Convertible Note Terms: How Convertible Notes Work

Convertible note is a very common early investment vehicle used for startup funding. Today we’ll talk about the typical terms you’ll see in a convertible note and at the end of the video we’ll talk about some of the advantages and the drawbacks of using convertible note financing. Hi I’m Steve Morris and I use this StartupSOS channel to provide practical how to advice for first time entrepreneurs. So a convertible note what is a convertible note. Well it really is simply a loan that an investor provides to a startup. It’s a loan that’s made with the intent that it is not going to be paid back but with the intent that in the future it will convert to ownership in the company. Typically it’ll convert into stock in a C corp. There are some financial terms. There are some conversion terms that determine how and when it gets converted to ownership. And there are some investor rights very commonly. And then a few miscellaneous other terms we’ll go over. So let’s start with the financial terms. Of course it begins with the financing amount – how much is being loaned. Second would be the closing date. When will this close and the money actually be provided to the entrepreneur. A third would be the maturity date. Very important term. When does the loan come due. Now that typically might be a year maybe a year and a half. Some cases perhaps as long as two years – you rarely see one that’s any longer than that. The maturity date becomes pretty important as we’ll get to in the next topic of conversion. And finally there’ll be an interest rate. This is a loan. So not only a maturity date but an interest. It’s usually a simple interest rate. 8 percent is is very very common. But this is not an interest that you’re actually paying it’s simply an interest that accrues along with the principal of the loan. So that in the future it’s the loan amount with interest that’s going to convert to ownership in the company. It’s not cash that you’re typically going to actually pay to the investor. The next category of terms would be the conversion terms that determine when and how the loan amount converts into ownership in the company. Now the first option and in a way the desired one is the automatic conversion. Automatic conversion happens when in the future there’s a priced round in other words an equity round where investors put a value on your company which determines a value – a price – on your stock and they buy stock in your company to make an investment. When that happens at some trigger amount that is what triggers the conversion. Now doing a future convertible note will not trigger a conversion. It’s not an equity round it’s only an equity round that will trigger it and it will be triggered by some particular amount like maybe a half a million dollar investment would be a common trigger. So in the future when there’s an equity investment for half a million dollars the loan would typically then convert to ownership to stock with the same benefits the same terms that are negotiated by the future investors. Okay except for the price the price will be a little bit better for the note in terms of what they pay for the stock and that’s reasonable because the note holder provided you money earlier when it was more risky. So it’s it’s reasonable that that money convert into stock with a little bit better deal than those future investors are going to get. Okay. So what determines the price that the note converts at. Well it’s two terms that come to play here. There will be a discount and there will be a cap and the price at which the stock price at which the note converts depends on which two of those gives the note holder the better deal. So let’s talk about the two examples using some some actual numbers. Let’s say in the future you have an investment round – some investors give you a five million dollar valuation and to keep the numbers easy let’s say you have five million shares of stock. Well OK stock price is easy to calculate then 5 million shares 5 million dollars. It’s a buck per share. Now if I have a convertible note let’s say the convertible note was a five hundred thousand dollar trigger on the on the automatic conversion and this future round is more than that so it’s going to trigger it and let’s say it has a 20 percent discount and a three million dollar cap. OK so a 20 percent discount. The dollar a share price is what’s going to be paid by the future investors. 20 percent discount on that is 80 cents. So under the discount term 80 cents is is what the note will convert at – the note will pay 80 cents per share for stock. Now how about the cap. What the cap means is that if in that future round you get a valuation above the cap then the price the note gets for stock won’t be determined by that future valuation – it’ll be determined by the cap. In other words the three million valuation in this example not the 5 million. So let’s do the math again. A three million dollar valuation cap with five million shares of stock outstanding. Do the math on that and it’s 60 cents a share. So if I use my discount term I get 80 cents per share. If I use my cap term I get 60 cents a share. So of course I’ll go with the 60 cents and pay 60 cents per share. So that’s how my loan amount will convert into stock. So that’s the basic idea of discount versus the cap and how you determine the price at which your loan is going to convert into stock. Now the second possibility is the optional conversion. Optional conversion is something that comes into play when you reach the maturity date. You reach the end of the loan and there has not been an equity investment. Well into the loan, the investor has three options. Basically they could call the loan but that’s typically not going to happen unless things are going really badly because you probably won’t have the money to pay it back anyway. And so the investor isn’t likely going to do that again unless things are going very poorly. Another option is to extend the loan and there will be a negotiation in that situation and probably the investor will want to get some better terms because they’re having to wait even longer. A third option would be this optional conversion where written into the note there will be already a predetermined valuation – a million dollars let’s say would be very common – and it will say the money will convert into ownership into stock at that val uation of a million dollars or again whatever is written into the note. Now the amount will be a relatively small amount in terms of the valuation because the expectation is if you reached the maturity date and didn’t have an equity investment. Things aren’t going well. The the investor still wants to have stock in the company still sees the potential. So they want to go ahead and convert but they want to get a pretty good price because the company isn’t making headway as fast as expected. So that’s the situation for the optional conversion. So there is one other scenario to cover and that is what happens if your company gets bought before the maturity date of the loan and before there is an equity investment that makes it convert to stock. Well very commonly