Hitting the right note

A primer for founders raising using convertible notes

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Convertible notes are one of the most common ways of raising financing for a startup. Particularly the first round of financing. We currently use a form of convertible for all of our pre-seed deals at Seedcamp. Having reviewed and issued many convertible notes over the past few years, I wanted to distill this knowledge down into some key questions for founders to consider and why I think they’re important.

Before we get to the questions, some background..

What is a convertible note?

Broadly speaking, a convertible note is a financing instrument that can be used to provide funds to companies in advance of issuing shares. It is often used on early stage financings because it avoids the need to establish an explicit valuation. Convertible notes can provide a faster and simpler way to document a funding round than a priced equity round.

I’m using the term “convertible note” in this post but many of the below points will also apply to other convertible financing agreements such as: Simple Agreement for Future Equity (SAFE), Advanced Subscription Agreement (ASA) etc. The reason for choosing one variant over the other is often driven by potential tax preferences for investors (i.e. ASA for EIS / SEIS investors) or familiarity (i.e. SAFE for US investors).

For an example of a convertible note and advanced subscription agreement and some of the main differences between the two check out the Seedsummit site here.

8 questions to consider when reviewing a convertible note

(1) What constitutes a Qualifying Financing?

As mentioned above, the primary intention of convertible notes is for them to convert into shares (the clue’s in the name) and the majority of such conversions happens at the next financing round of the company that constitutes a “Qualifying Financing”.

The Qualifying Financing is usually the trigger for an automatic conversion of the note which is then calculated using either the valuation cap (see below), discount (also, see below) or price per share paid at the round -whichever results in the greatest number of shares to the note holder.

The amount (i.e. size of the next financing round) that constitutes a Qualifying Financing can vary depending on the stage of the company and how much the company is raising in total under the convertible note. A reason behind having a qualifying amount is that it protects the investor from having their investment converted to equity in a company that is under funded. Before it is converted the convertible note will technically class as debt and therefore rank higher in the event the company becomes insolvent. This can also ensure that the Qualifying Financing is a true financing for a meaningful amount. However, this lower bound amount should not be set too high so that the Company risks having the money not convert at a true financing round.

(2) Is there a Valuation Cap?

This is often one of the most negotiated elements of a convertible note. The level the Valuation Cap is set at can have a major impact on the number of conversion shares issued. Understanding how it works is of crucial importance. Simply put, it is the maximum value at which the convertible note would convert in a Qualifying Financing (see above), regardless of the price set at such Qualifying Financing. This mechanic prevents the shareholding on conversion from being reduced to a very small % in the event that the company raises at a high valuation for its next round. To illustrate how this would play out in practice let’s look at an example..

Valuation Cap — Example scenario:

Company X is raising a £1m priced equity round (i.e. they are issuing £1m worth of shares to the new investors investing at this round) at a £3m pre-money valuation (for the purposes of the two examples in this post, we’ll call this the “Seed Round”).

Previous to the Seed Round, Company X had raised £50,000 on a convertible note with a valuation cap of £1m (this is the only note they have raised to date).

Assuming that the £1m round is a Qualifying Financing (see above), the convertible note would automatically convert at the valuation cap of £1m because this will result in a greater number of shares than if the convertible note converted at the terms of the round (i.e. £3m pre > £1m cap). Broadly speaking, the convertible note investor would get an effective~3x lower price per share than that paid by the new investors investing at the round by taking the Valuation Cap as the basis for calculation rather than the pre-money of the round.

I always recommend founders model the impact that the notes they enter into will likely have on their cap table when they convert. As the above example shows, the Valuation Cap can have a significant impact on the dilution incurred by the company. However, it’s worth bearing in mind that the convertible note investor has likely invested at an earlier point in time and therefore should probably be entitled to better economics to reflect the increased risk they took.

(3) Has a Discount been specified?

Like the Valuation Cap, the Discount placed on a note is another variable that can have a significant impact when calculating the number of shares that the note converts into. Hence, it is also usually front and centre in any negotiation. Generally, where included, the discount it is drafted as a % of the price paid by investors investing at the round often ranging from 0–30%. Again, taking an example scenario to help illustrate..

Discount — Example scenario:

Using the Seed Round metrics from above (£1m at a £3m pre).

In this example, assume that Company X had raised £50,000 on a convertible note with no valuation cap but a discount of 20% (this is the only note they have raised to date).

