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While purchasing convertible debt and preferred stock are the most common types of investments angels make, there are other financings out there that you or a company you’re investing in may prefer. Some of these are newer to the angel investment world.
Convertible equity is an entrepreneur-friendly investment vehicle that attempts to bring to the entrepreneur the advantages of convertible debt without the downsides for the entrepreneur, specifically interest and maturity dates. The convertible equity instrument the investor is buying will convert to actual equity (stock ownership) at the subsequent financing round, with some potential rewards for the investor for investing early. Those rewards are similar to the rewards for convertible debt, such as a valuation cap and/or a discount.
The amount of the equity the investor is entitled to receive is determined in the same way as a convertible note. The investor usually (but not always) converts at a discount to the next round’s price or at the valuation cap if that would result in a better price. As with convertible notes, the company avoids pricing its equity, which can be helpful when hiring employees.
Convertible equity is expressly defined as not being debt, so it does not bear interest. Nor does it have a maturity date.
Convertible equity is similar to convertible debt in that the documentation is simple—and therefore much cheaper—compared to a priced round, and so it is appropriate for earlier, smaller investment rounds, which can be anywhere from $50K to several hundred thousand dollars in size.
founderConvertible equity is an attempt to address the problems with convertible debt from the company’s perspective. Convertible notes bear interest, which is often small in amount but creates additional complexity; and convertible notes come due (that is, they have a maturity date). Companies would rather not have to confront interest rates and maturity dates if such issues could be avoided.
Convertible equity is a relatively new investment instrument in the angel investment world. You can access several different types of convertible equity term sheets on the web, including Y Combinator’s SAFE (Simple Agreement for Future Equity), and 500 Startups’ KISS (Keep It Simple Security). The Founder Institute has also published a form of convertible equity instrument.*
Entrepreneur Perspective on Convertible Equity
founderThe convertible equity deal structure is intended to give the startup the benefits of the simplicity and low legal costs of the convertible note format, without the downsides of debt.
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For one thing, having large amounts of debt on the balance sheet can be a turnoff for suppliers and potential partners the company may seek as they grow; convertible equity helps companies avoid this red flag.
Additionally, the maturity date attached to convertible debt can cause stress and distraction for a startup because it puts a deadline on when the company has to raise a qualified financing. There are a host of other provisions that may kick in if there is no qualified financing before the note matures; and at a minimum the company will have to do the legal work to extend the note.
This ticking clock problem is exacerbated if the company has issued a series of convertible notes over the course of months, each with a different maturity date. Calculating the conversion of the accumulated interest into stock at the time of financing can also be complicated, and the interest itself is dilutive to the founders, so there are benefits to eliminating the interest associated with convertible notes. (Like convertible debt, convertible equity can still contain a discount and valuation cap.)
Investor Perspective on Convertible Equity
The convertible equity financing structure is currently being promoted by several incubators and accelerators, including Y Combinator—if you want to invest in one of those companies, you will likely have to accept a convertible equity deal structure.
From an investor’s point of view, you might prefer convertible debt rather than convertible equity, because:
Convertible debt sits on top of equity; if the business fails, debt gets paid first.
Convertible debt is debt; it exists within a known and well understood legal category. Convertible equity is nebulous, where investors must accept equity of an unknown amount.
Convertible debt can bear interest, yielding a bigger payday for investors.
Convertible debt has a maturity date, meaning investors know when the loan is expected to be paid back.
If the company doesn’t achieve a qualified financing, you can probably demand a loan’s repayment and not be forced to accept stock in the company.
importantConvertible equity is entrepreneur-friendly, but with discounts and valuation caps, you can still be rewarded for your early participation. As an angel investor who comes in early when there is significantly more risk, you have the right to demand a benefit relative to investors who come in later when the company has made more progress. Those benefits are the discount on the price per share relative to later investors, and the valuation cap. You should negotiate hard for those, because if the company’s value increased dramatically from the time you invested to the time they raise a priced round, you deserve to benefit from that increase because you took the early risk.
Terms of Convertible Equity
Convertible equity deals do not have interest or maturity dates, but may contain any of the following terms described in the section on convertible debt:
calculating the number of shares to be issued at the cap
most favored nations clause
pro rata rights
As an angel investor, from time to time you might be asked to invest in common stock.
