Funding from startup to scale up happens in stages as noted in the book “Make It Big, Crossing the Entrepreneur’s Gap.” Different types of companies have different types of funding options. Hobby and lifestyle companies bootstrap and often use friends and family funding as noted in the related post on promissory notes. Those companies that have a view toward equity funding overtime often start with a convertible note.
Convertible notes are similar to a loan. The main difference is that the note can convert into shares of equity upon completion of an equity financing round. Many early stage ventures utilize convertible notes since they are easy to execute, have the option to convert into equity, and defer the need to define a company valuation. The company valuation will be set at the time the first equity round is completed. The note will convert into equity at the price defined in the equity round. Below is an example convertible note. The note is defined by a principle amount of the investment, the interest on the note (compounded annually), and the mechanics of conversion. These three points are to be negotiated and agreed to by the startup company as well as the investor. Notes sometimes include a warrant, which is an option to buy a certain amount of equity at the time of conversion at a discount to the round. Sometimes note extenders try and include covenants such as access to intellectual property or other assets in the case of wind up or non-conversion, but there are quite rare. Convertible notes are almost always unsecured with no asset as collateral that can be accessed by the investor in the event of default. By the same token, convertible notes are also not personally guaranteed by founders or shareholders.
Similar to a warrant, some investors will ask for a conversion ceiling. Depending on where the equity round prices at, the ceiling (often called valuation cap) offers the convertible note holder a discount relative to the new investors. For example, a preferred series A round may be negotiated at a $5 million valuation, but the conversion happens at a $3 million valuation. This is effectively a 40% discount ($2M / $5M) to the preferred investors. In similar fashion conversions can happen at a negotiated discount to the preferred equity round, for example offering the convertible note holders a conversion at 80% discount to the series A. Another way to provide a minimum return to a convertible note holder is to simply include a multiple on the principle which for example provides the convertible note holder a minimum 2X return on the principle they have invested. These are all commonly used mechanisms added alone or sometimes in combination.
“The use of convertible notes for pre equity investments has increased significantly since 2003,” says Marc Theeuwes, former venture capitalist and now Consulting Associate Professor at Stanford, “entrepreneurs in the valley and from our programs are starting up lean with small amount of capital to prove their way and reduce risk toward a more formal round. We’re using convertible notes almost exclusively at these early stages. I would consider the note below a good example of how things get done these days.”
Interest rates on a note increase based on the risk of the loan, the riskier the loan, the higher the rate. The lowest rate possible is called the risk free rate and is generally defined as the US 7 year treasury bill rate. This number is freely available on the web or in finance newspapers such as the Wall Street Journal. For example, on October 3, 2012 the risk free 7 year treasury bill rate was 1.02% (www.treasury.gov). In August 2012 the going rate for early stage company convertible notes was roughly 10%-12%. The difference in the rates allows the investor additional compensation for the added risk of this investment. Different assets have different going rates which fluctuate over time with the economy. Anything above 15% starts to get into the same territory as credit cards which are essentially one of the riskiest loans and have a rate of about 18%.
Here is an example of how a convertible note might work in practice. Let’s assume the convertible note is for $250,000 and the interest is 12%, annually. Assume the company will raise $2 million in a Series A round and the valuation is negotiated to be $2.5 million pre-money. Pre money simply means the valuation of the company prior to the addition of the Series A capital. The post money valuation is simply the pre plus the capital raised, or $4.5 million in this example ($2.5 million pre + $2 million Series A capital). Assume the convertible note has been outstanding for 1.5 years at the time of the Series A. The value of the note is then the principle ($250,000) plus 1.5 years of interest.
Interest can be applied compounded or non-compounded. It is more common for convertible notes to compound but we will show both examples.
- Non-compounded: The interest would simply be the principle multiplied by rate and time, or (Interest = Principle x rate x time) $45,000 ($250,000 x 12% x 1.5 years). So, the total value of the note at the time of conversion would be $295,000.
