurs.
For example, a 20% discount would allow the Note holder to buy shares at 20% less
than the new investors in the subsequent financing. If the new investors negotiate a
$1/share, a Note holder would purchase the shares at $.80/share. Sometimes the
discount percent increases over time.
Tip: Consider a sliding scale based on time.
Warrants Do you want to offer warrants as part of this note?
Another form of incentive to the investor is to issue a warrant, such as a 20% Warrant.
This would be a possibility if no conversion discount is in place; you would do not want
to do both.
Warrants give the Note holders the option to purchase additional stock for investing in
the Notes. It is basically like a stock option. If the investor has put in $100K as a note,
then upon the first funding round, he would have an option (warrant) to buy $20k of
stock at the next equity financing price, hence the 20% warrant coverage.
The Company would prefer common stock warrants with a high price and a short
duration for exercising them. Of course, the investor wants cheaply priced warrants
and longer periods, usually five years, to decide if they want to exercise them.
Sometimes the "warrant coverage" increases the longer the Note remains outstanding.
Thus, other variables you define in relation to the warrant include:
Percent coverage: (as mentioned above, 20% coverage means the dollar amount of
warrants he would be entitled to, based on the value of his note.)
Price per share: normally would be set at the next equity financing, but it could be a
price set at the time of the note.
Expiration date: How long does the investor have before he loses his right to purchase
the stock at the above price? Normally this will be in the 3‐5 year range.
Tip: A 25% Conversion Discount is like a 33% warrant coverage. With Warrants the
company actually will get more cash due to the exercise of the Warrants. However, in
practice, most investors will not exercise the warrants unless they know they will be in
the money.
Cap What other protection will you offer your Investors?
Sophisticated angels might ask you to put a cap on the valuation that their investment
dollars will ultimately convert into, such as $2 million pre‐money. If the next equity
investment occurs at a higher valuation than the cap, then the conversion is performed
as if the valuation were at the cap value. In other words, to calculate the number of
shares for the conversion, you would divide the loan amount by the lesser of either
discounted next equity financing price, or, the price based on the cap.
Tip: To put the cap into effect, you also like to keep the liquidation preference on a par
with the new investors. Thus your Convertible Note investor will get his shares in two
batches, some as preferred, and an additional set of shares of common stock. This is
carried out by a complicated formula whereby the original cash investment (note) is
divided by the per‐share price of the next round to come up with the number of
preferred shares. An additional calculation is made based on the valuation cap to come
up with the total number of shares the investor is entitled to. The difference between
the number of preferred shares, and the total number of shares is issued as common
stock thereby keeping the liquidation preference on par with the new investors.
Example: $100,000K Note. Cap valuation is at $.50 a share. Series A is at $1.00.
The note holder is technically entitled to 200,000 shares ($100,000 / .50). However,
with the liquidation preference at $1/share, then he would be entitled to 100,000
($100,000/$1.00 = 100,000). So 100,000 shares are issued as preferred and 100,000
shares are issued as common.
Tip: Use a lawyer. This is where the lawyers earn their fees!
Size of a Note How much money are you trying to raise via these Convertible notes?
Round
Be sure that the amount is enough to get you some where meaningful. Investors don’t
want a “Bridge to Nowhere”. They are usually interested in seeing that you raise some
meaningful amount of money to get to your next milestone. If your total size is $300K
and you can only get notes up to $95K, it is not worthwhile for the investor.
Investors might also want to limit how much you can raise under this arrangement.
Closing Date You’d like it to be rolling, so you can add more new investors.
for the Note
Round Investors want a fixed closing date, but would likely allow another, second, close if it
isn’t too late after the first. Investors will expect a minimum amount for the first
closing, to ensure that the company is not put in an untenable position if additional
closings do not occur.
They typically don’t want someone 6 months from now to get the same deal.
Tip: Transaction costs (legal fees, securities law filing fees, etc.) will be lower the fewer
closings there are.
Early Sale/ What happens if the company is sold before the note converts?
Change of It depends on the terms of the notes. Typically, the notes will be repayable (plus
Control accrued interest) on a sale or change of control. However, investors will also want to
hedge their bets in these circumstances and require the option to convert on the pre‐
determined terms if the outcome would produce a better result.
Tip: Try and gauge the likelihood and value of the early exit. Also, ensure that a change
of control represents a genuine liquidity event and not merely a recapitalization of the
company.
Other Terms Subordination and security
Should notes be secured or subordinated?
These are contrasting scenarios: if the notes are secured, investors will rank in priority
to other creditors of the compant if there is an insolvency; whereas if the notes are
subordinate, the investors will rank behind those creditors to whom the notes are
expressed to be subordinate.
Most often, convertible notes are treated as quasi‐equity and will be subordinated at
least to monies owed to banks or other third party lenders. However, if the notes are
secured and the assets representing the collateral have real value, then the terms of
the notes should reflect the reduced level of risk being taken by the investors.
Tip: Do not offer secured notes and suggest that the notes be at least subordinate to
bank or other third party lenders.
Events of default
When do the notes go into default?
In most cases the notes will only go into default if the company goes out of business
(including bankruptcy) or if the company fails to convert the notes into equity when
required to do so.
Tip: Try to limit events of default so that you do not hand over the power to the
investors to call the shots.
References:http://www.startupcompanylawyer.com/category/convertible‐note‐bridge‐financing/
Legal Help: We have worked with the following lawyers on Convertible Notes, and recommend their
services:
Buddy Arnheim (barnheim@perkinscoie.com), Perkins Coie
John Cook (jcook@orrick.com), Orrick
DJ Drennan (drennan@smlaw.com), SMT
Simon Inman (srinman@cmprlaw.com), CMPR
David Marks (dmarks@mhfmlaw.com), Marks Holmes Foley and Morales