Getting the Size of the Early Stage Note Round Right

So your venture needs capital, but for one good reason or another, or a combination of them, you are not going to "price" the company and raise funds from investors by issuing equity securities to them.

Instead, you are going to issue promissory notes to those investors, with the expectation that the notes will "convert" into stock when the company later has an equity round of financing. Perhaps that future offering will have to be of a minimum size to effect the "conversion," but the terms of that future offering have yet to be negotiated. In other words, your note investors are "pre- buying" stock you plan to issue later and haven't priced yet.

Interest rates will vary, as will discounts on the price of the stock when the notes eventually convert. Sometimes the note investors will receive warrants, to further compensate and incentivize them. But whatever the variations, case by case, the basic convertible note financing concept is remarkably versatile and can be used throughout the lifecycle of a company: for seed financing at the outset of the venture; for smaller amounts of working capital to "bridge" the company between rounds of preferred stock financing; or in later stages of the developed company (whether for bona fide strategic business purposes, or for the nefarious machinations of the gods on Wall Street).

So with the watch phrase of convertible note financing being "maximum flexibility," doesn't it make sense to also be open and flexible about how much money can be raised in a note round?

Where the mechanism is being used to raise seed money to get a venture started, yes, flexibility as to the size of the offering makes a lot of sense. Investors at this stage typically understand that the business plan itself is a work in progress, being tested and refined by what the entrepreneurs are experiencing and discovering on a daily basis. You want the capital raised to be used productively, and that may well mean changing your original "use of proceeds." Most ventures end up looking very different from the business envisioned in the initial executive summary. Some end up looking nothing like what anyone ever envisioned, using along the way seed and whatever other funds might have been raised against a different business plan.

True bridge rounds, however, argue for more certainty as to the offering size. The business that the company is in, the customers it is pursuing, the names and URLs of its competitors, all of these factors -- as well as the nature of the event being bridged to -- are known, or should be.

But here's the rub: no one wants a note round, seed stage or bridge, that can't be adjusted after the fact. This means that the financing documents must contain a mechanism to amend the terms of the financing, and to make the amended terms stick and apply to all investors. And this in turn argues for giving shape to the size of the round.

Let's say you go with the tried and true mechanism of allowing the note terms to be amended by the holders of a majority of the principal amount of all outstanding notes. When you're setting this up from a company perspective, it's good to have a feel for which note holders, or combination of note holders, you might have to appeal to later. To the extent that the size of your note round is in flux, additional uncertainties are introduced into the process of planning future financing.

And here's another reason: we need to file a report on the offering on Form D! (If Sen. Christopher Dodd's financial regulatory reform bill gets passed as currently written, we may also need to prepare and file more than simple notice forms to the various states in which the note investors reside.)

In all events, of course, your investors, their predilections and temperaments, what has worked for them in the past, what they are used to, and where they have been burned, will influence the size of your note round and the amount of flexibility you can build in.

Sent from my iPhone

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