- Compounded: The interest is calculated and reinvested / added to the principle at the end of the year. This is given by the formula M = P( 1 + i )^n where M is the value of the note at the time of conversion, P is the principal, i is the rate per year, and n is the number of years. In this case the value would be $296,324 [$250,000 x (1+12%)^1.5]. The interest in this case is slightly higher at $46,324 as opposed to the $45,000 for the non compounded case.
Assume now the company has 20 million shares (fully diluted) at the close of the Series A. Then the dollar per share is $0.225 ($4.5 million post / 20 million shares). Since the value of the compounded note is $296,324, the investor of the note is then entitled to receive 1,316,996 shares (note value / $ per share). If a warrant were included and purchased by the investor at the time of conversion, those shares would be added on top of the roughly 1.3 million.
CONVERTIBLE PROMISSORY NOTE
This Convertible Promissory Note (this "Note") is made as of _________________________ (the "Effective Date"), --------------- COMPANY NAME -------------, a -------- STATE ------- corporation (the "Company"), in favor of ------------ INVESTOR -----------------, a ----------- STATE ------------ limited liability company (the "Holder"). For value received, the Company promises to pay Holder, the principal sum of U.S. ---- SPELL OUT THE AMOUNT ------- (U.S. $___________). Interest shall accrue from the date of this Note on the unpaid principal amount at a rate equal to twelve percent (_______%) per annum, compounded annually. This Note is subject to the following terms and conditions.
1. Maturity. Unless converted as provided in Section 2 below prior to the date that is 18 months after the Effective Date (the "Maturity Date"), on the Maturity Date the outstanding principal amount of this Note, and, at the Company's option, accrued interest thereon, will automatically convert into shares of Common Stock at a conversion price equivalent to a pre-money valuation of $____ million. Notwithstanding the foregoing, the entire unpaid principal sum of this Note, together with accrued and unpaid interest thereon, shall become immediately due and payable upon the commission of any act of bankruptcy by the Company, the execution by the Company of a general assignment for the benefit of creditors, the filing by or against the Company of a petition in bankruptcy or any petition for relief under the federal bankruptcy act, or the continuation of such petition without dismissal for a period of ninety (90) days or more, or the appointment of a receiver or trustee to take possession of the property or assets of the Company.
(a) Investment by the Holder. The entire principal amount of, and at the Company's option, accrued interest thereon, this Note shall be converted into shares of the capital stock of the Company (the "Equity Securities") issued and sold at the close of the Company's Series A Preferred Stock financing (the "Series A Financing").
(i) The series A round must provide a minimum of $1,000,000 in capital. The Notes and any accrued interest will be converted into Equity Securities at a 20% per-share discount to the series A investors. In no event shall this Note convert at greater than 80% of the Series A share price based upon a pre-money valuation of $__ million. (NOTE THIS SECTION IS OPTIONAL)
(ii) The number of shares of Equity Securities to be issued upon such conversion shall be equal to the quotient obtained by dividing (i) the entire principal amount of this Note, and, at the Company's option, accrued interest thereon, by (ii) the price per share of the Equity Securities, rounded to the nearest whole share, and the issuance of such shares upon such conversion shall be upon the terms and subject to the conditions applicable to the Series A Financing.
(b) Conversion Upon Acquisition. In the event that all or substantially all of the assets or shares of the Company are acquired or merged into another entity prior to the closing date of the Series A Financing (an "Acquisition"), then at the Holder's option, either (i) the Company will repay Holder the outstanding principal amount of this Note plus all accrued but unpaid interest thereon, or (ii) the principal amount of this Note and accrued interest thereon, will convert immediately prior to the closing date of such Acquisition into preferred stock if a preferred financing is pending or common stock if a preferred round is not pending. The preferred conversion amount redeemable will equal what the Holder would have received had the Note converted immediately prior to a Series A Financing per Section 2a. Conversion to common will occur at a price per share equivalent to a fully diluted pre-money valuation of $__ million. (NOTE THE COMMON CONVERSION COULD ALSO BE HANDLED BY A MULTIPLE). Conversion will be paid in the same cash and stock consideration received by other equity holders as part of the transaction.
