Not so long ago, when one invested in an early startup, it was almost always through the purchase of preferred stock or equity in the company. An exchange of cash for a small percentage of ownership. Neat and tidy, everything on the table, no loose ends. Then, over time, founders (with the help of incubators and accelerators) decided that these equity instruments were becoming too difficult and time consuming, especially with respect to the negotiation of the price of the round and, to some extent, the preferences required by some investors. The “simplified” instrument that most companies started to use was the convertible note.
Convertible notes quickly became de rigueur in the startup community. They are, ideally, debt instruments that offer the investor interest payments in exchange for cash invested in the company. On the successful achievement of certain milestones, the investment (plus the interest earned) is automatically converted into ownership in the company. The key milestone generally being the closing of a subsequent equity investment round. Allegedly, if the company fails to raise an equity round in a specified timeframe, the investor can get their money back. This is supposed to be the advantage for the investor but is, in fact, a useless provision. If the company can’t raise a round, they have more than likely spent all the cash they have leaving nothing in the till to return to investors.
Initially, convertible notes did make things simpler for the founders of the startup. They could kick the valuation discussion down the road and the paranoid founder could withhold any control and financial preferences from their early investors. Unfortunately, these early, simple convertible notes were minefields of problems for angel investors. Foremost among these:
- They created situations where investors might only get their money back even though there was a large exit for the founders. Think of an exit that happens before a conversion takes place.
- They did not specify any control provisions or establish a board (every company needs one). No oversight.
- They often didn’t recognize the level of risk taken by the early investors with an appropriate combination of discount and conversion restrictions at the next financing round.
- Because the investment is debt and not equity, they kept the investors from starting the clock on capital gains treatment for the investment until the conversion took place.
To address these problems, investors negotiated new provisions in the notes to patch the holes which, in turn, made the convertible note documents increasingly complex and ultimately created documents at least as complicated as the equity investment instruments that they replaced.
Now, instead of discussing the valuation of the company and specific preferences of the preferred stock in an equity round, the cap on the note (the maximum conversion price), the discount (the reduction in price upon conversion), and the term of the note (when and how conversion takes place) need to be negotiated (some good descriptions of these can be found here).
Convertible note documents have ballooned into multi-page, complex forms that are not only negotiated just like their equity-based brethren, but now carry legal costs that are similar as well, taking away much of the advantage that was sought when they were widely adopted in the first place. In fact, they don’t even succeed any longer at their primary goal of kicking the valuation discussion down the road since the negotiation of the cap on the note has replaced that pretty much 1:1.
The realization that convertible notes are no longer either cheap nor fast has brought about several openly available standardized equity financing instruments like Series Seed, Techstars Open Source Model and others that promise to make a priced round even cheaper and faster than a current, complex convertible note. In my experience, and sadly, these documents are not changing the landscape much.
OK, that’s my rant. For a while, I refused to invest in converts. I wasn’t the only investor around who felt that way, but most didn’t care or push back. The debt instrument took hold and is here to stay. At least for a while. Now, I see very few seed deals that are not structured as convertible notes. Those that aren’t are generally led by institutional investors who often require an equity instrument to do an investment.
There is just so much fighting of the establishment that one can do and, as such, I’ve conceded that if I am to remain an investor, I have to adapt. That doesn’t mean I have to roll over, though. As such, I’ve created a set of criteria for myself when it comes to reviewing the convertible notes of potential investments. There are certain parts of a note that I like to see and some I don’t like. More importantly, there are parts that cause me to negotiate strongly and, ultimately, walk away if they are not added, removed or modified. I’ve tried to outline each of these below.
For angel investors reading this, I’d appreciate if you’d add your thoughts on what I’ve missed and where I’ve overstepped. For founders of startups, I hope you’ll look at these items as guidelines when you’re putting together your note. My intent is not to create an investor-biased instrument, but to fill the holes left by current convertible notes; to shed light on why some terms don’t work well for angel investors and to suggest how to change them so they work better. I don’t believe that any of the guidance I have or changes I recommend should be detrimental to the founders of the company. Speak up if you disagree.
Discount and Interest
Seed investors take a significantly higher level of risk than later stage investors. Let’s face it, the vast majority of startups fail and most of those fail early. In an equity investment round, the risk level taken by angel investors was built into the valuation of the company. Since this is not part of the note, then the investment risk has to be recognized through another avenue. This is the importance of the discount. A discount rate of 20% is pretty standard, but is it appropriate that the seed investor pays 80% what the next round’s investors pay when there might be a year between investment rounds? Probably not. So, the discount rate needs to be judged alongside the cap on the note. The combination of the two should recognize the risk taken by the early investor. That said, a discount rate of less than 20% is pretty big red flag for me.
