Convertible Debt

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Convertible Debt

Convertible debt is the most popular financing structure startups choose when they are raising less than $500K. Companies typically issue convertible debt when they are not raising enough money to justify a preferred stock round. This is because a company raising $200K, for example, can’t really justify the legal fee cost or time needed for a preferred stock financing. Convertible debt is relatively straightforward.

Convertible debt (or convertible note or convertible loan or convertible promissory note) is a short-term loan issued to a company by an investor or group of investors. The principal and interest (if applicable) from the note is designed to be converted into equity in the company. A subsequent qualified financing round or liquidity event triggers conversion, typically into preferred stock. Convertible notes may convert at the same price investors pay in the next financing, or they may convert at either a discount or a conversion price based on a valuation cap. Discounts and valuation caps incentivize investors for investing early and not setting a price on the equity when it would typically be lower. If a convertible note is not repaid with equity by the time the loan is due, investors may have the right to be repaid in cash like a normal loan.*

Convertible note rounds can be as small as $50K-$100K in size, but more typically they are on the order of several hundred thousand dollars (but below $500K). Rounds in this size can also be raised by selling convertible equity or common stock (which we’ll cover), but neither method is as popular as convertible debt.

Frequently a company will start a convertible note offering by showing potential investors a term sheet, rather than the note itself. This is also true in fixed price financings. You can see an example convertible note term sheet and an annotated convertible note in the appendix.

If you are doing a convertible note deal, the definitive documents might be:

  • the convertible promissory note (in which case the investor as well as the company will sign the note) or

  • a convertible note (signed by the company and delivered to the investor), and a note purchase agreement (signed by both the company and the investor) or

  • a convertible note (signed by the company and delivered to the investor), a warrant (signed by the company and delivered to the investor), and a note and warrant purchase agreement (signed by both the company and the investor).

Entrepreneur Perspective on Convertible Debt

founder Convertible debt can be beneficial for startups in the following ways:

  • Immediate access to funds. Unlike a fixed price equity round where there is typically a formal closing date on which a substantial portion of the money comes in, notes can be signed in small amounts ($25K) which individual investors and the company can start using right away. An exception to this is if the convertible note document itself requires a minimum amount of funds to be raised, but this is unusual. If a company is short on cash or needs additional funds to hire engineers or kick off patent work, this quick access to cash as individual investors come on board can be very useful.

  • Lightweight deal documentation. A convertible note may be only a few pages long, whereas the documentation for a fixed price equity round typically spans multiple long documents. As a result, notes can be executed quickly and legal costs are usually significantly less. If a company is raising $250K or less it does not make sense to spend $10K-$15K or more on legal fees for a fixed price round. Legal fees for a convertible note round are typically on the order of $5K.

  • Ability to reward early investors. There are several mechanisms for rewarding investors who come into the deal early, in addition to the general accumulation of interest over time. These can include a discount rate on conversion, a valuation cap, or some combination of those factors (each of which will be discussed in detail). It is also possible for the earliest note investors to get higher discounts and lower caps than subsequent convertible note investors.

    • For example, the first investor in a startup might get a 25% discount and a $1M conversion cap on their note, while an investor who comes in two months later could get a 15% discount and a $2M cap.

    • When a startup is trying to get its fundraising going it can be helpful to create inducements for the early investors. And as an investor, if you have faith in the company early on you can reap rewards for taking on the extra risk of being first in.

  • Delay in valuing the company. Generally speaking, convertible notes allow the company to delay setting a pre-money valuation on the company. For a very early-stage company it can be challenging to convince investors that the company is worth $5M, for example. By issuing convertible notes, setting the valuation can be delayed until the first priced equity investment, by which time hopefully the company has made more progress. The valuation cap, discussed below, effectively puts an upper limit on the value if it is included in the note.

While there are many benefits for founders, some founders and investors believe that convertible debt creates a misalignment of incentives.

