Convertible notes, along with other convertible equity instruments, have become popular financing tools for early-stage companies. In this article, we will outline key information on convertible note financing as well as its advantages and disadvantages. It is important for founders to understand the legal and business consequences of a convertible note financing.
WHAT IS A CONVERTIBLE NOTE?
A convertible note is a debt instrument that grants the noteholder the right to convert the principal amount of the debt (and often all accrued interest) into shares of the company at a later date. The typical terms of a convertible note include:
1. Maturity date: just like in any other debt instrument, a convertible note carries a maturity date at which all the principal and accrued interest shall become due and payable.
2. Interest: the company will pay interest on the principal amount of the debt. Interests rates are typically less than 10% per year, namely because the main incentive for investors is not the immediate cash return, but instead the ability to purchase equity at a discount at a later stage.
3. Conversion provisions: the convertible note provides the different methods by which the debt will convert into equity. Typically, the debt will automatically convert upon a qualified financing, but there can be other conversion provisions such as automatic conversion upon maturity or optional conversion upon a liquidity event (any event which triggers a payout to investors such as the sale of the company) or at the discretion of the noteholder before the maturity date.
4. Qualified financing: a typical convertible note will provide for the automatic conversion of the debt in the event of a qualified financing, which is usually a later stage equity financing round at a minimum predetermined amount.
5. Conversion discount: the investor often gets a discount on the equity purchase in the later round, which usually ranges between 10 and 25%. For example, if there is a later financing round at $3.00 per share, a noteholder with a 15% discount shall purchase such shares at $2.55 per share.
6. Valuation cap: the valuation cap is the maximum value of the company at the later round for the purpose of converting the note into equity. This is at times included instead of a conversion discount, and at other times included in addition to the conversion discount (in which case the conversion will occur at a price per share equal to the lower of (1) the price per share in the next financing round minus the conversion discount and (2) the price per share based on the valuation cap).
PROS
Convertible notes have some advantages which make them interesting for early-stage financing:
1. Simple Financing
Convertible notes have a relatively simple structure, because they require less time, paperwork and formalities compared to a standard equity financing round. Consequently, convertible notes tend to close more quickly, and they are usually less expensive in terms of legal fees.
2. No Immediate Dilution
Convertible notes allow the founders to finance the company without immediately issuing equity to investors, thus avoiding a change in the capital structure and a dilution of their ownership rights.
3. Delayed Valuation
The valuation of a company is a key term in an equity financing. The price per share will typically be calculated based either on the pre-money valuation (the valuation of the company prior to the investment) or the post-money valuation (the valuation of the company after the investment). Such valuation determines the percentage of ownership granted to the investors in return for their investment. The company’s valuation is sometimes difficult to determine with accuracy, especially for early-stage companies. By issuing a convertible note, the founders get to avoid dealing with this issue, since the valuation will be determined in a later round.
4. Discount
As a reward for their early investment in the company, the noteholders get to purchase equity at later stage at a discount. The valuation cap and the price per share discount are great tools to ensure that the noteholders get rewarded for taking the risk of investing in the company at an early stage.
CONS
There are certain elements in a convertible note financing which can lead to potential complications:
1. Poor performance
When the company fails or chooses not to obtain a qualified financing before the maturity date, things can get a bit tricky. Sometimes, the parties to the convertible note agree to extend the convertible note for an additional term. Such an extension is generally granted when the investor is confident about the company’s progress. However, when the company is not in a good position, the situation is completely different. The investor can opt for the reimbursement of the debt at the maturity date, the automatic conversion of the debt at the maturity date or the conversion of such debt prior to the maturity date, if such options are provided in the convertible note. However, if a qualified financing did not occur because of the company’s poor performance, we can presume that such company does not have the funds to pay back the debt. Also, in such situation, the investor has little to no incentive to convert the debt into equity of a company in a difficult position.
2. Company Capitalization
When the debt is converted into equity based on the valuation cap, the price per share is obtained dividing such cap by the company’s capitalization. Founders should pay close attention to the definition of such capitalization under the convertible note, as this could have a significant impact of the price per share of the conversion shares.
3. Valuation Cap Side Effects
The valuation cap in the convertible note can sometimes indirectly impact the valuation of the company in the next financing round. The new investors will likely ask to see the terms of the convertible note during the preliminary discussions before issuing a term sheet (or at least during the due diligence). If this happens, such investors may try to adjust their valuation to the cap set forth in the convertible note. This might not make a difference if the valuation cap has been well negotiated, but nevertheless in the event that the company has a lot of traction warranting a high valuation, the cap might serve as a price ceiling for a financing that occurs soon after the execution of the notes.
4. CONCLUSION
Convertible notes provide a simple and efficient solution for early stage financing, but it is important for both founders and investors to understand the implications of their use. NSC Legal can help you determine if a convertible note is the right option for your company.