Common stock is stock that entitles the holder to receive whatever remains of the assets of a company after payment of all debt and all preferred stock priority liquidation preferences. Common stock does not usually have any of the special rights, preferences, and privileges of preferred stock (although it is possible to create a class of common that does, such as a class of common stock that has multiple votes per share, or is non-voting, or that has protective provisions).
When a corporation is initially organized, typically only common stock is issued to the founders and set aside for issuance under the company’s stock option or equity incentive plan for service providers. (However, sometimes founders will issue themselves a special class of common stock with 10 or 100 votes per share and protective provisions.)
important Though common stock can be raised in a priced round, it is not usual for angels to purchase common stock. Common stock usually has one vote per share, no liquidation preference, no anti-dilution adjustment protection, and no protective provisions. As we have previously discussed, preferred stock is “preferred” because it has these types of special preferences. However—and though many angels will refuse to buy common stock—common stock deals are not necessarily bad deals. In fact, one of the best investment returns Joe has ever seen was a $100K angel investment in common stock that turned into $20M in cash.
If you are doing a common stock deal, the definitive documents will include a common stock purchase agreement, and may include other agreements such as a Voting Agreement.
Startups’ Perspective on Common Stock
founder The benefits to the entrepreneurs of a common stock round relative to a preferred stock round include:
A lack of liquidation preference for the common stock investors.
A lack of dividend preferences typically associated with preferred stock.
A general lack of other voting and control provisions typically associated with preferred stock. (That said, it is possible to put many provisions favorable to the investors in side letter agreements and other definitive documents associated with the financing.)
Significantly lower legal fees for documenting the deal.
From the company’s perspective, there are drawbacks to selling common stock to investors:
Once the company sells common stock, it will have fixed the value of its common shares for the purposes of granting stock options. If the company sells common stock at $1 a share, it cannot grant stock options at $0.25 a share without causing any optionees to have negative tax consequences.
In contrast, if the company sells preferred stock, it can typically continue to grant stock options, which will be options for common stock, at a price per share less than the price per share at which it sold preferred stock.
Investors’ Perspective on Common Stock
The reason angels do not normally invest in common stock is because common stock does not have the privileges of preferred stock (specifically, a liquidation preference). However, in some instances founders will not want to issue preferred stock because they will not want a liquidation preference ahead of their founder shares, and sometimes investors are willing to do this to get into the deal. The other situation where common stock might be sold is when the amount of money being raised is not large enough to justify the costs of a preferred stock round and the investors are willing to take common stock in a fixed price round rather than convertible debt or convertible equity. In general, as a rule of thumb, if a company is raising less than $500K, a preferred stock round does not make sense from a legal fees perspective, and a convertible note or equity round or common stock round makes more sense.
As the example common-stock term sheet suggests, investing in common stock can be relatively straightforward. However, as described above, there are drawbacks and potential pitfalls to consider:
dangerIf the company raises money at a lower valuation shortly after an investor’s common stock investment, the investor will not be entitled to the lower valuation (unless the investor negotiated a most favored nations or purchase price anti-dilution adjustment in a side letter or elsewhere in the definitive documents).
exampleYou buy common stock at $1 per share. Six months later the company sells preferred stock at $0.60 per share. Because you did not negotiate for an MFN or anti-dilution adjustment protection, or the right to convert your common stock into the next round of preferred, there is nothing you can do. You have your common stock, but you are probably not too happy that the preferred stock investors made a much better deal and at a 40% discount to your price.
dangerIf the company issues preferred stock with a liquidation preference, and the company is liquidated for less than the liquidation preference, you won’t receive anything.
exampleYou buy common stock at $1 per share. Preferred stock investors subsequently invest $1M at $1.25 per share, with a 1X liquidation preference. The company does not succeed and ultimately sells all of its assets for $500K. The preferred stockholders are entitled to receive all of the proceeds. You are not entitled to receive anything on liquidation in this scenario.
importantGenerally, common stock investments do not have any control mechanisms built into the deal. If you are a small investor (for instance, in the amount of $25K), it would not be reasonable for you to assert any control rights. But if your investment is larger, something on the order of $200K or more, you may want to request control mechanisms including a board seat and/or approval for certain company actions, such as the sale of the company. These controls can be built into the definitive documents or appear in a side letter.