Investor Perspective on Convertible Debt

Angel investors used to complain that convertible notes prevented them from getting fairly compensated for taking on the added risk of investing in a very early-stage company. A priced round by contrast would allow them to lock in a low cost for their shares. With the popularity of the valuation cap* as a feature of the convertible note, that argument has largely been addressed; but some investors still do not like notes.

From an investor’s point of view, sometimes convertible debt can be better than a fixed price equity round, because:

  • Debt sits on top of equity; meaning, if the company goes defunct, debt holders are entitled to be paid first, before equity holders.

  • Noteholders can have favorable conversion provisions, such as discounts and caps.

  • Noteholders can charge interest.

  • Noteholders can have warrants appended to their notes as an additional benefit of investing, if that is part of the deal.

  • Debt documents can contain “event of default” provisions, entitling the holder to declare the note in default and demand payment in cash in full. (In contrast, it is rare to be able to demand the repurchase by the company of your stock, and even if you have that right, state insolvency laws might prohibit the redemption of your shares.)

  • Noteholders can charge higher rates of interest when the note is past due or the company is otherwise in default on the terms of the loan.

  • Noteholders can take a security interest in the company’s assets.

  • Noteholders can have the right to optionally convert if the company raises money in a non-qualified financing at a lower than expected valuation.

  • Noteholders can still obtain standard contractual rights, such as a board seat, observer rights, participation or pro rata rights, information rights, and so forth.

In other words, with notes, you can do just about everything you could imagine, all in a relatively short document.

Tax Issues With Interest From Convertible Debt

If you invest in a convertible note that bears interest, depending on the circumstances you might be forced to take this interest into income on an accrual basis even though you don’t receive any cash payments of interest. How could this be, you ask? Well, because the IRS has rules in place that force note holders in certain situations onto the accrual method of accounting when it comes to interest on private company convertible notes. What happens if the interest is converted into stock? Well, the IRS will still tax you on the interest, even though it is paid in stock.

For most angel investments in convertible notes, this interest income problem is not that big of a deal, because the total interest amount that you might be forced to take into income doesn’t add up to much.

danger But beware if you are investing a considerable amount of money. The tax on the interest income might turn out to be more than you wanted to bear. In these cases, you might want to ask the company to pay the interest in cash so that you can pay the tax on this interest income.

Notes are not required to bear interest if the lender is not related to the company. Thus, another possibility is—just don’t include an interest rate in the note.

Terms of Convertible Debt

Common provisions of a convertible debt financing include:

  • The interest rate. Usually somewhere between 4% and 8%.

  • The maturity date. Usually 12–24 months.

  • A mandatory conversion paragraph. Specifies the minimum size of the round that the company must close in the future (a qualified financing) to cause the debt to automatically convert into equity of the company.

  • An optional conversion paragraph. Gives the investors the option to convert into whatever equity securities are sold by the company in its next financing, even if the financing does not meet the definition of a qualified financing (a non-qualified financing). This term is both common and recommended.

  • A change of control provision. Addressing what happens if the company is sold before the note converts (highly recommended).

  • A conversion discount. Specifies a discount note holders receive relative to the equity price in the qualified financing (common but optional).

  • A valuation cap. Specifies the maximum pre-investment value that will be used to convert the note into equity in the qualified financing (common but optional).

  • An amendment provision. Entitles the company, typically with only the consent of holders of the majority in principal amount of the notes, to amend the terms of the notes.

  • An attorneys’ fees clause. Entitles the holder to repayment of its fees if it sues to enforce the terms of the note.

confusion Note that while the interest and maturity date only apply to convertible debt, the rest of the terms here can be found in a convertible equity financing, which we’ll cover next.

Interest

Interest on a convertible note is not typically paid in cash while the note is outstanding. Most typically, it accumulates and is paid in stock on conversion. However, sometimes note holders negotiate for the right on conversion to have the interest paid in cash. Interest rates on convertible notes typically range from 4%-8%. Startups are very high risk, and the rate of interest typically would not adequately compensate an investor for that risk relative to alternatives; so it is best to think of the interest as a sweetener to the deal, since the main reason for buying the note is to end up with the equity when it converts.

caution You should know that even if the interest on the note is paid in stock, it is taxable to you as if paid in cash. In fact, you might be taxed on interest before it is paid in stock—in other words, you may be put on the accrual method of accounting for income taxes when it comes to the interest component of your note (and be taxed even if you haven’t received anything yet). We address tax issues in detail in Part V.

