Convertible Notes: What Founders Need to Know

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SEEDCHANGE

#ConvertibleNotes

About Your HostsKevin SmithFounder and CEO

Gadiel MorantesPartner

SEEDCHANGE

What’s a convertible note (and why should you care)?

3www.seedchange.com www.earlygrowthfinancialservices.com

• Historically used for bridge rounds

• Now standard for early stage funding (unless you’re in ROW)

• When to use convertible notes: – Seed– Bridge– Supplement

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Startup funding cycle




http://upload.wikimedia.org/wikipedia/commons/8/8e/Startup_financing_cycle.svg

Looks like a fish, flies like a bird. . . .

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• Debt / equity hybrid• Technically debt (interest and terms)• Behaves (mostly) like stock: will convert when

the company does a sizeable equity investment round

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IOU



The FAB of convertible notes—Features

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• Short agreement• Simple• Flexible• No company valuation• (Largely) standardized terms




Advantages of convertible notes

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• Short Quick close(s)• Simple Low legal fees• Flexible Close any time• No valuation No negotiation• Standard terms No negotiation




Benefits of convertible notes

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• Short Quick close(s) Save time• Simple Low legal fees Save $• Flexible Close any time JIT funding• No valuation No negotiation Save

$/time• Standard terms No negotiation Save $/time




How it works: a 1-page manual

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• Decide amount of round and minimum investment• Provide note terms to (accredited) investor• Agree terms• Sign and date

– the note purchase agreement (company and investor) and – the note (company)

• Exchange executed note purchase agreement and note for check/wire

• Add noteholder to cap table (debt page)

Convertible note is classified as debt until it converts to equity




All the terms that matter


• Interest rate

• Note term (Maturity date)

• Discount

• Note cap



Interest rate

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• All convertible notes include interest rate: IRS says so• Methods for determining the interest rate:

– Round number: 5%– Tied to accepted standard: LIBOR

• Interest is paid in shares, not cash• Interest begins to accrue on the date the note is signed• Interest is paid when the note converts to stock


Use 5%



Term (Maturity date)

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• Date of conversion/repayment • Typically converts after 12 or 18 months• On maturity• Convert or repay• If neither, talk to your investors about amending

the note purchase agreement


Use term = 18 months



Discount

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• Discount on share purchase at time of conversion to stock

• Compensates early investors for greater risk

• 20% is standard• Recent trend in Silicon Valley toward

15%, 10%, 0% discount


Use 20%



Convertible note cap

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• Dilution protection, not company valuation• Allows conversion to stock at a ratio

guaranteed not to fall below $_____ • Aligns incentives between investors and

founders• Investor chooses to convert using either note

cap or discount – not both

Median note cap = more or less approx. something like $4.5 million




Conversion example #1


Assumptions:

Note converts after equity investment of $1.5m.

Excludes 5% interest paid to noteholders in the form of shares issued at the time of conversion.

Assumes no post-money option pool (the last worksheet adds an option pool to this scenario)

Company (pre-funding): DISCOUNT CAP

Shares outstanding* 8,500,000 Series A at conversion Series A at conversion

Effective valuation $3,781,250 Effective valuation $3,925,000

Convertible note terms: Share price $0.44 Share price $0.46

Note Size $575,000 No. of shares 3,371,901 No. of shares 3,248,408

Note Cap $4,500,000 Equity 25.00% Equity 25.00%

Note Discount 20%

Note Holder at conversion Note Holder at conversion

Series A terms: Share price $0.36 Share price $0.46

Series A investment $1,500,000 No. of shares 1,615,702 No. of shares 1,245,223

Series A valuation $4,500,000 Equity 11.98% <----- Equity 9.58%

Return 1.25x Return 1.00x

Note holder converts via DISCOUNT -----> CONCLUSION At this Series A valuation, the note converts

using the DISCOUNT, creating 2.4% more equity for the note holder compared to a CAP. The note holder's return on the Series A is 1.25x.

Cap Table (Ownership) shares %

Team 8,500,000 63.02% *Shares issued to founders and

employees Series A 3,371,901 25.00%

Note holder 1,615,702 11.98%

13,487,603 100.00%



Conversion example #2


Assumptions:

Note converts after equity investment of $1.5m.

Excludes 5% interest paid to noteholders in the form of shares issued at the time of conversion.

Assumes no post-money option pool

Company (pre-funding): DISCOUNT CAP

Shares outstanding* 8,500,000 Series A at conversion Series A at conversion

Effective valuation $12,781,250 Effective valuation $11,775,000

Convertible note terms: Share price $1.50 Share price $1.39

Note Size $575,000 No. of shares 997,555 No. of shares 1,082,803

Note Cap $4,500,000 Equity 10.00% Equity 10.00%

Note Discount 20%

Note Holder at conversion Note Holder at conversion

Series A terms: Share price $1.20 Share price $0.46

Series A investment $1,500,000 No. of shares 477,995 No. of shares 1,245,223

Series A valuation $13,500,000 Equity 4.79% -----> Equity 11.50%

Return 1.25x Return 3.00x

Note holder converts via CAP -----> CONCLUSION At this Series A valuation, the note converts

using the CAP, creating 6.71% more equity for the note holder compared to a DISCOUNT. The note holder's return on the Series A is 3x.

Cap Table (Ownership) shares %

Team 8,500,000 78.50% *Shares issued to founders and

employees Series A 1,082,803 10.00%

Note holder 1,245,223 11.50%

10,828,025 100.00%

The down sides of convertible notes (and an alternative)

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• It’s still debt—and investors really want equity• Debt incurs interest—and investors really don’t

care• Debt has to be repaid---but what if you can’t?

Why not create something that looks and acts more like stock?

Someone did: SAFE (Simple Agreement for Future Equity)


Q&A and Thank You!

Kevin Smith415 Jackson StreetSan Francisco, CA [email protected]@seedchange

Gadiel Moranteswww.earlygrowthfinancialservices.comcontact@earlygrowthfinancialservices.com415.234.3437@EarlyGrowthFS

SEEDCHANGE

Convertible Notes: What Founders Need to Know

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