On interest rates, I usually see 5-6%. I don’t focus on these too much because that’s not why I’m making the investment. Still, if it’s much outside this range, I’ll want to know why.
First and foremost, there must be a cap on the conversion. Again, why should an early investor take the risk of an early investment only to have someone else decide on the actual value of that investment somewhere down the road?
There is no absolute on the cap, of course. It depends on the company’s stage and what’s happening in the overall market. The cap should reflect the projected value of the company at the approximate time of the next financing, discounted to take the risk of the market and execution into account. Good luck with that. Really, it’s the number that in combination with the discount will get investors to fill your round. Hopefully, you can begin to see why negotiating this is no more efficient than negotiating an actual current valuation
Events Prior to Conversion
One of the biggest problems with convertible notes from the investor’s viewpoint is plugging all the potential scenarios that can take place between investing via a note and the conversion of the debt to equity. For example, if the company is sold prior to conversion, does the investor simply get their money back without recognition of the value of their investment? This situation is covered naturally in an equity round, but not in most convertible note documents.
As such, the note must specify that any change of control of the company (aka sale of the company or liquidation event) before conversion has taken place triggers a capped and discounted (as per the terms of the note) conversion into common shares in the company immediately prior to the execution of the corporate transaction. What this means is that the investor’s debt will be exchanged for equity according to the terms of the note, making the transaction a proxy for an equity investment round.
If the transaction is for less than the conversion cap, then the investor should have the right to receive a multiple of their investment. This can be on a sliding scale based on the time between their investment and the transaction. I have seen a fixed multiple of 2X applied to cover this gap.
Closing of the Note
The convertible note should not remain open for a long period of time. Sometimes, company founders will create a note and continue to take money under the terms of the note for an extended period of time. Since the terms of the note represent the level of risk taken and time, generally, reduces risk, it’s not fair for later investors to get the same terms as substantially earlier ones. Therefore, notes should be closed within 90 days of their opening to recognize the risk being taken by the early investors. If a note remains open for a long time, many angel investors will do their best to be the last money in which can make it difficult for the founders to raise the cash they need.
Pari Passu with Future Notes
It used to be that the early seed round was done with a note and the subsequent rounds were equity deals. These days, angels are seeing multiple rounds of convertible notes. When this happens, it’s important that the original note holder ensures that any more favorable terms in the future notes apply to the original note as well. Why should the people who took more risk by investing early receive fewer benefits?
To be clear, this does not apply to retrofitting the terms of an equity investment to original note holders. On conversion, the note holder will become equity participants via the conversion and receive the same terms, with some exceptions mentioned below, as the participants in the equity round.
The Major Investor Clause(s)
Many note documents include a class of investor referred to as the Major Investor. The Major Investor is usually granted rights that include guaranteed information, inspection rights and the right to invest in the next round of funding at their pro rata level at minimum. Effectively, the Major Investor clause(s) give the company and/or investors the right to preclude non-Major Investors from getting information or investing in the next round. As an angel investor, this is a huge negative. If things are going well, I may not have the ability to invest further. I’m not sure how that benefits anyone. No such clause should exist. If it does, I’ll ask for a side letter including me as a Major Investor.
I cover this thoroughly here.
A permutation of this that is regularly found in notes covers what is often known as the Requisite Holders. Sometimes, I’ll find the description of the rights of a Requisite Holder at the end of the note buried in the boilerplate stuff that no one ever reads. Here’s an example:
Any provision of the Notes may be amended or waived by the written consent of the Company and the Requisite Holders.
Where the group of Requisite Holders may be defined as the largest investors in the round. So, basically, certain investors may change the terms of the note at any time even to the extent of making the terms of the note different for each investor. The especially bad part of this, as I mentioned, is that this clause is often found at the end of the note, where no one is really paying attention. Why would I agree to this? Does this serve the company?
Whew! That was long. If you’ve read this far, I hope it was helpful. I’d like to believe that this is a treatise that will reverse the tide of the use and overuse of convertible notes. Of course, I know it won’t. So, at the very least, if this helps a few angel investors be more diligent about convertible note documents and convinces more to push for equity investments instead of debt, then I’ve done my job.