Maturity

The maturity of the note—the length of time before it is due—typically ranges from 12–24 months. It is common that startups take longer to achieve their milestones then they or you expect. A shorter maturity date (12 months) is a ticking clock that might pressure an entrepreneur to raise money on unfavorable terms.

If progress is slow, startups may extend the note. This is quite common—in fact, this is one of the common uses of an amendment provision. In this case, the maturity of the note would be extended with the consent of a majority of the existing note holders.

Sometimes a company will try to negotiate for the note to not come due until after the stated maturity date holders of a majority of the principal amount of the notes demand payment. This is a helpful provision for companies, because they do not have to worry about one small note holder demanding payment in cash at the maturity date. It is also a helpful provision if you are in the majority, because you can control the demands of minor note holders as well.

Conversion

Mandatory Conversion In A Qualified Financing

Convertible notes usually automatically convert to stock when the company raises money in what is typically defined as a qualified financing.

A qualified financing in a convertible note is usually defined as a fundraising of at least a fixed amount of money (for example, $1M), either including or excluding amounts raised under the note. These criteria cause the note to automatically convert into the type and number of shares being sold in the qualified financing. There are subtleties to how a qualified financing is defined.

A non-qualified financing is a financing that does not meet the definition of a qualified financing in your note, and thus does not cause your note to be automatically converted into shares of stock sold in the financing.

Here is an example of a definition of a qualified financing:*

⚖️legaleseIn the event that the Company issues and sells shares of its Equity Securities to investors (the “Investors”) on or before the date of the repayment in full of this Note in an equity financing resulting in gross proceeds to the Company of at least $__________ (including the conversion of the Notes and other debt) (a “Qualified Financing”), then…

You want to be sure the financing is a “real” financing and not a financing of some small amount by the founders to simply convert your debt to equity. You also want to make sure that there is going to be enough new money coming in to give the company the runway it needs. This is why the amount is usually on the order of at least $500K or more. The definition can be written to include the money previously raised on the convertible notes or not, but usually excludes amounts raised in convertible debt.

You may also negotiate whether the qualified financing is only triggered on the sale of preferred stock or whether the common stock financing could trigger the auto-conversion on a qualified financing as well. Many investors prefer that their notes expressly say that a qualified financing has to be a preferred stock financing.

Optional Conversion

Optional conversion clauses address the ability for the investors to convert their notes under scenarios that do not meet the qualified financing definition. For example, an optional conversion clause can be written to allow the investor to convert if the company raises money in a fixed-price financing at attractive terms, but not enough to trigger automatic conversion under the qualified financing definition.

Another optional conversion scenario is the company does not raise any money before the notes mature. In that situation, if you do not want to extend the note, you might want the right to convert into common stock or a predetermined series of preferred stock at a pre-agreed valuation.

To break it down, there are three different moving parts that can be specified in optional conversion paragraphs:

  • At whose option does the conversion happen? Typically the investors have the right to invoke the optional conversion, and it is what you want as an investor. The founders will not want conversion at the option of the investor in the absence of a qualified financing until the company passes the maturity date. They might also want a clause giving them the right to invoke the optional conversion, but this is not a typical formulation.

  • At what value? If the company consummates an equity financing that does not constitute a qualified financing, an optional conversion clause can stipulate that the note holders have the option to convert at the price per share or at a discount to the price at which shares are sold in that financing (this is fairly common). Another possibility is that the clause includes the valuation cap and stipulates that the conversion price is the better of a predetermined discount to a non-qualified financing or the price determined by the valuation cap.

