Everything You Ever Wanted To Know About Convertible Note Seed Financings

http://techcrunch.com/2012/04/07/convertible-note-seed-financings/

by msbii • 14 years ago

48 11 14 years ago

motti_s3• 14 years ago

"In addition, the issuance of shares of common stock creates three potential problems. First, the founders risk substantial dilution because it is often difficult for the founders and the investors to agree on a valuation for the startup and, accordingly, to agree on the percentage ownership the investor will receive."

Isn't determining the cap of the convertible note equivalent to negotiating the valuation when issuing stocks? The dilution won't occur until the conversion, but it will occur eventually and at the ratio that was determined at the time of issuing the note. I think the above applies to uncapped notes, but I don't believe those are very common.

patio11• 14 years ago

They are analogous but not equivalent. A cap of $5 million is a strictly better deal than a valuation of $5 million from the investor's perspective, because if the startup underperforms their next valuation will be below the cap (investor gets more of the company than a $5 million valuation would imply) and if the startup outperforms their valuation will be above the cap (and the investor gets shares worth more than their slice of $5 million would imply). This makes it much easier to pick higher dollar amounts with less kvetching, which is in startup's interests.

Also, just as a social norms thing, the "round" structure forces contemporaneous investors to get the dame deal regardless of value add (and you have to herd cats to make it happen) but you can close convertible notes individually at heterogenous terms. This helps break deadlocks.

See pg's article on Higher Resolution Fundraising.

motti_s3• 14 years ago

Thanks Patrick.

I'm familiar with pg's essay about High Resolution Fundraising, but as stated in the essay, this can happen even without the use of convertible notes: "You may not need to use convertible notes to do it."

Is it a fact that it's much easier to get a higher dollar amount with a note deal compared to shares? When issuing the investor shares with an anti-dilution clause doesn't it have the same effect as a cap, so the investor is protected from a down round? Wouldn't this ultimately allow the investor to agree to the same dollar amount as in a cap?

loceng• 14 years ago

So negotiate strongly on the cap - don't undersell yourself.

motti_s3• 14 years ago

I once dealt with a sophisticated investor, though with no experience in tech investments. The idea of a convertible note was foreign to him and thus unacceptable. He wanted to own preferred shares right away, but I wanted to avoid lengthy and costly negotiations and giving away control at that point.

We then discussed a middle ground between the two: the investor gets common stocks without any special rights except anti-dilution and an option to convert them to preferred at the time of the series A round. This way we could achieve many of the benefits of a convertible note, such as reduced legal costs and the ability to close faster. Eventually we didn't close that deal, but it seems that it could have been an interesting middle ground.

Has anyone ever done something like that? Is it common? I'm interested to know how it turned out and if you'd do it again.

rdl• 14 years ago

No.

This is a horrible idea because it establishes a high price for the common stock. If the guy invests $100k into your common stock for 1%, you've just established that anyone getting a stock grant of 1% also owes taxes on $100k in income.

Reasonable lawyers familiar with startup financing wouldn't have advised this. Your investor probably isn't very sophisticated when it comes to equity compensation for employees, not just tech.

auston• 14 years ago

I'm very curious as to what happens when things go south with your company & you've got a Convertible Note that has not yet been converted.

ww520• 14 years ago

Good question. I guess it would have seniority over shareholders (investors) in liquidating the company's asset. Assuming the company is a C corp, you should not be responsible for the debt personally.

bonesinger2• 14 years ago

It depends if the note was subordinated or not. Generally you have debt that is ranked based on seniority, so if the convertible note was a secured debt, it will rank higher than the unsecured creditors; however, it may still rank below other secured debt.

Example Ranking: Secured Debt 1 Secured Debt 2 Unsecured Debt 1 Unsecured Debt 2

In the case of bankruptcy, SD1 is going to be able to make a claim and get first dibs on assets and things to recover its debt. Everyone else has to wait their turn. (This is a super simplified definition)

LLC and C Corp liability is generally designed to shield you from personal liability. There are few cases where the shield of liability is "pierced" to go after the person who ran the company. "Piercing the veil" is what it is called, and it doesn't happen often, but when it does its a big deal.

I've seen a few cases in school about it, mostly about CEOs just running amok and stealing money, while having duties of good faith, loyalty etc...

ilamont• 14 years ago

I just had a conversation with a lawyer about this last week. We haven't gotten a quote, but it looks like it's going to cost a little more than $1000 for a template that I can use with different investors.

Reading this article, the one thing that was new to me was the purchase agreement. Does anyone have any experience with this, in connection with a convertible note?

bonesinger2• 14 years ago

A purchase agreement is going to lay out the ground rules that the convertible note is going to be issued under such as who is buying the note, who is offering, the closing date, how to handle notices, what law will govern in certain situations, how litigation will be handled; most of these are categorized as representation and warranties by the issuer of the note. There also maybe Reps. and War. that the purchaser of the note must oblige by.

This is an extremely brief definition, and not to be taken as any legal advice.

Source: my 2 semesters in transactional practice and business planning. (I'm a law student!)

Everything You Ever Wanted To Know About Convertible Note Seed Financings

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