Introduction

If you’re picking up this guide, it’s a really exciting time in your life. You’ve likely taken a big risk to build something that you believe could have a huge impact. You’re trying to build out your minimum viable product and test it with customers to see if you have a product market fit. Congrats!

For more than a decade, I’ve worked with hundreds of early-stage founders to help them move from concept to scale. In that time, our firm has been legal counsel to startups in various industries from food to fashion and education technology to e-commerce. I’ve worked with founders from the most elite schools and incubators, and I’ve worked with outsiders and underrepresented founders. I’ve learned a lot about raising capital along the way.

My goal here is to share that experience with you in this ultimate guide to the convertible note. By the time you finish this guide, you will understand the basics of a convertible note and be equipped to confidently step into negotiations with investors.

I’m rooting you on and am here to support your fundraising journey if you need legal counsel.

Sincerely,

Kyle Westaway
Managing Partner, Westaway

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Convertible Note

What Is a Convertible Note?

A convertible note is a loan (debt) from an investor which, under certain circumstances, may be converted into stock in the company (equity). Convertible notes are a popular instrument for several reasons.

Advantages

  • Simple and fast — Convertible note financing has simpler terms, thus, takes less time to negotiate than a priced equity round. Less due diligence is required because of its simplicity.

  • Understandable and well-established — Convertible notes have been widely used for the last decade. Therefore, investors and their lawyers are familiar with the mechanics. The timetable to complete a financing round with convertible notes is relatively short, and legal fees are lower than a priced equity round.

  • Operating flexibility — Convertible note investors usually do not enjoy rights to control the company, unlike equity financing. This allows founders to retain operational freedom, which can be crucial to a seed stage company.

  • Delay valuation — Using convertible notes allows the company to delay a formal valuation of the company until the next financing round. Valuation can be time-consuming and challenging when the company is at a very early stage without concrete data like sales or growth numbers. However, this does not mean that founders can be completely clueless as to the value of their business—the valuation cap and discount in convertible notes can also function as maximum approximate valuation.

Disadvantages

  • Repayment — Convertible notes usually come with a maturity date of 18 to 24 months, at which time the loan either needs to be repaid or converted into equity. This means that the company needs to have the funds to pay back the loan or raise the next round of financing within such timeframe. Very often, investors will agree to extend the maturity date to give the company additional time, but this is often at investors’ discretion and requires additional legal work.

  • Low valuation cap — A valuation cap is the highest valuation at which the convertible note would be converted into equity (regardless of discount). This means that if the valuation cap in the convertible note is too low, it will create a windfall for the convertible note investor and create downward pressure on the valuation of the next round.

  • Not as Simple as SAFE — Though the convertible note is much simpler than raising a priced equity round, it’s still not as simple as the Simple Agreement for Future Equity.

For convertible notes, depending on the document set you use, there are either two or three documents required to close the investment.

  • Term sheet — The term sheet is a high-level summary of the deal terms. It frames the universe of terms to be negotiated. In a pre-seed round company, counsel will often draft their own term sheet. However, if the investor is a venture capital firm, they may draft the term sheet.

  • Convertible promissory note — The convertible promissory note is the central document in a convertible note financing. It articulates the terms of the investment in detail.

  • Note purchase agreement — If the note purchase agreement is included, it sets forth additional representations and warranties as well as administrative provisions.

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Convertible Note Term Sheet

The Convertible Note Term Sheet provides a summary of major deal points. Most negotiations between the founder and the investor will happen at the term sheet level. Once both parties are aligned on the term sheet, then counsel will draft the deal documents. Below is a standard term sheet. We will break down each term in the following sections.

TERM SHEET
FOR CONVERTIBLE PROMISSORY NOTE FINANCING OF
[[COMPANY NAME]]

This term sheet is an expression of intent only, does not express the agreement of the parties, is not meant to be binding on the parties and is meant to be used as a negotiation aid by the parties. The parties do not intend to be bound until they enter into a definitive agreement regarding the subject matter of this term sheet.