  • Into what type of security do the notes convert? Some optional conversion clauses say that in the absence of a qualified financing the note will convert into a series of default preferred stock. Alternatively, the note could convert into common stock.

What if the note does not specify an optional conversion? If the convertible note does not specify an optional conversion in the event the company does not achieve a qualified financing, there is a risk to the company that the investors may make a demand that their notes be repaid in full. It also means that the parties may just have to meet and hash out a negotiated compromise. Negotiating changes to the note when things are not going well and the company is trying to secure additional funds can take up a lot of the CEO’s time, and it may jeopardize or delay the future funding due to the uncertainty. At a minimum, it is important that the notes contain a provision that they can be amended with the consent of a majority of the note holders, as we discuss below.

Sale of the Company Before Conversion

A convertible note should address what happens if the company is sold before the note converts to equity. Typically, this is addressed through a provision that states that if the company is sold before the debt converts into equity, the note holders get something more than just their principal and interest back (that would be a bad deal). Typically, they are entitled to the greater of some multiple on their principal and interest (for example, 2X or 3X), or a greater amount as if they had converted at the valuation cap or another value specified in the note.

Valuation Cap

A valuation cap is a term included in a convertible note that sets the maximum valuation of a company at which an investor’s note can be converted into stock of the company. An angel investor will typically want a valuation cap in a convertible note so that they are not converted at an unexpectedly high valuation.

exampleAn investor makes an investment of $50K in a convertible note with no valuation cap. The terms of the note state that the note will be automatically converted into equity of the company once the company raises $1M in equity in a fixed price financing (a qualified financing). The company raises $1M in a qualified financing at a $100M valuation. Without a valuation cap, the investor’s stock would convert at the $100M valuation. The investor believes that the increased valuation was attributable in part to their investment. However, the investor does not share in the valuation increase between the time of her investment and the subsequent round at the $100M valuation because there was no valuation cap when the investment was made.

  • But assume there had been a valuation cap of $5M. In that case, the investor’s note would have converted at a much better price per share and the investor would have gotten more shares and not been so heavily diluted.

  • Let’s do the math. Assume there had been 3M shares outstanding, and no warrants, options, or any other convertible securities outstanding except the notes. The price per share at the cap would have been $5M divided by 3M shares, or $1.66 a share, and the investor would have received $50K divided by $1.66 a share, or 30,120 shares, excluding interest. At a $100M valuation the price per share would have been $33.33 a share, and the investor would have received $50K divided by $33.33 a share, or 1,500 shares, a stark and dramatic difference.

While this is an extreme example, you can see that valuation caps can be very important.

founder There are two schools of thought on what an ideal valuation cap should be:

  • The first—let’s call it the “Investor’s School of Thought”—says that the cap should be the current fair market value of the company. In other words, the cap should be the valuation that you would place on the company at the time of the investment, as if you were doing a priced round.

  • The second school of thought—let’s call it the “Founder’s School of Thought”—says the cap should be the outside range of potential values for the company. Ultimately, this is a philosophical question for which there is no precise answer.

Conversion Discount

A conversion discount provides that the holder of the note gets a purchase price discount when the note is converted into stock. Typically, the discount is 10%-20%, but discounts higher than that are not out of the question.

exampleThe note might say that upon conversion in a qualified financing, the note will convert at a price per share equal to 75% of the price per share at which shares are sold in the offering (meaning, a 25% discount). If in the qualified financing round, shares were priced at $1, you would be getting them at $0.75; so your $25K investment in the note would result in your owning 33,333 shares rather than 25K shares.

Conversion discounts are very common in convertible notes. It is a term that you should always look for when you are reviewing a convertible note offering. However, not all convertible notes provide discounts. For example, at one time companies graduating from Y Combinator were issuing notes with no cap, no discount, and no interest rate. Of course, these are exceptional circumstances and very founder-friendly.

Interaction Of Caps And Discounts

important If a note has both a cap and a discount, the note should read that you get the better of the two conversion possibilities. If you would get more shares at the discounted price, then you would get the discounted price. If you would get more shares at the valuation cap price, then you will convert at the valuation cap price.

