Convertible Notes Without the NotesBy http://profile.typepad.com/1237764140s22740 // September 4, 2012 in Convertible Notes, Legal Docs, Seed Financings
Yokum Taku has designed a new security for tech startup financing, something with the positive features of a convertible note, but without the problems presented when a new and unprofitable venture issues debt.
The thinking is: convertible notes do a good, entrepreneur-friendly job of deferring the pricing of an equity round - but they also carry a promise to repay principal by a deadline; and, as debt instruments, convertible notes must accrue interest.
Yokum's solution is a security that, in the ideal case, converts into preferred stock (if and when a "Qualified Financing" is obtained) or, in other cases (such as change of control), into common stock. All just as a convertible note might. And, like a note, the "no hassle" convertible security can convert at a discount or at discounts weighted differently for different investors.
The model "Convertible Security" Yokum has published also incorporates that clever feature of more sophisticated note templates, whereby the holder of the convertible instrument gets no more preferred equity for her investment than does the new money in the Qualified Financing, and takes her discount in the form of common shares.
Looking through the template documents Yokum put together to illustrate the debt-free convertible concept, I wondered where the corresponding charter provisions were. Shouldn't there be something authorizing and defining the rights and preferences of this convertible security? I asked Yokum about this in a Disqus thread, and he explained: "The concept is that the convertible security is a contract -- like a warrant."
That makes sense.
For entrepreneurs with the leverage, or in seed deals where the angels are truly indifferent to downside protection, a convertible instrument that raises cash but leaves no residue of debt is clever.
Some angels will want the debt feature. It isn't that such angels would ever expect (or desire) a note issued in a seed financing to be repaid in cash. But having a note means the investor has a kind of liquidation preference - they will receive value, if any, from the liquidating company's assets, before the founders do.
Debt with a maturity date also gives investors the ability to say, time's up, time to re-capitalize, give way, or let go. But here we come full circle. It is the very purpose of Yokum's new security to foreclose the possibility of foreclosure.