Posted by Assure ● Feb 26, 2019 9:51:14 AM
Five Need-to-Know Key Convertible Note Terms
Investors new to investing in start ups will likely run into many terms that they are not familiar with on the public markets. One of the most important and frequent term they may see is convertible debt.
There are two circumstances where an investor is most likely to run into convertible debt. First is when the investment company is in the early stages of existence. When a young company is seeking financing, it is not beneficial to either the investor or the founder to spend a significant amount of time and money working on the details of an equity round. The time founders and investors spend determining a valuation could easily derail a company, and the legal costs associated with negotiating and drafting a complex legal structure, while always cumbersome, could do serious harm to a company. In addition, a company may opt to use a note round between equity financing rounds. If their revenue turned out to be not as high as projected, or the burn rate was higher than the founder had hoped, the company may find themselves short on cash. A note round allows the company to receive quick financing without all of the efforts of an equity round. Within the various types of convertible debt, there are several important terms that an investor needs to understand. Below are some of the key terms within convertible debt.
In order for the debt an investor purchases to turn into a tangible benefit, the debt must convert into equity. There are typically two different ways for debt to convert into equity. First is through the maturity date. A maturity date is a functional backstop for investors, which guarantees that at some point they will have the option to convert their interest even if the company is not going through a qualified financing event. The maturity date is determined at the time the note is created and will typically be two years after signing the note. If the maturity date has passed, the debt does not convert automatically, it is for the individual investors to elect to convert. Maturity date conversions are fairly uncommon, because a company that passes the maturity date will often have gone through a financing round, and forcing a conversion could jeopardize the company, and consequently their investment. Additionally, if the note investors hold accrues interest then they are financially incentivized to wait, as the equity they receive will be greater if the company manages to find financing.
Qualified Financing Event
The second and more common means of triggering a conversion is through a Qualified Financing Event (QFE). A QFE is a set amount negotiated in the debt instrument that set a limit within the next equity financing round. If the money raised in the round exceeds the QFE, then the debt will convert into equity. For convertible notes, the QFE is negotiated by the company against the investor. SAFEs and KISS’ typically only require a bona fide transaction, so even a $1 financing round will trigger a conversion under those terms. The purpose of the QFE is two-fold; first is to protect the investor against a down round where the company can only raise a small amount of money, which will cut off the investor from collecting interest. The second is to allow the company to gain a significant amount of cash in their equity round without having to deal with the complication of issuing additional shares.
The valuation cap is protection for investors against being diluted in companies that have high-growth fund raising rounds. For example, say an investor purchased a $500,000 note in a company, with no valuation cap. At the time of the next financing, the company saw tremendous growth, and had a pre-money valuation of $100,000,000, with 100,000 shares outstanding. The ownership percentage of the investor is very small, about 500 shares. Whereas, if the note contains a valuation cap, say at $5,000,000, then the investor would use the pre-money valuation of $5,000,000 rather than the true valuation, and the investor would receive many more shares in the company, around 10,000 shares.
Convertible debt will often have a discount rate written into the terms. The discount rate is a benefit to investors that values the shares issued in the subsequent financing round at a lower rate than what new investors are paying at a price per share. If the investor buys a $500,000 note with a 20% discount rate, and the company does a round and issues shares worth $10 a share, the investor is only paying $8 per share and would receive 62,500 shares.
Finally, the liquidation preference is a term that becomes tremendously important whenever there is an exit or payout of some kind. The liquidation preference determines in what order and how much money a preferred stock owner will receive over common stockholders. Typically, liquidation preferences are expressed in terms of multiples of the investment, though sometimes they are expressed on a price per share basis. In the current investing climate, the most common liquidation preference is a 1x return, meaning the investor will receive all of the money they invested back before any of the common stockholders receive payment. If the liquidation preference is 2x, then the investor will receive their investment back, and double their money before common stockholders are paid back. The most important scenario for liquidation preferences is when the company exits, and there is not enough money to pay off all of the investors and stockholders. In that case, some investors will get all of their money back or even profit, while others may get nothing.
Convertible instruments have become more and more popular over time as start ups and investors have sought to streamline the fundraising process as much as possible. While the process is arguably easier now than it has ever been, there are still several complexities that both investors and founders need to know about.
At Assure, we have successfully converted over 800 debt instruments, with hundreds of others yet to convert. We track interest, sign consents, verify share allocations, and receive new certificates. We work with organizers and companies to make sure that all of the required documents are filed in a timely and accurate manner.