(c) Mechanics and Effect of Conversion. No fractional shares of the Company's equity securities will be issued upon conversion of this Note. In lieu of any fractional share to which the Holder would otherwise be entitled, the Company will pay to the Holder in cash the amount of the unconverted principal and interest balance of this Note that would otherwise be converted into such fractional share. Upon conversion of this Note pursuant to this Section 2, the Holder shall surrender this Note, duly endorsed, at the principal offices of the Company or any transfer agent of the Company. At its expense, the Company will, as soon as practicable thereafter, issue and deliver to such Holder, at such principal office, a certificate or certificates for the number of shares to which such Holder is entitled upon such conversion, together with any other securities and property to which the Holder is entitled upon such conversion under the terms of this Note, if any, including a check payable to the Holder for any cash amounts payable as described herein. Upon conversion of this Note, the Company will be forever released from all of its obligations and liabilities under this Note with regard to that portion of the principal amount and accrued interest being converted including without limitation the obligation to pay such portion of the principal amount and accrued interest.
(d) Payment of Interest. Upon conversion of the principal amount of this Note into the Company's capital stock, any interest accrued on this Note that is not by reason of Sections 2(a) or 2(b) hereof simultaneously converted into securities of the Company shall be immediately paid to the Holder.
3. Payment. All payments shall be made in lawful money of the United States of America at such place as the Holder hereof may from time to time designate in writing to the Company. Payment shall be credited first to the accrued interest then due and payable and the remainder applied to principal. Prepayment of this Note may be made at any time without penalty.
4. Transfer; Successors, and Assigns. The terms and conditions of this Note shall inure to the benefit of and be binding upon the respective successors and assigns of the parties. Notwithstanding the foregoing, the Holder may not assign, pledge, or otherwise transfer this Note without the prior written consent of the Company, except for transfers to affiliates. Subject to the preceding sentence, this Note may be transferred only upon surrender of the originally-signed Note for registration of transfer, duly endorsed, or accompanied by a duly executed written instrument of transfer in form satisfactory to the Holder. Thereupon, a new note for the same principal amount and interest will be issued to, and registered in the name of, the transferee. Interest and principal are payable only to the registered holder of this Note.
5. Governing Law. This Note and all acts and transactions pursuant hereto and the rights and obligations of the parties hereto shall be governed, construed, and interpreted in accordance with the laws of the State of ___________________, without giving effect to principles of conflicts of law.
6. Notices. Any notice required or permitted by this Note shall be in writing and shall be deemed sufficient upon delivery, when delivered personally or by a nationally-recognized delivery service (such as Federal Express or UPS), or forty-eight (48) hours after being deposited in the U.S. mail, as certified or registered mail, with postage prepaid, addressed to the party to be notified at such party's address as set forth below or as subsequently modified by written notice.
7. Amendments and Waivers. Any term of this Note may be amended only with the written consent of the Company and the Holder. Any amendment or waiver effected in accordance with this Section 7 shall be binding upon the Company, the Holder and each transferee of the Note.
8. Entire Agreement. This Note, and the documents referred to herein constitute the entire agreement and understanding of the Company and Holder relating to the subject matter set forth in this Note and supersede any and all previous agreements or understanding between the Company and Holder relating to the subject matter set forth in this Note.
9. Statutory Notice. ORAL AGREEMENTS OR ORAL COMMITMENTS TO LOAN MONEY, EXTEND CREDIT, OR TO FOREBEAR FROM ENFORCING REPAYMENT OF DEBT ARE NOT ENFORCEABLE UNDER WASHINGTON LAW.
10. Subordination; Not Secured. This Note shall be unsecured and shall be subordinate in right of payment to all current and future indebtedness of the Company to banks and other financial institutions.
11. Expenses: The Company and Holder will bear their own legal and other expenses with respect to this Note.
AGREED TO AND ACCEPTED AS OF THIS _____ DAY OF ________ 20___:
Name: _______________________Inc., ______________________________
Name / Title ___________________________ ______________________________
Address: ___________________________ ______________________________
Disclaimer: Material provided herein is for illustrative and educational purposes only. If you require the use of these or similar documents, you should seek the advice of a legal attorney.