Patrick Tickner – July 30, 2019
In an Early-Stage Company
If you’re a start-up founder in an early-stage company, odds are you don’t have the means to entirely self-fund your new venture. That’s fine; creating a business out of nothing can be enormously expensive, and almost all early-stage companies face the need to raise outside money to allow the business to grow. As a founder, it’s important to understand your options for raising money at this stage. At an early stage, it can be difficult to bring in investors with equity because the value of the company may be unclear, which makes negotiating the price and the percentage of equity issued difficult. You may also not be ready to give up a piece of your company yet. There are a few ways to raise capital that delay the valuation question and don’t require founders to give up a stake in the company right away.
One of the most popular ways for early-stage companies to raise capital is through a convertible note offering. Like a traditional debt instrument, a convertible note is a promise by the issuing company to repay the note holder for the price of the note plus interest. Unlike a traditional debt instrument, a convertible note has the ability to convert to equity of the issuer or some other company upon one or more defined events. Like shares of stock, convertible notes are securities, and thus are subject to the same rules and regulations promulgated by the Securities and Exchange Commission as equity. Because of this, it’s very important to consult with an attorney familiar with securities offerings before, during and after the offering.
Who should consider offering convertible notes?
Convertible notes can be used companies at any stage, and it is not uncommon to see more developed start-ups issue convertible notes as bridge financing between fixed price rounds of investment. But with respect to early-stage companies seeking seed financing, companies that are pre-valuation and not quite ready to undertake the task of valuing the business should absolutely consider a convertible note offering.
Why convertible notes and not equity?
Issuing equity would require the issuing company to undertake a valuation in order to determine what percentage of the company to offer to investors and how much investment to ask for in return for that percentage equity. A formal valuation requires time and money most early-stage companies can’t or don’t want to spend. By issuing equity, founders are diluting not only their economic interest in the company, but they will be giving up a certain amount of control of the company, depending on the amount of investment. Early-stage companies also risk a taxable event to the founders with a valuation if the investors purchase shares at a significantly higher rate than the most-likely nominal amount the founders paid for their equity. Undertaking a valuation too early in the life of a company can be prohibitively expensive and risk a number of bad outcomes, so many start-ups look to raise capital using a means that allows them to do so while deferring valuation. Since convertible notes are debt, not equity, a valuation is not necessary in connection with their issuance. Issuing debt instead of equity avoids the need for a valuation and the risks of creating a taxable event and diluting the founders.
What kind of terms should I expect in a convertible note?
Convertible notes are simply contracts. This means issuers and note holders have a lot of flexibility with respect to the terms, as long as the note contains the definitive features of a convertible note. As a debt instrument, a convertible note will contain an interest rate and a maturity date. We typically see interest rates in convertible notes between four and eight percent per year, but this can be almost any number and will ultimately be determined as a result of negotiations between the issuer and the note holder. Note holders should be careful that the interest rate does not violate state usury laws, which set limits on the amount of interest that can be charged on debt. A convertible note will also contain a maturity date upon which the principal amount and all of the accrued interest will become due and payable, but unlike most debt instruments, convertible notes are not intended to ever reach their maturity dates. Under the terms of most convertible notes, interest is simply accrued over the life of the note and is not paid periodically as it would be in a traditional debt instrument. Instead of the issuer making periodic interest payments and paying the balance of the note off at maturity, a convertible note is intended to convert the principal amount of the note and all accrued interest into equity of the issuer upon a qualified financing.
A convertible note will define qualified financing, the final definitive term of a convertible note. This is the event upon which the debt under the note will automatically convert into equity of the issuer. A convertible note should specify the minimum amount of capital to be raised in a qualified financing and the class of equity issued in exchange for the investment. Like all other terms of the note, a qualified financing can be defined as any type of financing the issuer and note holder agree upon, but with early-stage companies seeking seed financing, the definition of qualified financing is usually tailored so that conversion is triggered by a Series A financing, and not by a smaller fixed price round. When a qualified financing occurs and conversion is triggered, a note holder will receive the same class of equity as the investors in the qualified financing, and conversion will likely occur at a rate determined by either a conversion discount or valuation cap.
Conversion discounts and valuation caps are terms that may appear in a convertible note, but do not necessarily have to be present. These terms are intended to protect the note holder’s investment and reward note holders for taking the risk at such an early-stage in the issuing company’s life. Conversion discounts allow note holders to convert their debt into equity of the issuer at a more favorable rate than the qualified financing investors; i.e. if a note holder has a 20% conversion discount and the qualified financing investors are receiving equity of the issuer at a rate of $1 per share, the note holder will receive the same class of equity at a rate of $.80 per share. A valuation cap sets an upper limit on the valuation of the issuing company for the purposes of determining the conversion price of the note; i.e. if a convertible note contains a $5 million valuation cap and a qualified financing occurs at a $10 million valuation of the issuing company with a price per share of $1, the note holder’s debt will convert as if the company were valued at $5 million, at an effective rate of $.50 per share. Conversion discounts and valuation caps are common provisions to find in a convertible note, but whether either or both end up in a note will be determined as a result of the negotiations between the issuer and note holder. Sophisticated investors will ask for both a conversion discount and a valuation cap and they will include a provision that, in the event that both terms are applicable, allows the note holder to convert at the lower of the two rates.