Issuer: [[Company Name]], a Delaware corporation (the “Company”).
Investors: Investors shall be identified by the Company (the “Investors,” each an “Investor”). Amounts may be funded in multiple closings.
Promissory Notes: The Company shall issue promissory notes (the “Notes”) in exchange for amounts invested by the Investors. The Notes will have the following principal provisions:
  Maturity: Unless repaid or converted at an earlier date, outstanding principal and unpaid accrued interest on the Notes shall be due and payable upon request of the Majority Holders made on or after the date, which is 24 months from the initial closing (the “Maturity Date”).
  Interest: Simple interest shall accrue on an annual basis at the rate of 4% per annum.
  Conversion at Qualified Financing: In the event the Company consummates, while the Note is outstanding, an equity financing pursuant to which it sells shares of its equity securities (“Next Round Securities”), with an aggregate sales price of not less than $1 million, excluding any and all indebtedness under the Notes that is converted into Next Round Securities, and with the principal purpose of raising capital (a “Qualified Financing”), then all principal, together with all unpaid accrued interest under the Notes, shall automatically convert into shares of Next Round Securities at the lesser of (i) 90% of the cash price per share paid by the other purchasers of Next Round Securities in the Qualified Financing and (ii) the price obtained by dividing $10 million by the number of outstanding shares of common stock of the Company immediately prior to the Qualified Financing (assuming conversion of all securities convertible into common stock and exercise of all outstanding options and warrants, including all shares of common stock reserved and available for future grant under any equity incentive or similar plan of the Company, and/or any equity incentive or similar plan to be created or increased in connection with the Qualified Financing, but excluding the shares of equity securities of the Company issuable upon the conversion of the Notes or other indebtedness).
  Change of Control: If the Company is acquired prior to the Qualified Financing, each Investor shall receive a cash repayment equal to the outstanding principal and unpaid accrued interest.
  Pre Payment: The principal and accrued interest may not be prepaid unless approved in writing by the Majority Holders.
  Security: The Notes shall be unsecured obligations of the Company.
Documentation: The investments will be made pursuant to documentation prepared by the Company’s legal counsel. The Notes may be amended by the Company and the holders of a majority (by unpaid principal amount) of the Notes (the “Majority Holders”).
Expenses: The Company and Investors will each bear their own legal and other expenses with respect to the Notes financing.
Diversity Rider: In order to advance diversity efforts in the venture capital industry, the Company and the lead investor [[Lead Investor Name]] will make commercial best efforts to offer and make every attempt to include as a co-investor in the financing at least one Black or other underrepresented group including, but not limited to LatinX, women, LGBTQ+ check writer (DCWs), and to allocate a minimum of 10% or $100,000 of the total round for such co-investor.

[Signatures on next page]

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Issuer and Investor

The issuer is simply the name of the company that is seeking funding. The investor is the person, company or investment firm that is investing the money into the company. It’s possible that there is a single investor in your pre-seed round, but more likely there will be a syndicate of investors in each round.

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Maturity Date

A convertible note is a loan from the investor to the company. Just like any loan, there is a date when the amount lent (the principal) plus any accrued interest must be repaid. This is known as the maturity date. Convertible notes usually come with a maturity date of 18 to 36 months. Ideally, the maturity date is after the date the founder intends to raise their next round of funding. When setting a maturity date, founders should carefully consider how long it would take for the company to make enough progress to raise the next round of financing. So, if the company intends to raise their next round in 18 months, you may want to set the maturity date at 24 months to give a little buffer.

The convertible note is a loan that may convert to equity under certain circumstances discussed below. If a convertible note is converted into equity before the maturity date, the maturity date is no longer relevant because the loan is canceled upon conversion. However, if there is no event that triggers conversion prior to the maturity date, the company that issued the convertible notes will have the obligation to pay back the loan. Unlike other loans you may be familiar with, such as student loans or auto loans, most convertible notes don’t have monthly payments. Instead, at the Maturity Date, the startup must pay back the investor the entire principal and accrued interest in a single payment if it has not been converted into equity.

Investors in convertible notes (convertible note investors) are not traditional financial institutions, like banks, that look for a stable return from interest payments and repayment of principal. They believe in the founders they invest in, and usually spend considerable time and effort to help them succeed. Therefore, if a company needs additional time to raise the next round of financing, seed investors usually agree to extend the maturity date.

Convertible note investors are generally looking for 100%+ returns on their investment, so they rarely consider repayment of a loan with 5% interest a success. Demanding a repayment can also tarnish an investor’s reputation, as promising entrepreneurs might avoid such investor in the future, causing an investor to lose potential investment opportunities.

Though convertible note investors have the legal ability to force the company to pay the loan at the maturity date, and if they can’t pay, force bankruptcy, in practice, this rarely happens. Generally, if the convertible note hasn’t been converted or repaid by the maturity date, the company and the convertible note investors will discuss extending the convertible note to give the company more time to grow.