How to Protect Yourself in a Common Stock Round
There are a number of ways you can try to protect yourself if you are investing in common stock. For example, you could have the company agree (perhaps in a side letter) that if it sold preferred stock in the future, it would convert your common stock to preferred. That would be unusual, but it is possible to do this.
Another possibility is that you negotiate for purchase price anti-dilution protection (perhaps to be embodied in a side letter agreement with the company).
Another idea is to set a pro rata right, so you can apply your pro rata right in subsequent rounds of financing by the company.
You can find an example of a side letter agreement from a common stock investment that gives the investor full ratchet anti-dilution protection in the appendix (though this is rare).
Revenue loans are another relatively new financial innovation in the early-stage company space.
A revenue loan is a loan that has a monthly or periodic repayment amount that is a percentage of the company’s gross or net revenue in the period with respect to which the payment is going to be made (for example, the preceding month or quarter). The payment amount is typically somewhere between 5-10% of the preceding period’s gross or net revenue. In other words, the payment amount is not set and fixed like in a traditional loan. It goes up and down based on the performance of the business. A revenue loan may have a four-, five-, seven-, or ten-year term, and is considered repaid when the lender has received the negotiated multiple of the loan amount (anywhere from 1.5X-3X) and any other costs of the loan.
Revenue loans may or may not be secured by the company’s assets and may or may not be guaranteed by the company’s founders. They may or may not have any financial operating covenants. They may or may not have any equity component (for example, they could come with warrant coverage. They may also come with a “success fee,” meaning a payment of some additional amount to the lender on the sale of the company.
Revenue loans fill a gap between typical commercial loans and traditional equity-based financing instruments. They are often used by companies that have cash flow and are looking for expansion capital but do not want to give up any equity in the business. For example, if a new coffee shop is doing really well and the owners want to open three more locations, they may not have the working capital required for that expansion. A traditional bank may not see enough operating history or might want personal guarantees from the owners along with constraining financial covenants. With a revenue loan, once those new venues start generating cash the owners can use margin on that new revenue to pay off the loan over time. The other advantage of the revenue loan structure is that if it took several months for those new locations to ramp up sales, the company would not be burdened with a high fixed monthly loan payment from a traditional loan. The revenue loan payments would start low and ramp directly with the sales.
For a revenue loan to work, it is important that the company have a high-margin product since they will be using a percentage of revenue to pay off the loan. For example, a company sells a product for $100 and the direct costs of producing and delivering that product are $50. They have a 50% product margin, (revenue-cost)/revenue. They will also have operating costs. Let’s say the cost of product support and the sales team and marketing average 30% of the revenue. The company now has $100 - $50 - $30 = $20 from each product, which they can use to cover their overhead and provide a profit. For our purposes, let’s call that the operating margin: 20%. It would be very risky for this company to take a revenue loan that takes 15% or even 10% of revenue, as it would leave them almost no cash (5% or 10% of revenue) to cover overhead and other needs. Software and SaaS (software as a service) companies are the canonical example of the high-margin products, with typically 80% or higher margins. For that reason, revenue loans have come to tech companies as well. Lighter Capital, for example, a revenue loan business based in Seattle, is an active lender to SaaS and technology services companies.
dangerOne legal issue you will need to watch out for in the revenue loan context is usury. Some state usury laws specifically exclude from the definition of interest a share of the revenue of the business. Other states do not have usury laws at all in the context of commercial loans. But some state usury laws apply to revenue loans and prohibit effective interest rates above a certain amount. This is an issue that needs to be thought through when making revenue loans.
Startups’ Perspective on Revenue Loans
Assuming that the company has a high-margin product or service, a revenue loan has advantages over a bank loan, including:
Flexible payments, which go up only when the revenue is flowing, as opposed to the fixed payments of a bank loan, which can be especially helpful if there is a lead time to develop revenue from the investment.
Typically fewer financial covenants, so more flexibility to run the business.
Potentially no personal guarantees for the founders.
Potentially no equity in the business has to be given up.
