There are three common types of investment structures: Convertible Notes, Convertible Equity, and Priced Rounds.
Convertible notes are short-term debt that convert into equity. Put simply, investors can provide a first round of funding, before the company issues preferred stock, and then, once preferred stock financing occurs, the investor gets shares of that stock rather than the typical loan return, which is principal plus interest.
Startups use convertible notes because it allows them to postpone valuation of the company — before stock is issued, decisions about the company’s overall value do not have to be made, and the founders don’t need to determine what percentage of the company a small investment is worth. Instead, they can take the money and provide the promise that stock equivalent to the value specified in the note will be provided once that stock has been issued. The decision of whether that amount will be 1% of the company, 2% of the company, 10% of the company, or more, is postponed until a later financing round.
The other advantage is simplicity. Preferred stock takes time — and legal fees — to negotiate the specifics of. Convertible notes have relatively standard terms and shorter documents, usually as simple as a short promissory note.
There are a few industry standard terms to be aware of when dealing with convertible notes:
Discount. How investors are rewarded for their risk, in terms of the reduced price percentage they will receive for their stock as compared to Series A investors. A discount of, say, 30%, means that they will pay 30% less per share than the price of the Series A stock.
Note Valuation Caps. Another way investors are rewarded for their risk, a cap puts a ceiling on the company’s value at the Series A round, potentially providing an even lower price per share than the discount would. Note that standard language typically states that the investor gets to apply the cap or the discount, whichever leads to a lower per share price, and not both the cap and the discount. It is also important to remember that a note cap is not a valuation — it is merely a maximum valuation for purposes of conversion. The company can end up valued at a price far less than the note cap (in which case the cap is irrelevant), or far greater (in which case the cap provides a large discount to the investors), but the cap amount does not drive the valuation figure. To illustrate:
A. A startup issues $500K of convertible notes with a 20% discount, no cap and later raises a Series A at a $10 million post-money valuation. Assume the startup has 10 million shares so each share is worth $1. The discount means that the early-stage investors will receive equity at a price of $0.80/share and end up with 6.25% of the company (625K shares/10 million shares).
B. Same scenario, but the startup issues notes with a 20% discount and a $5 million note cap. At the time of the Series A, rather than using the $10 million valuation to calculate the early-stage investors’ ownership stake, we’ll use the $5 million note cap (the cap and discount are either/or: the investors get whichever is more favorable). Thus, the early-stage investors will now own $500K/$5 million, or 10% of the company (equal to 1,000,000 shares at $1/each).
Term. Convertible debt is issued with a maturity date when the term is complete. However, convertible notes have came to be seen as “near-equity” in the minds of investors:
– Investors almost always expect to receive shares some day, not return of principal or periodic interest payments; as such, if conversion has not occurred by the maturity date then agreements are often re-negotiated
– No one expects repayment of convertible notes and forced repayment, even if a company never gets to its conversion milestone, is rare
Automatic Conversion Trigger. The automatic conversion trigger indicates when the debt will be converted to stock. It is typically when $1.5-2 million or more of equity capital is raised, which for most companies is Series A. At this point, stock will be issued and the debt will be converted over.
Convertible equity takes convertible notes to the next level, removing the maturity date and the interest, and thus the risk to the startup that it will have to repay these earliest investors if the financing round is not completed in time and stock is not issued. Convertible equity is simply the promise to receive equity later in exchange for an investment now.
Y Combinator and 500 Startups have both released standard terms for convertible equity, known as KISS (500 Startups) and SAFE (Y Combinator). Both are intended to replace convertible debt with a simple agreement that eliminates the problem of later investors diluting the earlier ones — both provide a most favored nation clause that evens things out among all investors at this stage. Thus, if a future investor gets more favorable terms, such as a lower note cap, then all previous investors have the right to redraw their documents at the lower note cap. Therefore, investors always get the best deal regardless of when they choose to invest. The flip side, it eliminates an entrepreneur’s ability to offer strategic or larger investors better terms.
SAFE was released in December 2013. KISS is slightly more recent, released in July 2014 in order to prevent smaller investors from ending up with unfair deal terms. Notably, KISS offers any investor who invests $50,000 or more the guaranteed right to participate in future rounds.
The major differences between these forms and convertible notes is that the KISS and SAFE documents tend to be more investor friendly whereas most convertible note documents are balanced.
Finally, in a priced round, participating investors and the startup first negotiate the company valuation, or price at which the startup will sell shares to investors. Investors then purchase some number of shares, usually preferred stock that provides certain rights and protections greater than those offered to common stockholders. A typical early-stage round often results in investors owning 10-30% of the startup.
Of the three investment structures, priced rounds are the most challenging to execute in large part due to the need to negotiate valuation. As such, there are usually certain milestones that are met before a company launches a priced round — the completion or delivery of the product, a landmark sale, quarter-over-quarter growth, or other milestones that can help predict the startup’s projected path.
As noted, the prime advantages of convertible notes over priced rounds are 1) they avoid the need to negotiate valuation of the company and 2) the note purchase agreement is considerably simpler and easier to understand than the standard stock purchase agreement.