Outside of the definitive terms, note holders and issuers can negotiate for any provisions they desire to be in a convertible note; sophisticated note holders will require most-favored nation clauses, so that they receive the benefit of favorable provisions other note holders in the current and any subsequent rounds of financing negotiate for themselves. It is also common to see note holders include a provision that prohibits the issuer from making payments on the principal amount of the debt or the interest prior to maturity so that the note holder can receive the full benefit of their investment upon conversion of the note.
What are the risks of issuing convertible notes?
While convertible notes do address real and significant issues presented by issuing equity and setting a value on the company, they do present their own risks to the issuing company. The main risk in issuing convertible notes is that until a note converts, it is a debt obligation. If a qualified financing does not occur prior to the note’s maturity date, or if the terms of the note permit the note holder to call the debt, an issuing company with small reserves and low liquidity can quickly find itself insolvent upon the debt becoming payable. While convertible notes are a great option for early-stage companies to raise capital, in the past few years another option has emerged.
In 2013, well-known start-up accelerator, Y Combinator, developed an alternative to issuing equity and convertible notes for the purpose of making their initial investment in the start-ups that make up their accelerator classes. Y Combinator’s solution, the Simple Agreement for Future Equity or SAFE, is intended to address the issues in convertible notes while maintaining their flexibility. SAFEs avoid the need to make a valuation of the issuing company and the risks of diluting the founders and creating a taxable event, similar to convertible notes, while also not creating a debt obligation for the issuing company. A SAFE is an agreement that entitles the holder of the SAFE to convert their investment into an amount of equity of the issuing company upon a priced round of financing, acquisition or initial public offering of the issuing company.
How do SAFEs compare to convertible notes?
While a SAFE is not a grant of equity, it is still a security, and like equity and convertible notes, subject to SEC rules and regulations. Since a SAFE is not equity, issuing SAFEs will delay valuation of the company just like convertible notes. Also like a convertible note, a SAFE will convert into equity upon a future event, usually a Series A priced financing round with provisions triggering conversion upon an earlier acquisition or IPO. A SAFE will likely contain either or both a conversion discount and valuation cap, but like a convertible note, whether or not these are present will be a result of negotiations between the issuer and holder. Similar to convertible notes, SAFEs are not equity, but unlike convertible notes, SAFEs are not debt. A SAFE will not accrue interest, and it will have no maturity date upon which the issuer has to repay the investment.
How does a SAFE address issues presented by convertible notes?
The fact that a SAFE is not a debt obligation addresses the primary risk of a convertible note. Without a debt obligation to potentially repay, issuers of SAFEs don’t have to worry about the potential insolvency presented by a maturing convertible note. The investment connected to a SAFE will also not accrue interest, which in connection with a convertible note, increases over time the amount of equity a holder will receive. By addressing these issues for issuing companies, SAFEs may also benefit holders. Without interest accruing over the life of the SAFE, as it would with a convertible note, issuers may be more likely to agree to conversion discounts and valuation caps that are more favorable than a holder could obtain with a convertible note.
Is there a downside to issuing SAFEs?
Although SAFEs address a lot of issues presented by equity and convertible notes, they do have their own downside. Without a maturity date, there is no guarantee a SAFE will ever convert or pay out like a convertible note. This uncertainty can deter investors. SAFEs are also relatively new and mostly used in the technology and start-up space in Silicon Valley. While the use of SAFEs is growing outside of the West Coast, they are still not extraordinarily common, and investors may not be comfortable using them. If investors are uncomfortable purchasing SAFEs, then it will be difficult for an issuing company to raise capital offering them. Issuers may see conversion discounts and valuation caps as a downside of SAFEs and convertible notes, and if an issuer finds those provisions objectionable, maybe a traditional equity round is the way to go for their financing. Otherwise, investors have come to view conversion discounts and valuation caps as the price issuers pay to investors for taking the risk of investing early on and delaying their status as equity holders.
There are many ways for early-stage companies to raise capital. Convertible notes and SAFEs are two almost limitlessly flexible alternatives to a traditional equity offering that allow issuing companies delay a valuation and founders to temporarily maintain their control of the company. No one option for raising capital is right for every company, or even every round of financing for the same company, so take the time to consider what goals you want to accomplish for your company prior to each offering and consult an attorney to guide your company through the process.
DISCLAIMER: This article is prepared by lawyers, so of course there is a disclaimer. The above is not legal advice and is presented for information purposes only. No attorney-client relationship is formed until you formally engage us as your attorneys in writing.