The cost of a revenue loan in terms of the effective interest rate paid by the company is typically significantly higher than for a bank loan. That can still be very attractive to founders compared with equity financing due to the following factors:
Potentially not much in the way of lender control provisions or operating covenants (no investors on board seats, for example).
Usually much faster and cheaper access to capital than traditional equity financings.
No need for an exit strategy, meaning it’s fine if the business turns out to be a lifestyle business for the founders.
The downside of a revenue loan to the company of course is that loans can drain cash from the company. If a company wants to continue to expand beyond where its initial revenue loan took it, then they have to find the cash within existing operations for the next product development effort or business initiative. If a business suffers pricing pressure, cost increases, or other margin erosion, a revenue loan can be challenging.
Investors’ Perspective on Revenue Loans
Revenue loans can be great for investors because they allow investors to get a return on their investment without having to wait years for a company to be sold or go public. In equity financings, many angel investors run into the following problem: They are investing in stock and convertible debt in startups and early-stage companies. They are making a number of investments per year. Years roll by. They keep making investments. But none of the companies are getting sold or going public. “I’ve got plenty of deals on the conveyor belt,” Joe heard an angel investor once cry. “But I’ve got nothing coming off the conveyor belt.”
important When you invest in a private company, you are signing up for the long haul. The lack of liquidity in angel investing can be challenging. For this reason, revenue loans can be a complementary part of your startup investing portfolio. You are not going to get the big win, but you are much more likely to get the 2X-3X return on your investment; and as the loan is paid off, you will have additional capital to deploy.
The other advantage of revenue loans to the investor is that the loan is debt and it can be secured. Debt is senior to equity—meaning that if the company fails, debt gets paid back first, before equity.
A warrant is a contract entitling the warrant holder to buy shares of stock of a company. It is not stock itself. It is merely a contractual right to buy stock.
A warrant will set out:
the price per share at which you can buy the shares (for example, $0.01 per share)
the type of shares you have the right to buy (common or preferred)
the period of time during which you can exercise the purchase right (for example, two, five, or ten years).
Warrants are fundamentally the same as stock options (both are rights to purchase stock), but warrants and stock options differ in their format, complexity, and the contexts in which they are used. Warrants are usually issued in investment transactions, such as convertible debt financings that include warrant coverage, and stock options are used for compensatory purposes (a stock option for employees and advisors, for example).
Warrant coverage most frequently arises in the context of a convertible debt financing, but it can also arise in the context of a preferred stock financing.
Warrant coverage has fallen out of favor in convertible debt financings because of the tax issues (forced inclusion in income on an accrual method basis of phantom interest income) and the ability to mirror (at least in part) some of the economics of a warrant through discounts and caps in convertible notes while avoiding the tax issues associated with warrants.
Very rarely, warrants are issued as stand-alone instruments—meaning, by themselves, with no accompanying purchase of a note or stock.
A warrant can be very valuable. Suppose you had acquired a ten-year warrant to buy 100K shares of an early stage company’s stock for $0.40 a share. Five years later the company goes public and the shares are worth $40 a share. You can now exercise your warrant for $0.40 a share, and sell the shares on the open market for $40 a share.
In addition to the exercise price, the type of shares for which the warrant is exercisable, and the duration (term) of the warrant, warrants typically also have the following terms:
A net exercise provision (“net exercise” means that if the shares underlying the warrant have a value greater than the exercise price per share at the time of exercise, rather than paying cash to exercise the warrant, you can pay the exercise price with shares that would otherwise be deliverable on exercise).
An automatic exercise on a “net exercise” basis prior to termination (you would hate to have an in-the-money warrant suddenly terminate; an auto-exercise provision prevents that from happening).
Notification of a pending sale of the company and other material events.
Adjustments to the purchase price and number of shares covered for capital restructures, such as a stock split or stock dividend.
Calculating The Number Of Shares Represented By Warrant Coverage
When negotiating a financing, you might hear a founder say, “We are offering 50% warrant coverage.” Calculating the number of shares you are entitled to purchase based on a warrant coverage percentage requires the following inputs:
the amount of your investment
the exercise price per share of the warrant
the warrant coverage percentage.
exampleSuppose you are investing $200K in a convertible debt investment, and the deal carries 50% warrant coverage. The price per share of the company’s shares is not yet set because the company is offering this warrant coverage to you in a convertible debt round and your warrant is going to be exercisable into the preferred stock sold in the next round at that round’s price. How do you calculate the number of shares covered by your warrant?