Will, nice reading and great explanation. I have been on the founders side of two convertible notes- one for $2+M and one for $400k. The first oddly was demanded by the lead investor. It was full of personal guarantees, asset collateral and cram down language for our other investors. The “note” eventually made it very difficult to bring on more financing and ultimately we shut the company down and walked away.
The 2nd note, we are currently operating under, was well constructed and negotiated but its still a note.
I speak to entrepreneurs often about the dangers of convertible notes but as you said, “there here to stay,” and inevitably they end up doing them to avoid the valuation discussion and often without a experienced law firm involved.
The irony for me is- in both scenarios the note was required by the investors, when the founders wanted to establish a priced round!
Fletcher, thanks for the comment. On your first, larger note it sounds like it was an appropriate tool for you investor to get the preferences and rights he/she needed. Perhaps easier for them than doing an equity round. On the second, perhaps they have just given into the status quo? It’s hard to tell without more detail. I think the advice you give founders is great with widsom well earned!
Dear Will Herman,
Thank you for you insightful comment on convertible notes. Mattermark included your article in their daily newsletter, for which I am thankful, as otherwise I wouldn’t have come across your notes.
As an angel I have invested in several companies, mainly through angellist and a couple of other crowdfunding website. One of the companies I have invested in directly is close to their convertible debt maturity date. Their progress is not sufficient for a major new round. They want the investors to role into new Prefferred Shares, with which I am happy with, in particular as the company is close to profitability. However, the lawyers sneakily introduced the Major Investor Term, with which you wouldn’t be happy with either. Do you mind sharing with me privately or openly how such a side letter should look like?
I think I can cover it publicly. Basically, the side letter should simply state that you are entitled to all the rights and privileges due any investor who otherwise qualifies under the Major Investor clause of the note. That’s it. Again, I’m not a lawyer, so you may want to have your lawyer look at it. I have done this several times and each side letter is a sentence or two. Only one ever really came into play and I still had to argue for the position, although I had strong legal standing.
Thank you Will.
I think you got most of it. Information rights are very important to me. I also require a bigger discount if the loan matures and there is an automatic conversion to Common. On a 20% discount, I usually want to see a 35% discount if I get common instead of preferred.
Common terms for me: 20% discount, 6% interest, I need a CAP that reflects early investor risk, 18-36 month term, ESCROW (or no consummation) until an agreed upon minimum is raised (IMPORTANT AND MAYBE YOU MISSED IT?), Outside Board Member mutually agreed upon, Most Favored Nation (pari passu),
I have one investment (Kiwi Crate) which has “Major Investor” terminology, although it is Preferred Stock, not a note, and frankly I will never make another investment without these rights. I therefore require it in the note terms.
I have found these to be very easily negotiated since it is all boilerplate stuff for attorneys (I can almost write one myself), so I like to use them to save legal fees and times for early stage ventures.
Mike, thanks for the detailed reply.
I get you on information rights. I don’t make a big deal out of it because I’ve never run across a CEO who isn’t happy to share all the information they have. So, I’m happy to trade it off for something more important to me. As far as inspection rights go, I really don’t care.
On the Escrow, as you point out, it’s a bad situation when a company is underfunded. My section above, Closing of the Note, is meant to cover this, but incorrectly does not specify the detail as you point out. I don’t always require that escrow be established, but I create the escrow myself by coming in as the last money frequently when I suspect that meeting the round’s goals may not be met.
I never lead a round any more, so I’m most often coming in behind a larger investor who has set the terms. As such, the discussion about Major Investor is with the lead, not with the company and is often problematic. I can’t say I never do a deal with a major investor clause any more, but I rarely do and I push hard for at least similar treatment.
Your point about automatic conversion to common is an excellent one. I do not do that, but will in the future. Although if in the situation where it applies, the company is likely in real trouble anyway.
Again, thanks for the feedback.
Thank you Mike and Will. The note rolled into new Preffered Shares which I certainly preferred over common shares. The Major Investor Clause already existed when I invested (my oversight on one of my first investments). I could have probably pushed for a sideletter at note maturity, but decided against it in the end. I will put this down as a lesson learnt.
By the way, have you guys seen the SAFE documents? What a joke. I would not touch one of those deals with a 100′ pole!!
I’ve walked away from two SAFEs in the last two weeks. Like you, no interest at all. Since these are Y-Combinator docs, I’m seeing them mostly from Y-Combinator companies, although the instrument is definitely spreading. Ugh!