5 posts categorized "Convertible Notes"

Secondary Sales and An Investor Covenant You Don’t Want To Miss

Dear Readers: This is a post I co-wrote with Joe Wallin, who has published the almost identical post here.

If you are investing in early stage companies, there are certain deal terms you want.

Most you probably know already: if it’s a round of convertible notes, you want a discount and a cap; if it’s a priced round, you want a liquidation preference. Etc.

But there is a new thing you need to add to your list of “must haves.”

You now want your investment documents to include a Section 4(a)(7) covenant.

What the heck is Section 4(a)(7)?

Section 4(a)(7) is a new federal securities law that basically says, it’s OK for you to sell your investment in a private company, as long as you don’t generally advertise the securities for sale, sell to another accredited investor, and the company cooperates with certain information requirements.

The new federal law trumps state law. So state law won’t hold you up.

Unlike the existing resale exemption most commonly used, there is no holding period required under this new law.

What is a Section 4(a)(7) covenant?

This new law is great—but you need the company’s assistance to access it, because the law requires the company to provide certain information to the purchaser.

So, get this covenant in your investment documents, and it may be easier for you to later sell your shares.

You can find draft covenants to include in your securities purchase agreements here.

And if you’re a founder or exec, don’t despair: Section 4(a)(7) will work for you, too. For a longer, in depth discussion of the new law, see this article in TechCrunch.

Convertible Notes Without the Notes

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.

Cancelled promissory note verticalYokum'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.

Will I Save Legal Fees by Doing My Seed Round with Notes Instead of Stock?

No.

If an investor or fellow entrepreneur tells you that you will save legal fees by doing your seed round with notes instead of stock, what she really means is that the kind of investment that can be done with a note or notes will be less formal, will involve less scrutiny and due diligence, than a round that is priced.

There are good, very pro-founder reasons to use notes (assuming the amounts and terms and investors are mixing right!), and these include managing and mitigating founder dilution.

But there's often the implication - misleading, I think - that legal fees can and should be minimized as a byproduct of choosing to use notes. I say, don't ice your strategic cake this way!

The level of formality of the seed round has to do not only with how seriously your investor takes the investment, but also with how seriously you take the investor. It is not a function of whether you issue notes or stock.

Even if you have the friendliest angel in the world, or even if the world's savviest super-angel tells you she can't be bothered to read a term sheet, you'll independently have your own good reasons to put your company through something like the drill you'd encounter in a modestly-diligenced, priced round.

If you've done this before, you'll know what I mean. If you haven't, ask your lawyer: has she ever, ever done a Series A or priced early round, with even the lightest set of reps and warranties in the purchase agreement, and not found a significant problem needing to be cleaned up? An assignment of inventions that was missed? License terms that morph when you move from prototype to commercial release?

Founders benefit as much as investors do from having the company organized and ready to do business.

Convertible Note Comeback?

A tweet by @cdixon, saying his angel group is active in August, led me to a link in @erickoester's tweetstream, which linked me to this intelligence @grellas posted on on Hacker News:

"Just some scattered notes I took on broad trends identified during the presentations:

  . . .

9. On the legal side, some 80% of recent early-stage funding deals in the presenting lawyer's recent experience have involved convertible notes ([presenter was] John [Bautista] of Orrick - this surprised me, as such notes have fallen into some disfavor over the past year in my experience)."

(I think the "presentations" referred to must be from the same Y Combinator event alluded to on this blog on Friday, picking up Fred Wilson's post about an Anthony Ha write up on the occasion.)

Eighty percent surprises me, too. Of the seed deals running through my firm right now, some are notes and some are priced (stock, with a valuation), but a majority are still priced. And today's status quo -- more stock rounds than note rounds -- is an inversion on how it used to be.

From a founder's perspective, notes are going to be better if fairly pricing the company is just too difficult or not possible. On the other hand, I'm coming to appreciate some of the company-friendly benefits of not taking on too much convertible debt. Among other things, the traditional note round tends to lock one in on planning a subsequent equity round of a pre-determined minimum and within a pre-determined time frame. Much depends on getting the size of the note round right.

There are term sheets, such as Dan Rosen's (link is to a pdf), which help simplify a priced angel round. And to make a priced round just as efficient as a note round, in terms of legal costs and turnaround time, there are Ted Wang's Series Seed docs (I love the Series Seed docs).

Eric's take is that, while some seed deals should be priced, "a note w/ valuation cap is a good hybrid option," especially when you are dealing with sophisticated angels.

Notes may be on the way back. But I hope we keep thinking through whether pricing may be the better alternative for the given situation.

Update 9:55 Pacific: @cdixon has tweeted a response to a tweet from @davidmeunier with the following: "my preferred seed is convert with cap. lower legal fees and investors get economics without control." I hope to someday soon be able to present Chris with evidence that a priced seed round can be done as efficiently (in terms of legal fees) as a note round.

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.

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