In this example, the number of shares represented by the warrant coverage will depend on the price per share in the fixed-price round, once that is set. Suppose you invest $200K in the note round and the company ultimately consummates a “qualified financing” at $2.50 per share. In that case, you would be entitled to purchase 40K shares under the warrant. How?
Start by calculating the number of shares from the conversion of your investment, excluding the warrant—$200K, divided by the price per share in the offering, $2.50, equals 80K shares. Now multiply the 80K shares you get from the conversion by the warrant coverage percentage, 50%, to get 40K additional shares from the warrant.
You could also start with your investment amount, $200K, multiply that by the coverage percentage (50%) to get $100K, and divide that by the price per share, $2.50, to arrive at 40K.
Logically, this makes sense. You were offered 50% warrant coverage, or the right to buy an additional number of shares equal to half the shares you purchased when your note converted. What type of shares you get to buy and what price depends on the terms of the warrant as mentioned above. Typically the warrant coverage is for the type of shares sold in the next round, at the next round’s price. However, if no next round occurs, you will need a “default” class of shares to convert into, which might be common stock or a new series of preferred stock described in the warrant.
Tax Issues With Warrants
If you buy a note with a warrant, be aware that special tax issues arise.
Original Issue Discount
Assume you invest $100K for a note with a principal amount of $100K and a warrant. The IRS will view the note and the warrant together as one investment “unit.” It will deem that the $100K you invested must be allocated between the note and the warrant. This will result in the note having what is referred to in the tax law as the original issue discount (OID). OID must be included in taxable income on an accrual basis.
For example, assume the IRS determines that the fair market value of the warrants received is $20K. This would mean that you would have $20K of OID in the note, and would have to include that in taxable income over some period of time. It will be phantom income on which you have to pay tax. This tax issue is one reason note and warrant financings have fallen out of favor. More common today are note financings without warrants. Instead of warrants, notes have conversion discounts.
Investment Warrants vs. Services Options
There is a significant tax difference between warrants issued in connection with an investment transaction, and warrants or options issued in consideration for services rendered.
If you receive a warrant or a stock option in exchange for service rendered, then the same rules for nonqualified stock options apply:
Section 409A applies, which means that if they are priced below fair market value the optionee will be subject to 20% penalty taxes and interest upon the vesting of the options.
If priced at fair market value on grant, the receipt of the option is not taxable.
If priced at fair market value on grant, the vesting of the option does not give rise to tax.
On exercise, ordinary income tax is owed on the difference between the fair market value of the stock received and the exercise price.
On the other hand, if you acquire a warrant in connection with and as part of an investment, then the exercise of the warrant does not give rise to any taxable income, even if at the time of exercise there is a significant spread (meaning, the fair market value of the stock at the time of exercise is greater than the exercise price).
What About A Warrant Financing?
It is rare, but we have seen circumstances where someone will want to buy just a warrant in a company. Warrants are typically not purchased alone, so a “warrant financing” is atypical. Why? Think of it this way. Why would you invest in a security that only entitles you to become a stockholder if you later “exercise” the warrant? A warrant does not make you a creditor of the company, because a warrant is not a promissory note. Nor does a warrant make you a stockholder of the company, because it has to be exercised before it is converted to stock.
If you have the opportunity to buy a warrant, standing alone, and you want to go ahead, make sure the warrant has the terms that you desire, including, at least: (i) a lengthy term (like 10 years); (ii) an automatic exercise prior to termination if in the money: (iii) adjustment provisions in the event of a stock split; (iv) a net exercise provision; (v) an attorneys’ fees provision (and if possible, a favorable venue clause).
In the sections so far covering the different investment vehicles, each section has included terms that are unique to or typically associated with that investment type. This section includes the general investment terms that could show up on any term sheet, regardless of the investment vehicle. We have touched on many of these terms already, but in this section we will go deeper.
We have grouped the terms into subsections, and you can use this chapter as a reference whenever you come across one of these concepts.
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