Convertible note financing enables a business to quickly raise capital without negotiating a valuation for the company. In exchange for their investment, investors receive a convertible promissory note that will convert into stock at a future date with a share price, economic rights, and control rights set by later investors. Prior to conversion, convertible note investors do not actually own stock or have voting rights.
There are vetted and widely accepted templates for this type of financing: SAFE, KISS, and techstars. The most important distinction is whether the template is an equity or debt convertible financing. In an equity deal, there is no maturity date or interest rate on the note. In a debt deal, there are additional investor friendly terms including an interest rate (~6%) and maturity date (~24 months) so the investor has recourse if a company does not raise a subsequent financing round. This means that by taking on convertible debt, founders risk having to pay a large lump sum upon the maturity of the loan (interest + principal), if the conversion does not occur.
Two important terms in most convertible notes, whether equity or debt, are the discount and valuation cap which reward early investors. The valuation cap places an upper bound on the company’s future valuation for purposes of calculating the number of shares the investor will receive upon conversion of their note. This rewards early investors if the Company’s valuation jumps above the cap in the next financing round. A discount (~20%) is a percentage discount on the price per share paid by investors in the next financing round.
Now that we’ve reviewed the basic mechanics of a convertible financing, let’s look at some of the most common terms. The following list is not exhaustive and these deals can get creative. Don’t hesitate to involve your lawyer early in the discussion as they can provide guidance and value by spotting potential problems early at this stage in the financing process.
Valuation Cap & Discount
This term is favorable to investors and explains the process of obtaining the conversion price below that of the financing round. Most convertible notes include this provision. The valuation cap and discount mechanisms are mutually exclusive; thus, they cannot be used simultaneously. The investor will choose the mechanism that results in the best purchase price.
Most Favored Nation (MFN) Clause
This purpose of this term is to protect early investors from later investors receiving a better deal. The MFN clause promises the investor that the company will not offer another investor better terms without first offering those terms (or better terms) to the original investor.
Pro Rata Rights
Pro rata rights protect early investors against dilution of their ownership percentage. This term allows convertible debt investors to participate in a subsequent funding round in an effort to zero or less dilution.
This provision shouldn’t be too burdensome, so long as the company has a competent accountant. Information rights allow the investors to access the company’s financials (and any other including information) upon request.
Appropriate Company Representations
Investment is typically contingent upon the investors receiving true and correct representation and warranties from the startup. This term requires the startup to disclose significant information, usually any potential securities issues, intellectual property infringement, and pending or threatened litigation against the company. To provide investors with a general risk assessment of the investment and the companies financial health, the term sheet always includes representations and warranties.
Convertible notes will require the startup to only receive funding from accredited investors. The SEC defines accredited investors as a natural person who:
- Earned income exceeding $200,000 in each of the prior two years, and reasonably expects the same from the current year; or
- Has a net worth of over $1,000,000, either alone or together with a spouse.
Additionally, accredited investors may also be institutional investors like a bank, partnership, corporation, nonprofit, and trust. For a full overview, read this notice from the SEC. The reason for this term is because securities compliance is much easier with exclusively accredited investors.
Amendment terms outline how the investor or entrepreneur can trigger a change in the agreement terms.
Appropriate Conversion Mechanics
This term defines how, upon conversion, the debt converts to equity. Typically, the conversion automatically occurs if the following events occur: (1) subsequent equity financing (i.e. Series A); sale of the company (merger, acquisition, stock sale); (3) change in control; or (4) dissolution of the company.
Maturity Date, Interest Rate, and Prepayment
This provision will schedule the loan’s maturity date, define the interest rate expected at time of maturity (if not converting to equity), and stipulate how/when a startup can begin to prepay the principal and interest on the loan.
Change of Control Payment
This term rewards early investors by providing an early bonus payment that becomes due upon change of control in ownership. Upon the triggering event, the maturity date of the note is accelerated, and the principal amount plus interest becomes due at the change of control.
If there is a dispute that requires the involvement of attorneys, this term outlines who pays the lawyers. Typically the breaching party, whomever breaks the term sheet agreements, is the one to pay the attorneys fees.
Priority of Repayment in Dissolution
Upon dissolution and liquidation of the company’s assets, this term provides the investors with priority in repayment; helping to ensure they will receive some (if not all) of the principal plus interest due on the loan.
We know that is a lot of information! We hope this blog post helps clarify the main terms on your convertible note. For more education, click here for 6 Investment Term Sheet Mistakes Founders Make.