in that scenario you’ll see a term that says that the investor the note holder gets paid to 2x – 2x of the note value plus 2x of the interest that’s accrued since the note was provided. So that’s a very very common term you’ll see in the case of an acquisition that happened earlier than expected. Another category of terms that you’ll often see are investor rights terms. Now those can include things like information rights maybe the investors have the right to get quarterly financial statements maybe a quarterly update from the management team. Those are certainly very common. Another set of rights that are common would be approval rights where the investors get the right to approve. In other words a veto power over important financial decisions – maybe over an acquisition somebody offers to buy you. They may get a veto. Maybe if you want to make a major change to your corporate documents you know maybe the investors get to veto that if if they’re not happy. So those kind of control rights are not uncommon. Another common right for a large investor in a convertible note round might be board observer rights where the investor gets a board seat not a voting board seat but an observer seat so they get to participate in board meetings even though they don’t get a vote. Another very common investor right that you’ll see written in is pro rata participation rights. Now what that means is the note is going to convert in the future to stock in an equity round. Let’s call that these series A the pro-rata rights say that the investors whose whose stock converted have the right in future rounds. Let’s say the series B in Series C and so forth to invest more to maintain their their percentage of ownership. So for example let’s say when the convertible note converts my note ends up owning 1 percent of the stock in the company in the series a. Well then in the series B I have a right to invest alongside the new investors for the series B enough money to maintain my percentage ownership in the company and again for the Series C and so forth. So it gives investors of the note an option to maintain their percentage ownership in the company. Those are the investor right terms that are common. Let’s get into some general other types of terms that you can see. One would be a most favored nation clause that basically means that if you provide subsequent to the note let’s say you provide me you provide a note to another investor that has better terms than the note that you gave to me. Then I have the right to adopt those better terms into my note retroactively so for example if there’s a lower cap or a steeper discount a higher interest rate I would get the option of adopting those better terms from that other note. So again that is actually a pretty common term that you’ll see. Another term you may have something in the documents about use of funds that perhaps say something like the funds are to be used for the operation of the company. And of course they can be more specific than that in terms of limiting what the funds can be used for and cannot be used for. A convertible note will almost always have a term that says prepayment of the note to pay it off is not allowed. And the reason of course is that the investor is providing you with that loan not with the intent that you’ll pay it off but with the intent that it will convert. So you’re not allowed to simply pay off the loan unless the investor agrees with that. Another very common term you’ll see is if you’re getting a convertible note investment as an LLC that’s fine. That’s not a problem but it may well say that in the future. Okay. When you get the equity investment round and the note converts to ownership at that point there’s a requirement that you convert your company from an LLC to a C corp and that has to do with concerns investors typically have about flow through profit from an LLC. That’s not an issue when you just have a loan but it is an issue when you sell a portion of the company. Now that usually isn’t an issue because typically when you have that equity investment in the future typically those investors are going to require that you come a C corp. So this generally is not a big deal. It’ll happen anyway. So those are the main terms that you’ll see in your typical convertible note. Few words on the advantages of the convertible note and the disadvantages. On the advantaged side. One big advantage to the entrepreneur is a convertible note provides you with funding and it puts off, it delays a valuation of your company. Well that’s a good thing. You get money to operate with and you push off your valuation until later when you’re hopefully worth more money because you’ve made more headway so that convertible note then will convert into less stock because you’re worth more so the price of your stock is higher. So that’s a good thing for the entrepreneur. Your dilution is less. The other advantage of the convertible note compared to a priced round is that a convertible note is really a pretty small set of documents. It’s typically a note agreement. The actual promissory note itself and and typically an accredited investor questionnaire where the investor verifies that yes they are an accredited investor. Those are pretty small pretty simple documents generally which means the legal expense is pretty small. To do an equity investment round involves many more documents much longer documents and in other words it gets a lot more expensive because there are so many more things to negotiate in the terms and you’re typically paying legal fees every time you negotiate those things. So a convertible note saves you a lot of money versus doing a price round so it’s another reason why you see them very very commonly in smaller early stage investments. Now there is a key drawback to a convertible note and that is that it has a maturity date. It comes due. There comes a point where you’re you’re going to face either having the note called or having it renegotiated and extended or having it converted to stock at a very low valuation. So that’s the drawback. Now that’s one of the attractions of a SAFE – simple agreement for equity. We’ll tackle that one in the next video. But that’s a disadvantage for the entrepreneur. It’s an advantage for the investor because the investor often likes the idea that there’s this date out there where if the company hasn’t performed as expected by that date then the investor has a little bit of negotiating leverage to determine what happens next. So perhaps a good thing for the investor a little bit of a challenge for the entrepreneur. That is an overview of the convertible note the key terms and some of the pluses and minuses for the entrepreneur. If this was helpful Pplease click the Like button and share it and please subscribe. If you haven’t there’s a link down in the corner to do that. And after you’ve subscribed you can click on the bell to get notified of the next video because we’ll have more coming up in this series. Next will be the SAFE. The simple agreement for equity. So I hope you’ll join us for that one. That’s it for now. Thank you very much for watching.

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