Amendment Provisions

Amendment provisions exist so that the investors and the startup can adjust the terms of their relationship as conditions change. It may be that a non-qualified financing opportunity comes along and the note holders want to convert. If this is not specifically addressed in other clauses within the note, the note could be amended to allow the investors to take that action. It is also possible that the lead investor in the upcoming priced round does not like some term in the note and wants to negotiate that with the note holders. The note investors may be willing to do that to get a deal to close on otherwise favorable terms.

Generally, notes are amendable with the consent of the company and holders of a majority in interest of the notes. This prevents any single investor from holding up progress of the company. Most of the time, these amendment provisions do not specify a supermajority requirement to amend. Similarly, most of the time the amendment provisions do not say anything special about minority rights—such as a provision that an amendment cannot treat a single note holder differently from other holders of the same note (although if you can ask for this you should). The only scenario in which this could be problematic is if a majority of the convertible notes are owned by someone or some entity, such as a strategic investor, with a different set of goals than yours.

Attorneys’ Fees

Your note should contain an attorneys’ fees clause, entitling you to an award of attorneys’ fees if you have to sue to enforce the terms of the note. (There is sometimes a separate provision in which the company agrees to reimburse the investor their attorneys’ fees, usually capped.)

Advanced Topics on Convertible Debt

Default Provisions

Sometimes notes will specify what happens in the event the company defaults on the note. Most of the time the primary default is the non-payment of the note on the maturity date. Higher interest rates in the event of default are not common.

It is not uncommon for a note to require that before an action is taken against a company to enforce the terms of the note, the holders of a majority in principal amount of the notes approve the action, rather than just one note holder. Sometimes the majority required is a supermajority, set at something like 70%, to ensure that a large minority investor has a veto right on any amendments.

exampleIf there are eight investors, three who put in $100K and five who put in $50K, there are $550K of notes outstanding. Holders of notes with principal amounts aggregating more than $275K can, with the company’s consent, amend the note.

Should Your Note Be Secured?

When you say that a loan is secured by the company’s assets, what you mean is that the company will grant the lender a security interest in its assets, which the lender may perfect.* A security interest is a direct interest in the assets of a company that the borrower grants to the lender. If the lender has a security interest in the company’s assets, the lender can perfect its security interest by filing a financing statement (typically, a UCC-1) to ensure that subsequent creditors are behind it in line with respect to payment from proceeds of a sale of the assets. Once the lender does this, they have priority over subsequent creditors. A secured party can take action to seize the collateral and dispose of it in the event of a default on the loan.

Secured notes are not typical in angel financings. There are a few reasons why angels rounds are rarely secured:

  • First, many angel rounds are pretty small financings and people do not want to take the additional time and hassle to put a security agreement in place.

  • Many early-stage companies do not have a lot in the way of assets to secure.

  • The investors frequently feel more like equity investors than debt investors in these transactions.

  • All parties involved in the early stages typically want to make sure that the company does not have any legal impediments to raising its next round of financing (such as having to subordinate the angel debt to a bank loan).

  • Secured debt adds a layer of complexity. Not having secured debt removes a layer of complexity.

But that does not mean that your note should necessarily not be secured, just that it is not a very common practice and might be viewed as aggressive by founders. If you decide you do want a secured note, make sure you consult with legal counsel to ensure that the “grant” of the security interest is adequate under the law of the jurisdiction governing the note, and that you file a Uniform Commercial Code financing statement perfecting your security interest.

Liquidation Preference Overhang

founder One issue that comes up with convertible notes is that it is possible, depending on how a note is drafted, for note holders to receive shares with a liquidation preference per share greater than the amount of their actual cash investment per share. This happens when the note converts at a discount or valuation cap and no special allowance in the note is made to address this issue.

Liquidation preference overhang refers to how you might, if you invest in a convertible note or convertible equity instrument with a valuation cap or a discount (or both), ultimately might receive shares of preferred stock with a liquidation preference in excess of what you paid.

