Convertible Note, a form of financing

Convertible Notes have played a significant role in Venture Capital during the past years.

Before joining the venture capital ecosystem, I had worked with several other financing documents such as loans, promissory notes, and project financing agreements. When you start in venture capital, you are likely to think all the documentation surrounding this environment is less sophisticated, but let me tell you that this is not the case. In my experience, within this ecosystem there are plenty of highly-developed entrepreneurs and lawyers, even more prepared than those around Private Equity major Project finance transactions (fun, right?). Every financing transaction has its own complexities behind it,  whether it is a convertible note, a SAFE, or an equity series financing; and the complexities are not only on legal terms but in the financials, as well. 

With this in mind, I decided to share with you some of my day-to-day experiences as an In-House Counsel for a venture capital fund. I want to contribute with some of the insights, stories, and hopefully, tips that can better guide you in your day-to-day life as a new entrepreneur in these shark-infested waters or as a new lawyer (like me) in this amazing ecosystem.

These first lines are going to be about Convertible Notes, but first I want to tell a short story that I will be using as an example for a better explanation:

On my third day working in a venture capital firm (coming from law firms where lawyers are very protected by their partners, or I had some pretty good ones!); My boss asked me: Luisa, please prepare a hybrid of 1.5 million over a 30-million valuation. I said: Ok! (I thought: I can do this). Immediately, I googled it: hybrid… Sample (please Google it: more than 30 million results with just numbers and calculators; it blew my mind)... I left my ego behind and asked for details around what kind of hybrid (instead of what the f… is a hybrid) and then the magical answer: he said: a Convertible Note, that will convert in the next round of at least 5 million at a 30 million valuation or 20% discount (known as qualified financing rounds or “QFR”)...  Pufffff O.K.!

Convertible notes are a form of debt taken by a company during funding, designed to convert into equity upon the subsequent sale of preferred stocks in excess of a certain threshold known as QFR. (In the above example, QFR is the sale of more than 5 million of preferred stock).

While convertible notes are very common during seed funding (converting at the Series A financing round), I’ve seen these hybrids in Series A, B, and even C. So, basically, this gives the Company a little bit of runway while the closing of the next financing round occurs.

Through these notes, a company promises to pay the Investor a certain amount (called  “principal amount”) plus accrued interests on or after the maturity date. Although the “real” promise is to pay the principal amount plus interests, that is not the real motivation. As mentioned before these documents are designed to be converted into equity, so the real motivation is actually to be paid that amount in stocks. Ironic, right? The real deal is more like: “I give you money now, in exchange for a discount on the price per share in your next financing round”. 

In this sense, in the event the company issues shares (usually preferred stocks) to investors in a financing round before the maturity date (which is usually the case) or while such note remains outstanding, the Investor has the right to convert (principal amount plus interests) at the lesser of: (i) same price per share of such financing round with a discount percentage (usually between 15-30%, ”discount”) or (ii) company’s valuation divided by the number of shares representing a fully diluted capitalization of the Company prior to the conversion, “cap”.  

The attractiveness of the notes is that Investors may convert at a cap or a discount. Without cap or discount, investors will convert at the same price as the preferred stock issued in the QFR, in which case Investors are not receiving anything in exchange for their risk in such investment. 

So, if the real deal is that the note will be converted into securities at the company’s next financing round, what happens to the Investor if such financing does not occur? At the Investor’s request, the note would become due and payable. Alternatively, the Investor may hold the note until the company’s valuation is reasonable or attractive to convert.

Two important things to take into consideration when drafting or negotiating a Convertible Note are: 

• First, carefully analyze and understand the difference between the Company's valuation cap vs discount. Valuation is intended to ensure that investors do not miss any appreciation between the execution of the notes and the QFR. So, 1.5 million converted at a cap of 30 million (considering that fully diluted capitalization of the Company is 1 million) convertible notes will be converted into 50,000 preferred stocks (5% ownership). 

On the other hand, if the notes are issued with 20% discount (and the QFR is 35 million) the convertible notes would be converted into significantly more preferred stocks (increasing your ownership percentage). This tiny difference may be significant to both: investors and founders, so pay attention to terms of your note, and do the math.

In addition, a company's valuation may not only affect the company’s price per share to be paid by Investors, but may also help (or not) in your financing round. Although the shares are not issued, negotiations with other investors may turn hostile if your company is overpriced. To mitigate this, Investors like to push a “most favored nation” clause which guarantees better terms than those negotiated in the convertible note if the company agrees to them afterwards.

• Second, analyze the percentage (%) required to become a Requisite Holder or Majority Holder. Generally, a note is one of several notes issued by the company during a certain period and for a certain amount. Note holders representing a certain percentage of the aggregate amount of all notes (generally, between 60% and 70%) become “Requisite Holders”. Requisite Holders have the power to change certain previously-negotiated terms (yes, maybe previously negotiated by you!). For example, they can change the previously agreed amount of the QFR (in the example mentioned above, to convert in an equity financing of less than 10 million), or give their consent for the Company to prepay the Note prior to the Maturity Date. It is important to understand and validate if you (as Investor) would be within such a majority threshold or not, just be aware of it. A conversion with a significant low valuation will affect your investment’s return.

You should also review the representations and warranties, conversion scenarios, Event of Default definitions, among others. Also, you have to carefully consider financial matters to avoid a headache in the future and attract more investors! 

I hope this sheds a little more light on convertible notes for you! If you want to share some additional tips with me and/or want to connect, please follow me at www.linkedin.com/in/luisaarnalmachado. I will share some lines around new topics every month.