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Interest

As with any loan, the investor is lending the company a certain amount of capital—the principal—and expects that to be paid back plus accrued interest. Generally, the interest rate is a simple (not compounding) interest rate of between 4-6% per year.

For reasons discussed above, seed investors are not really looking to profit from interest payments. Thus, it is unusual for experienced seed investors to demand higher interest rates. If a convertible note investor is asking for a high interest rate, you should be alarmed and consider not working with them. This is a sign of an inexperienced startup investor.

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Conversion at Qualified Financing

The first way the debt might convert to equity in a convertible note is when a Qualified Financing occurs.

What Is a Qualified Financing?

A qualified financing is a priced round of equity fundraising above a certain dollar threshold. This threshold is generally $1 million but could be as low as $250,000, depending on the deal. Note that the threshold amount includes only new money invested in the company, not the amount being converted.

What Happens to a Convertible Note at a Qualified Financing?

Upon a qualified financing, the principal and all accrued interest (total investment) converts into shares of preferred stock in the company. The shares will have the exact same preferences, rights and restrictions as the preferred shares of the new investors in that round of funding (new investors). So, founders should keep in mind that when they are negotiating the terms with the new investors, they are negotiating the terms for the new investors but also for the previous convertible note investors.

The number of preferred shares that convertible note investors will receive depends on whether there is a discount and/or a cap.

Now it’s time to pull out the calculators. We’re about to do some math.

What Is a Discount Rate in a Convertible Note?

To compensate for the higher risk of investment, seed stage investors expect higher returns for investing early. This expectation is reflected in the conversion mechanisms commonly found in convertible notes, one of which is a discount. A discount rate, as the name would suggest, refers to the discount on price per share that the convertible note investors receive relative to the price the qualified financing investors are paying. The discount usually ranges from 15% to 25% (20% is by far the norm).

Here’s the formula to calculate price per share with a valuation cap:

Discount Price Per Share = Convertible Note Investment / (New Investor Price Per Share x Conversion Discount)

For example, if the new investors purchase preferred shares from the company at $1 per share and convertible note investors had a 20% conversion discount, the convertible note investor would pay $0.80 per share (instead of $1). This means that if the convertible note investor invested $100K, they would receive 125K preferred shares ($100K/$0.80) rather than the 100K shares they would have receive if they invested in the qualified financing.

However, a discount alone may not be sufficient in protecting an early investor’s interest. In a scenario where the amount raised in subsequent round of financing is significantly higher than the seed round financing, the early investor might be left with a smaller percentage of the company than expected. Consider the example above where the early investor receives 125K shares at conversion, but the subsequent financing round is $10 million as opposed to $1 million. The percentage of shares owned by the early investor will be reduced to 1.25% after conversion. Accordingly, some investors will use a valuation cap in their convertible notes to account for such circumstances.

What Is a Cap on a Convertible Note?

One of the most heavily negotiated terms in convertible notes is the valuation cap, sometimes called the price cap or simply the cap. What is a valuation cap, and why does it receive so much attention? A valuation cap is the highest valuation at which the total amount may be converted into equity regardless of the actual valuation of the qualified financing.

Here’s the formula to calculate price per share with a valuation cap:

Cap Price Per Share = Valuation cap / Number of shares outstanding immediately prior to the Qualified Financing

For example, in the convertible note term sheet above, the valuation cap is $10 million. If the new investors are investing in the company at a $20 million valuation, then the convertible note investors will be paying half price for their shares relative to the new investors. In other words, they can buy twice as many shares for their money as the new investors.

Founders should always keep future rounds in mind when they set a cap on their convertible note. The convertible note investors are taking a risk because they are investing earlier in the startup when there is increased uncertainty, so they should be rewarded for that early investment. But you probably don’t want them to be buying at a half price of the new investors. If the cap is too low, founders risk giving up too much equity to the convertible note investors and diluting themselves in the process.

If the valuation cap is set significantly lower than the pre-money valuation, the convertible note investor gets a heavy discount on the price per share as illustrated in the example above. This downward price adjustment can create the unfavorable outcome of diluting the founders’ share of the company and gives early-stage investors an oversized stake in the company.

Setting a valuation cap at an appropriate level requires understanding your company thoroughly and knowing the commercial value your business can bring. Founders should not treat a valuation cap as a valuation and should never let potential investors get away with that argument. A valuation cap is a projection of the maximum price (ceiling) at the subsequent round of equity financing rather than an actual pre-money valuation. Founders can also consider limiting the size of the seed stage financing to try to reduce the negative impact the valuation cap imposes.