Assuming that the £1m round is a Qualifying Financing (see above), the convertible note would automatically convert by taking the price paid per share and discounting by 20% because this will result in a greater number of shares than if the convertible note converted at the terms of the round (i.e. Seed Round price per share> 0.80*Seed Round price per share). Broadly speaking, the convertible note investor would get an effective 20% lower price per share than that paid by the new investors investing at the round.

Note: Convertible notes can also be drafted to include a Valuation Cap and a Discount (and, in rare cases, they could include neither). If they include both, the convertible note holder would choose to either convert into shares using the Valuation Cap or the Discount (whichever would result in them receiving the most shares).

Overall, both the Valuation Cap and Discount are very important terms and care should be taken in particular when determining the effect they can have on the ownership position following conversion.

(4) Is there an Interest Rate?

To flag, not every convertible note will carry an Interest Rate (i.e. the note we use as the basis for our pre-seed investments at Seedcamp does not carry an interest rate). If it is included, the Interest Rate will usually start accruing from the day the convertible note is signed and issued until the day the note becomes due and payable or converts. The interest rate is important to consider because, on a conversion, the accrued interest can be thought of as acting like an additional discount. Overall, the Interest Rate is an additional factor that impacts the investor’s return and therefore can form part of a negotiation.

(5) What happens if the next round is not a Qualifying Round?

Usually the convertible note holder would have the option of whether to convert or not if the next round does not constitute a Qualifying Round. The Valuation Cap or Discount may be set at different levels compared with how the note would convert on a Qualifying Financing (if different it would be common for the valuation cap and/or discount to be more favourable for the investor). This provision may also give the convertible note holder the option to convert the note to shares in the event there is no financing round prior to the maturity date (see below) based on an agreed pre-money valuation. This clause can have an impact in the event things don’t go to plan and the company has to raise a smaller than planned round (i.e. a bridge financing or similar).

(6) What happens if the company is acquired before conversion?

There will usually be a specific clause that addresses the situation in which the company is acquired before the convertible note has had a chance to convert into equity in the company. This situation is common in “acquihires,” or the acquisition of a company at a very early stage, and in which the amount being paid for the company is based on the recruitment of its employees rather than the company’s intrinsic value (i.e., the company’s intellectual property, revenue, etc.). The three most common possible scenarios for the treatment of the note are: (1) the convertible note converts into ordinary shares of the company, and then proceeds from the acquisition are distributed to the common stockholders on a pro rata basis; (2) the convertible note converts into preferred shares, which provides protection of liquidation preference, among others; (3) the convertible note holder is entitled to a return of a certain amount, based on then balance of the note (i.e. the amount they invested under the convertible note). In (3), the return entitlement can be 1x, 2x or higher. This clause is important for founders to consider particularly if aquihires are common in their industry or they believe the company may be acquired prior to a conversion.

(7) What’s the Maturity Date and what does it mean?

The Maturity Date is the date that the convertible note technically would need to be repaid if it is still outstanding (i.e. it has not converted or been repaid in some way). In practice, if the Maturity Date comes to pass it is often agreed by the convertible note holder that it can be extended (particularly common for VC investors, experienced Angels etc.). Look out for wording explicitly stating that the Maturity Date can be extended. However, investors may enforce the repayment which could have dire consequences for the company (i.e. if they have insufficient funds or if such a call on funds would lead to insolvency). Most sophisticated investors would appreciate that extending is likely the best route because, in practice, it is very unlikely that the company would have sufficient disposable funds to repay the note. However, the same may not be true of all investors. Be careful in picking your investors - particularly if they have not invested using a convertible note before and don’t fully understand the risks and what the situation would likely be in the event the company does not succeed.

(8) What type of shares will the note convert into?

Generally, this will be either ordinary shares or the same class of shares that are issued to other investors at the round. It’s favourable for the investor to receive the same class of shares as those issued at the round because they will generally be preferred shares and carry such rights (i.e. protection of liquidation preference etc.). It’s important for founders to understand this clause because they are potentially increasing the size of any liquidation preference (see this post) they create on a future round.

The above points are by no means exhaustive but hopefully they provide a useful primer. I’d recommend founders run any detailed points past a lawyer and get legal advice before entering into any agreements.

I’d love to hear feedback or potential additions. You can find me on Twitter @tom_wils.