For example, if you invested $100K in a convertible note with a 20% discount on conversion. If the company ultimately sold preferred stock for $1 a share, you would buy your shares for $0.80, but you might receive shares with a liquidation preference per share of $1. Sometimes notes and convertible equity instruments are set up so that you don’t receive shares with a liquidation preference in excess of what you paid, or you receive common stock to make up the difference in the number of shares you are supposed to receive. So, instead of receiving that number of shares of preferred stock equal to $100K/$0.80 per share, in this example, or 125K shares of preferred stock, you would receive 100K shares of preferred (so that your liquidation preference matches the amount you invested, ignoring interest for the sake of this example), and you would receive 25K shares of common stock.

Another way to handle this is for the company to create two classes of preferred stock, one with a liquidation preference per share equal to $0.80 and one for $1 per share, and then issue you the $0.80 liquidation preference per share shares (and all the other terms of the preferred stock would be the same).

This problem can become especially acute when there is a valuation cap, and the cap comes into play. A note investor may receive a significant amount of liquidation preferences beyond what they invested in the convertible notes.

founder Founders may think this is problematic. Some investors think it is unfair to founders. It is not really a problem for the investors, except to the extent that the founders and other investors think it is unfair.

One solution is to have the discount shares convert into common stock. Another possibility is to have the debt convert to a series of preferred stock whose liquidation preference matches the amount of capital actually invested, but otherwise has the same rights, preferences, and privileges sold in the round. This is becoming more common and is the standard set by Y Combinator in the SAFE.

Calculating Number Of Shares To Be Issued At The Cap

If a company is going to issue shares to you at the valuation cap, you will want to know how the number of shares will be determined. Will the number of shares be determined on a fully diluted basis or on some different measure? It is typical to exclude the debt being converted.

Some convertible notes are written this way:

⚖️legaleseThe price equal to the quotient of [the Valuation Cap] divided by the aggregate number of outstanding shares of the Company’s Common Stock as of immediately prior to the initial closing of the Qualified Financing (assuming full conversion or exercise of all convertible and exercisable securities then outstanding other than the Notes)…

Note that the “then outstanding” language implies that you are not going to count the entire stock option pool—you are only going to count options that have been issued to workers and that are still in the hands of workers at the time of conversion. Other notes might say “including the Company’s shares reserved for future issuance under the Company’s equity incentive plans,” meaning the issued options and the available option pool.

importantFrom an investor’s perspective, you want clarity on what is going to be counted in determining your price per share—you don’t want the note to be silent on this point. You would prefer the entire available option pool plus all outstanding options be counted in the denominator. The text below provides an example of including the option pool under the definition of “Fully Diluted Capitalization.”

⚖️legaleseIn the event the Company consummates, prior to the Maturity Date, a Qualified Equity Financing, then the Principal Balance will automatically convert into shares of capital stock of the Company at a price per share equal to either: (i) the “Preferred Purchase Price”: the price per share of preferred stock sold in the Qualified Equity Financing (notice no discount here) or (ii) the “Target Price”: the price obtained by dividing the Target Valuation (where the “Target Price” is the Valuation Cap) by the Fully Diluted Capitalization (defined below). The lower of the Preferred Purchase Price and the Target Price is the “Conversion Price.”

“Fully Diluted Capitalization” means the sum of (i) all shares of the Company’s capital stock (on an as-converted basis) issued and outstanding, assuming exercise or conversion of all options, warrants and other convertible securities (other than this Note and Other Debt) and (ii) except with respect to conversions of this Note in connection with a Change of Control, all shares of the Company’s common stock reserved and available for future grant under any equity incentive or similar plan of the Company.

It is better for the note holder to count the whole stock option plan share reserve. Notice this is done in the above example but not in the event of sale of the company where it wouldn’t make sense in any event (because unused pool shares are disregarded in a company sale, just like authorized but unissued shares).

The details of dilution and ownership calculation, as well as valuations, are discussed in Part IV.