The best-case scenario for founders is for the convertible note to be uncapped but discounted. The discount allows the convertible note investor to be rewarded for their early risk. But it avoids the problem of trying to set some random value on the company, which could turn out to be incredibly high or low. Some investors insist that they will “never” invest in convertible notes without a valuation cap, as it is so common in pre-seed financing. However, the outcome usually depends on the bargaining power of respective parties. An uncapped note at the pre-seed stage might indicate that the company is attractive with some leverage in negotiations. This can help attract better investors in subsequent rounds of equity financing.

However, not every early-stage startup has investors knocking on its door. When faced with a valuation cap negotiation, founders should ensure that the valuation cap is set at an appropriate level—ideally at a level higher than the company could achieve if it were to do a priced equity round of financing.

Discount or Cap?

It is important to note that investors do not apply both the discount and the valuation cap at the same time. The conversion mechanism that results in the lowest price per share for the convertible note investor will be applied.

For example, in a scenario where the investor invested $100K on a convertible note with a 20% discount and a $500K valuation cap, and in the subsequent round of financing, the new investors agree that the company is worth $1 million and purchases shares at $1 per share. Applying the discount, the convertible note investor would pay $0.80 per share, whereas if you apply the valuation cap, the convertible note investor would pay $0.50 per share.

In the scenario above, the valuation cap would apply instead of a discount because it results in a lower price per share for the convertible note investor.

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Conversion at Maturity

What happens when the company does not have a qualified financing before the maturity date? Most convertible notes contemplate this potential event and allow the total amount to be converted into equity at the maturity date. In the term sheet example above, the conversion is automatic, but it could also be optional at the election of the investor or the company.

If there is a valuation cap, then generally the total amount is converted at the cap. If the convertible note is uncapped, the investor and founder will negotiate a valuation for conversion at maturity.

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Change of Control

From time to time, a company will be acquired after they’ve issued convertible notes but prior to a qualified financing. This is generally a great thing for founders. But what happens to the convertible note investors? As with everything on the term sheet, this is a point of negotiation.

The first option is a cash payout. The company will pay the investor a certain amount of money. In this term sheet, it’s the total amount. Sometimes, investors will negotiate a two-time or three-time multiple of the total amount.

The second option is conversion of the debt to equity. In this scenario, the investor converts the debt to equity based on either the cap or an alternative valuation mechanism negotiated between the founder and investor.

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Documentation

Once the term sheet is agreed upon, the documents need to be drafted to align with the terms. In a pre-seed round, the documents are often drafted by company counsel unless an established venture capital firm is participating. They may push for their counsel to draft these documents. Fortunately, convertible notes are fairly standardized, so there shouldn’t be significant variations no matter who drafts them. However, all things being equal, it’s in the founder’s interest to have their counsel draft the documents.

The biggest pitfall to avoid here is to have incompetent counsel draft the documents. From time to time, either an investor or company uses counsel, who otherwise is very talented, smart and competent but does not practice in the startup world on a daily basis. They often slow down deals, and increase costs and frustration just because they aren’t used to doing this work.

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Expenses

Who’s paying the legal bill for all this work? Unfortunately, it is common practice for the startup to pay both investor and company counsel. We strongly recommend that every founder pushes back on this, especially in an early stage financing.

To put it bluntly, this term is bullsh*t.

The wealthy investors/firm are asking the startup that’s struggling to stay alive to pay not only their own legal bills but the legal bills of the investor. We find this term to be a highly offensive abuse of the investor-entrepreneur power dynamic. This is hands down the most short-term, unnecessary, power-grabbing term in the term sheet. In our opinion, it should be struck from all standard term sheets.

This clause forces the startup to pay the legal fees of the counsel that is negotiating against their best interest. Additionally, opposing counsel has the power to drag out the diligence process and negotiations of the deal, which increases their legal bill. Unlike company counsel, the startup has no ability to rein in costs. The startup is left covering a legal bill they had no control over.

If investors don’t have the money to pay legal fees, they shouldn’t be investing.

The sample term sheet above simply requires each party to pay their own lawyers, which is quite reasonable.

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Diversity Rider

The diversity rider is a new term that’s designed to create more access for underrepresented venture capitalists. It obligates the lead investor to make a good faith effort to include as a financing co-investor at least one African-American or other underrepresented group, including but not limited to LatinX, women, or LGBTQ+ ad diverse check writers (DCWs). Also, they should allocate a minimum of 10% or $100K of the total round for such a co-investor.

This is a powerful step in the right direction for the industry, and I hope that this term becomes the industry standard.

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