Convertible Stack Follow Up
Nearly two years ago, SOSV discussed the dreaded Convertible Stack. Two years later, SOSV is still concerned with the significant number of convertible securities we see Founders stacking. The issue has not gone away…..
SOSV knows only too well how difficult it can be for startups to raise funding and sometimes options can be limited and you accept what is on offer, but “Founder Beware”.
Convertible instruments are, and will continue to be, a very valuable and efficient source of funding for Founders. The general speed and efficiency in closing a convertible round as opposed to a priced round is clear for both Founders and investors.
However, we have seen a number of recent examples where Founders have been exposed to the harsh reality of continually stacking convertible securities in their companies, with multiple convertible rounds, often with different terms and capped values, and the further issues that can arise with MFN provisions in previous convertible round documents seeking to benefit from subsequent terms (lower cap, greater discount, etc.).
In each of those instances the Company was a Delaware corporation (across different sectors ranging from food and hardware, to life sciences), and all of them had participated in a SOSV Program in 2014.
In these cases, the total accumulated debt ranged from $3m to $6m and the debt rounds were executed with different terms, specifically in respect of the capped value for conversion purposes.
In one such extreme case, the principal Founder’s shareholding was reduced to below 2% (from ~30%) as a result of the conversion of the stacked convertibles when the company finally managed to secure a priced round. Dilution such as this is a massive cause of concern not only for the relevant Founder, but also for existing and any potential future investors. What happens after this is that the interests of the Founders may become misaligned with those of the investors. When a Founder’s equity holding falls to these levels prematurely in a company’s investment life cycle, there can be little or no incentive for a Founder in such a position to remain motivated towards a company exit (especially if that Founder is offered a very attractive employee package by a well established company, or given the nominal equity holding that Founder now has, there may be such a lack of any incentive to sell this equity). In this particular case study, after detailed and protracted negotiations with the investors in the priced round, it was ultimately agreed to increase the Founder’s position to under 10% by the issue of additional options, which causes dilution to all the other investors at that point.
There appears to be an increasing reliance on the form of post money convertible instruments that are currently circulating in the startup world. Again, while there is no doubt that these are really effective instruments for Founders (easy to understand, circulate and execute, with little or no adjustment required other than to the cap and/or discount), Founders and investors should be reminded again of the dangers of continuing to stacking such instruments. It is the Founders’ equity percentage that will be hit the hardest when these instruments do eventually convert.
With a view to helping Founders avoid the significant dilutive impact as suffered by the Founder in the specific case study as referred to above, SOSV continues to encourage the use of a “trigger” in convertible instruments and to circulate this approach with all SOSV Founders. By using the “trigger” approach, once the aggregate amount of investment raised in any such debt round exceeds a pre-agreed trigger level (the “Maximum Convertible Amount”), the round would automatically convert to a priced round with the instruments converting to a pre-agreed class of Preferred Stock. This can be achieved by way of a simple addition of a conversion clause in the debt instrument providing for the conversion to a pre-agreed class of Preferred Stock once the Maximum Convertible Amount is achieved, and a short form Schedule to the instrument setting out the pre-agreed rights of the class of Preferred Stock to be issued on conversion. Suggested wording for such clause might be along the lines of:
“Conversion Upon Company’s Receipt of Maximum Convertible Amount. If, at any time when this Note is outstanding and prior to a Qualified Financing, the Company secures the Maximum Convertible Amount, all of the principal and accrued interest outstanding under this Note shall be converted within 30 days of completing the closings of the Notes for such Maximum Convertible Amount into fully-paid, non-assessable shares of Preferred Stock, with the rights, preferences and privileges as set forth on Schedule X attached hereto and incorporated herein by this reference, at a conversion price equal to (A) the Price Cap multiplied by the Discounted Price Percentage, divided by (B) the number of Fully Diluted Shares as of the conversion date (excluding the shares issuable upon conversion of this Note and any other convertible promissory notes).”
Template instruments and a pro forma cap table for the purposes of detailing the scope of a “trigger” event are all included in the previous SOSV post on the Convertibles Stack.
To emphasise again, the recommendation of SOSV is that both Founders and investors would have the ability to benefit from the speed and ease of a convertible round, but incorporating a “trigger” conversion event. Once such trigger is achieved, the debt round automatically converts to an equity round ( a Series Seed financing round) on terms as pre-agreed by all parties to the debt instrument. SOSV would typically see the trigger documentation being based on the NVCA model document set.
A further advantage of the trigger conversion is that Founders can have the benefit of staying in better command of the due diligence requirements over the life cycle of their Company, especially for the purposes of the next financing round which will be to the benefit of all, especially that next lead investor. Founders should always assume a proactive approach in respect of their Company’s corporate records, filings, cap table, IP, consent matters, etc., which is not only a positive for corporate governance purposes, but can also result in a more efficient and effective experience for closing that all important next financing round (see The Ultimate Guide to Due Diligence for Founders).
From SOSV’s perspective, both Founders and investors can benefit from this approach — once the “trigger” is hit, all parties are aligned on the cap table position with the dilutive impact clear for the Founders; the Founders, now having an exact position on the cap table, are likely to be more motivated and dedicated to scaling the business; a valuation is agreed and set for the Company; investors have the benefit of equity rights (pre-emption, voting, protective provisions, Board/Observer position, benefit of more oversight, etc.), thereby removing the cloud of outstanding convertible instruments and allowing the Company, the Founders and the investors to be in a clear, focused and solid position to move forward.
Warning — this post does not, and is not intended to, constitute legal advice. The discussion above is for general information purposes only and should not be interpreted as legal advice.
