December 15, 2017 | 5-minute read (915 words)
We recently sat down with Matthew Moisan, managing partner of Moisan Legal P.C., for some much-needed clarification on convertible notes. Matthew assists companies and entrepreneurs in recognizing, mitigating and managing risk. Because he views his clients as strategic partners, he is able to communicate and collaborate in a manner that often leads his clients to view him as a member of their team. Matthew used his extensive experience to explain the ins and outs of convertible notes, and he answered many great questions from our participants in the below webinar:
How Convertible Notes Work
If you have a small business or a startup, you will want to raise capital. There are three ways to do this - an equity round, raising debt (a loan), or with convertible notes - which are a combination of the first two. Essentially, convertible notes are debt that acts like equity. They function as legal IOUs, but with repayment in stock instead of cash. That said, convertible notes must have certain debt features such as interest rates and maturity dates.
What are Convertible Notes & Why Should You Care?
A convertible note is a debt instrument (a loan) that converts to equity upon certain events.
Why is it used?
-Doesn’t cause any dilution when it is issued
-Not taxed typically
-No valuation required
-Allows you to streamline the process - money in the door quickly
Startup Funding Cycle
This image portrays the ideal life cycle through funding rounds. As you’re climbing the ladder, hopefully you’re breaking even or starting to make money which gives you more flexibility.
- Seed Capital - First capital raised from either angels or friends and family
- Early Stage / Later Stage Capital - raised from an early stage VC or an angel investor
- Series A, Series B, etc.
A Convertible Note is a Debt/Equity Hybrid
Convertible notes are great when you’re early stage, cash is tight, and you just need some cash in the door as quickly and efficiently as possible. They are technically debt with interest and terms, but they behave mostly like stock. They will convert when the company has a sizeable equity investment round - the "conversion event."
Features and Advantages of a Convertible Note
Short -> Quick close
Simple -> Low legal fees
Flexible -> Works in many circumstances
No Company Valuation -> No negotiation
Largely Standardized Terms -> No negotiation
How it Works: A One Page Manual
- Determine round amount and minimum investment
- Present note terms to (accredited) investor
- It is important to know that your investors are a part of your company and whether or not they are sophisticated plays into how hard it is to run your company later on & also plays into exemptions you may be able to claim.
- Agree terms
- Execute documents
-The note purchase agreement (company and investor) and
-The note (company)
- Exchange executed note purchase agreement and note for check/wire
- Update cap table to reflect the new debt/investment
All The Terms that Matter
-Note term (Maturity date)
-Note cap (The convertible notes convert at the note cap)
-Qualified Financing Amount (Your next fundraise is defined by Qualified Financing Amount
When you raise this amount, conversion of the notes is triggered)
-All convertible notes include interest rate: the IRS says so. You must have interest on a convertible note because it is debt.
-Methods for determining the interest rate:
1. Round number: 5%
2. Tied to accepted standard: LIBOR
-Stock interest- not cash
v-Begins to accrue on the date the note is signed
-Interest is paid when the note converts to stock
If no triggering event occurs before this date, this is the date of conversion OR repayment. It typically converts after 18-24 months. The maturity date is important because it forces action - you have to either convert or repay on maturity. If neither, you must talk to your investors about amending the note purchase agreement, and choose whether the notes are converted or extended.
The discount is used to compensate early investors for the risk they took in funding your business. A 20% discount on the share purchase price when the debt converts to stock is typical. The discount is on share purchase price at time of conversion to stock and this it protects against a raise that is below the cap. For example, if you have a $500,000 rase at a $5 million cap, and you raise a $4 million round valuation, that’s where the discount kicks in.
Watch Out For…
-Short maturity dates
-Excessive discount rates
-Burdensome restrictive covenants
-Letting debt go unconverted/unpaid
Conversion Example #1
Example of Conversion via discount:
Conversion Example #2
Example of Conversion via CAP:
Watch the entire Webinar for many more questions answered by Matthew, and much more detail on this topic!
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