Key Considerations in Convertible Note Financings
A convertible note is a type of promissory note that is convertible into a company’s equity securities. Typically, these securities are issued when a company is initially raising money through friends or family, or in between preferred equity financings. Convertible note financings may be preferable in these circumstances, as compared to common or preferred equity financings, for the following reasons:
- When issuing convertible notes, the parties to the financing are not required to determine an exact pre-money valuation of the company. In other words, because shares of common equity or preferred equity are not being issued, there is no need to determine a price per share. This avoids the problem of inadvertently valuing the company too low or too high.
- The terms of a convertible note are investor-friendly and afford an opportunity to reward early friends and family investors by giving them a discount upon conversion or a conversion cap (discussed below). A convertible note is also a hybrid debt/equity security, which means it is somewhere between debt and preferred equity when it comes to the liquidation stack, and if the company liquidates, convertible note holders are paid before any proceeds from the liquidation are distributed to the equity holders.
- The legal documents necessary for convertible note financings are typically very limited, as compared to equity financings. No charter amendments, pro forma cap tables, voting agreements, etc. This means legal fees and other transaction expenses are typically much lower.
The key terms of note financings are as follows:
- Interest. Interest that accrues on convertible notes varies widely and can be as high as 18-20% and as low as the federal minimum interest rate effective at that time. This is a negotiated point in each financing, and it depends on the company’s financial condition and the relationship between the startup and its investors.
- Conversion valuation cap. A valuation cap on conversion essentially guarantees the investors that they will receive a certain percentage of the company, prior to any new money investments. For example, if a note investor receives a note with a principal amount of $100,000 and a valuation cap of $1,000,000 upon conversion, they will be able to convert their note based on a pre-money valuation of $1,000,000, even if the financing through which they are converting values the company at a higher valuation, thereby guaranteeing that they will receive approx. 9.1 percent of the company.
- Conversion discount. A discount upon conversion provides that upon conversion, the note holder will be entitled to receive preferred equity purchased at a discounted per share price as compared to new money investors.
- Qualified financing. Typically, the notes will convert automatically when a “qualified financing” occurs. This is usually a preferred equity financing through which the company raises over a certain amount.
- Restrictive/affirmative covenants. Convertible notes sometimes provide that the company may not engage in certain activities without the consent of the existing convertible note holders. Examples include amending the company’s organizational documents; issuing equity, debt or other convertible securities; and entering into major contracts outside the ordinary course of the company’s business.
- Secured/unsecured. Some investors may ask for a security interest in the company’s assets in connection with their investment.
- Maximum amount of financing. Many times, parties to convertible note financings prefer to limit the total amount of money raised through the financing to limit dilution
Alternatives to convertible note financings include SAFEs (simple agreements for future equity), KISSes (keep it simple securities) and CEIs (convertible equity instruments), which are identical to convertible notes but lack interest and maturity dates and are not secured by the company’s assets.
For more information, please contact a member of our Early Stage & Emerging Companies practice group.