By Ralph Turlington
Convertible notes are used for many early stage investments to protect the interests of both the start-up and note holders. They are most common for start-ups to use when raising initial outside-funding, after the family and friends of the entrepreneurs have already invested.
Convertible notes are relatively inexpensive to draft and usually quick to negotiate because the start-up will have a form document with blanks that are filled in by each investor.
It appears that some investors (and startups) will give the note only a cursory glance – often only looking to ensure the cap, discount, and interest rate are correct. However, there are several important sections that must be reviewed prior to signing a convertible note.
Here’s our list of the most important sections of convertible notes:
1. The Interest Rate: These often range from 2.5% to 9% and the payment of interest is almost always deferred until the note matures or is converted.
2. The time to maturity of the note: This may range from about 18 months to about five years. Longer is often better for an investor, as it allows a note holder a longer period of time to monitor how the company is progressing.
3. The Cap Value: This is the value that the startup and investor agree is the maximum value of the company the investor will use when converting his note into stock of the company.
4. The discount: The discount from the Cap Value if there is a qualified financing. This often ranges from 0% to 25%.
5. Optional conversion into stock: Some notes may have this term and others may not. An optional conversion may be used if there has been an equity financing that does not qualify as a qualified financing-known as a non-qualified financing. If the note holder is given this option, then the discount is usually the same as in a qualified financing. With such a provision, the note holder has the right to convert into the same class of stock (common or preferred) as was issued to the new investors in the non-qualified financing.
6. “Change of ownership” provisions: This section describes what will happen if the company goes through a change of ownership and what criteria must be met to qualify as a change in ownership. This makes sure that both founders and investors know the exact terms that must be met to trigger the provisions in the Note that are dependent on a change in ownership. Some of those provisions may be beneficial to the note holder. Some may be adverse. The Note should make clear what the note holder will be allowed or required to do when the situation occurs.
7. Note maturation with no qualified financing, no optional non-qualified financing and no change of ownership: If this happens, the terms should allow the note holder the right to (i) convert the note into common stock (usually at a discount of 15%-25% from the Cap Value; but sometimes at the full Cap Value), or (ii) the note holder may be repaid the amount owed on the note in cash.
8. Option to convert at the Cap Value per share: This affords the note holder protection in case the company is doing well with a value above the Cap Value but the company hasn’t had:
a. a qualified financing
b. a non-qualified financing
c. a “change of control;”
that would otherwise allow the note holder to convert at a value per share below the current value. This protects against the company deliberately avoiding the three examples listed above; financing itself from positive cash flow or conventional loans, and waiting for the convertible notes to mature so the company may pay off the note holder in cash rather than stock. The right to convert into common stock at any time at the Cap Value protects the note holder.
9. Computation of the “pre-money” value per share: The pre-money value per share of stock is important to the note holder who wants as many shares of stock as possible to be counted as outstanding – since this produces a lower value per share and more shares will be issued to the note holder upon conversion. The most equitable method is to count all currently outstanding shares and add the number of new shares that will be outstanding if all outstanding stock options are exercised and other convertible notes with lower conversion prices (other than notes in the issue being computed) are converted.
10. Uniform terms throughout notes in the same issuance: The terms of all the notes in one issuance should be the same (except for dates and amounts). Very often, convertible notes don’t have what are known as “ratchet-up” provisions. These are provisions that allow the conversion formula to be changed to give a note holder more stock if a subsequent investor puts in money at a lower price so the original note holder’s interest will not be diluted. If this is not clear, then the note holder should consider asking for adjustments in terms if any notes are issued subsequently to other investors with more favorable economic or legal rights.
11. Right to invest in subsequent issuances: Most convertible notes don’t offer this provision. If the investor thinks this is important and would like the option to invest more cash in subsequent rounds on the same terms the subsequent investors get, then such a provision should be requested.
The bottom line is that you should always read a note purchase agreement (NPA) and the attached convertible note, and understand them before signing. Not all notes are comparable. It is possible, unfortunately, that a crafty lawyer could use a poorly written note that leaves money on the table for investors or the reverse – reduces what an entrepreneur’s share of the company should be. So, please, read your NPA and convertible notes carefully. If something seems confusing or unclear be sure and ask your legal advisor.