At a recent startup talk I gave, most of the questions were asked in terms and structure of convertible notes and how they affect a founder’s economics. Therefore it would be useful to outline the key terms for it.
A convertible note is a flexible alternative while issuing investor’s equity but can often be misused or misunderstood leading to excessive dilution of founder’s equity stake or structural issues which complicate future fund-raising.
This is not an exhaustive explanation of notes and assumes some basic knowledge of notes – SeedInvest is a good starting place for this.
Why a note instead of an equity ?
Before diving into the terms of notes, it’s appropriate to ask why use a note instead of equity in the first place.
The main reasons are convenience, speed and cost. A shareholders agreement for an equity round typically runs 40-50 pages and whilst many terms are standard, each needs to be considered and negotiated which usually takes 2-6 weeks and legal costs are rarely under US$10,000 and can be US$50,000 even for a seed round.
A note, by contrast, can be concluded within a week and with limited legal expenses.
What is a note?
The first generation of notes were modified from convertible bond documentation from the world of banking and were ill-suited for startups raising equity.
Terms such as an interest rate did not make much sense for equity rounds and the lack of standardisation was a big source of confusion.
These notes are still being presented to founders (the inclusion of an interest rate term is usually a tell-tale sign) and it is always better to reject them in favour of standardised notes.
This changed in 2013 when YCombinator introduced the SAFE note with streamlined, standard terms focused on fundraising for early-stage companies. 500 startups followed with their KISS note, and in 2018 YC updated their SAFE with major changes such as a post-money valuation and no pro-rate (see below).
It is always recommended to use a SAFE or KISS note which can usually be modified to address any reasonable issue an investor has.
The cap is definitely the most important term in a convertible note. Uncapped notes mean the investor only receives the discount on the upcoming equity round – if that round is not concluded shortly the investor will almost always overpay for their shares.
The one circumstance where uncapped notes is seen is when the note is a bridge to the next equity round which is anticipated within a few months.
In this circumstance, the founder wants flexibility in negotiating the valuation of the equity round and does not want a note with a cap (which is essentially a valuation) that is a recent benchmark valuation.
In this circumstance a larger discount is reasonable (20-25 per cent) and a cap which becomes effective if the equity round is not concluded within a reasonable timeframe (6-12 months).
Founders usually understand the cap but the discount can cause some confusion.
The discount is only used if the valuation of the next equity round less the discount is below the cap. For example, on a note with a cap of US$5 million and a 20 percent discount, the discount will be disregarded if the next equity round is over US$6.25 million (US$5 million / US$0.8).
Therefore if the valuation at the next equity round is US$9 million then the discount is ignored and the investor will receive shares based on a US$5 million valuation (the cap), however, if the next round is US$4 million, the investor will receive shares based on a US$3.2 million valuation (US$4 million x US$0.8).
The important thing from a founder (and investor’s) perspective is that a discount essentially provides full protection from a ‘down-round’ which is a very investor-friendly term and will cause additional dilution to founders if they fail to grow their valuation.
Standard terms are for a 20 per cent discount but we feel anything from 10-20 per cent is reasonable.
Maturity / repayment
A maturity date allows the note holder to force the conversion into shares after a given date.
This term is often omitted from notes (for example, the standard SAFE note does not contain a maturity date), however we always insist on this being included.
The risk to an investor in a note with no maturity date is that the startup becomes self-financing before having to raise an equity round and therefore does not raise equity.
In this circumstance, the notes never convert and the noteholders never receive equity and thus have no way to monetise the investment (such as selling shares or receiving dividends).
Founders should be aware that the maturity date can sometimes be accompanied by a repayment clause, meaning that on the maturity date the note holder has the right to convert the note to equity or receive their investment back.
They should always resist a repayment clause as it can give the note holder a lot of leverage if the company is struggling with cashflow and would not be able to make the repayment.
Pre-money vs Post-money caps
This is now a major difference between the various flavours of notes – the original SAFE and KISS notes have pre-money caps whereas the 2018 SAFE note has a post-money cap.
Post-money caps give the noteholders more equity for a given cap and hence dilute the founders more. For example, a for $500k investment on a note with a US$5 million post-money cap will convert to a 10 per cent equity stake for the note holder, whereas a pre-money cap would convert to a 9.1 per cent equity stake (US$500,000 / US$5.5 million).
Thus the post-money cap has meant an additional 0.9 per cent equity dilution for the existing shareholders.
This example illustrates the limited impact of post vs pre-money caps when the investment amount is small. However, the impact becomes magnified when the investment amount is higher – if the investment amount in the above example is US$1.5M the difference between pre and post caps is seven per cent.
Founders also need to be aware that the 2018 SAFE is not only post-money but the noteholders are insulated from any dilution caused by subsequent notes.
Thus, in a scenario where the founders are raising multiple rounds of notes, all of the dilution is borne by the existing shareholders. For this reason, founders using the 2018 SAFE should not be using the notes to raise multiple rounds or for large investment amounts.
Pro-rata rights allow investors to maintain their equity stake by investing in later rounds.
Pro-rata rights are extremely important to investors as the ability to continue investing in successful companies is essential for generating high returns so investors will often insist on these be included in the note terms (standard KISS and SAFE notes contain pro-rata rights by default whereas the 2018 SAFE omits the pro-rata rights needs to be added via a side-letter agreement).
In reality, even if pro-rata rights are given they will usually need to be re-negotiated at later rounds since Series A and B investors often want to be allocated the entire round when investing in a high-growth company.
Most favoured nation (MFN)
This clause means that the noteholders can avail of any favourable terms in notes issued at a later date.
For example, if notes issued at a later date contain a lower cap, or a special provisions such as a board seat the holders of notes with an MFN clause can also take advantage of the new terms.
MFNs are not a common term and we only ask for this term to be inserted when there is a lot of uncertainty or disagreement regarding the valuation of the business.
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