Most-Favored Nations Clause

A most-favored nations clause (or MFN clause or MFN) is a clause in a convertible note or convertible equity purchase agreement (or side letter agreement) that provides that the holder of the security is entitled to the benefit of any more favorable provisions the company offers to later investors. If you are an early investor in a convertible note round, an MFN clause can be a very good idea.

The reason MFNs exist in convertible debt and convertible equity is that these investment instruments are often sold to individual investors over a period of time. If you make an early investment via a convertible note, you are taking more risk than someone who comes in later, and you want to make sure they don’t get better terms. A most-favored nations clause in a note or side letter agreement might look like this:

⚖️legaleseThe company hereby agrees that if it offers any subsequent investors convertible-note terms that are more favorable to the subsequent investor than the terms included herein, the company will provide the holder of this instrument with those more favorable terms.

Here’s the most-favored nations clause included in Y Combinator’s SAFE documents, which more clearly addresses the mechanics:

⚖️legaleseMFN Amendment Provision. If the Company issues any Subsequent Convertible Securities prior to the termination of this instrument, the Company will promptly provide the Investor with written notice thereof, together with a copy of all documentation relating to such Subsequent Convertible Securities and, upon written request of the Investor, any additional information related to such Subsequent Convertible Securities as may be reasonably requested by the Investor. In the event the Investor determines that the terms of the Subsequent Convertible Securities are preferable to the terms of this instrument, the Investor will notify the Company in writing. Promptly after receipt of such written notice from the Investor, the Company agrees to amend and restate this SAFE to be identical to the instruments evidencing the Subsequent Convertible Securities.

exampleYou want a 20% discount on a convertible note because you are the first investor. The entrepreneur resists going past 15%. To get the deal done, you agree to 15% but you add an MFN, so that if the entrepreneur grants a higher discount to any later convertible note investors you also get that higher rate.

Pro Rata Rights and Convertible Notes

Although convertible notes don’t typically contain pro rata rights (which are typically handled on the company’s first fixed-price financing), this is definitely something you can ask for. For an example of pro rata rights language, see Y Combinator’s pro rata side letter.

Convertible Note Cheat Sheet

important When negotiating a convertible note financing, focus on the following elements of the term sheet:

  • What is the valuation cap?

  • What is the conversion discount? (10% to 20% typically.)

  • What is the repayment premium in the event of a sale before conversion?

  • What defines the qualified financing?

  • What happens if the company does not achieve a qualified financing?

  • Do you have the right to participate in any financings which are not qualified financings?

  • Is there an optional conversion provision that is at your option, or the company’s option?

  • Do you have or want a most-favored nations clause?

  • Will interest be paid in cash or stock or a combination of cash and stock? (Although this is less common, if you are being paid a considerable amount in interest because you are making a sizable investment, this is something you could ask for.)

danger Provisions to watch out for in a convertible note financing:

  • Make sure that in the event of the sale of the company the company can’t just return your principal and interest. You are investing in a note for the potential equity upside, not interest.

  • You will usually want a valuation cap that is acceptable to you (not too high).

  • A mandatory conversion paragraph that doesn’t convert you at the lower of the discounted price or cap.

  • The lack of a change of control payment provision.

  • A mandatory conversion paragraph that does not contain a sufficiently sized round to justify your forced conversion.

  • The lack of an optional conversation paragraph, giving you the option to convert into equity either (i) when the company closes a financing round that does not meet the definition of a qualified financing, or (ii) after the maturity date, at a specified valuation (for example, the cap).

Preferred Stock

Preferred stock rounds are the most common type of fixed price round for angel investments—in fact, when investors and founders refer to a fixed price round or a priced round, they usually mean a preferred stock financing, although common stock fixed price rounds are possible. Preferred stock is equity that has specified preferences relative to common stock and potentially to other classes of preferred stock. Those preferences are negotiated as part of the term sheet and documented in the definitive documents of the stock sale.

The most common preferences conferred to preferred stockholders are:

  • a liquidation preference

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