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Updated August 29, 2023You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
Sometimes notes will specify what happens in the event the company defaults on the note. Most of the time the primary default is the non-payment of the note on the maturity date. Higher interest rates in the event of default are not common.
It is not uncommon for a note to require that before an action is taken against a company to enforce the terms of the note, the holders of a majority in principal amount of the notes approve the action, rather than just one note holder. Sometimes the majority required is a supermajority, set at something like 70%, to ensure that a large minority investor has a veto right on any amendments.
exampleIf there are eight investors, three who put in $100K and five who put in $50K, there are $550K of notes outstanding. Holders of notes with principal amounts aggregating more than $275K can, with the company’s consent, amend the note.
When you say that a loan is secured by the company’s assets, what you mean is that the company will grant the lender a security interest in its assets, which the lender may perfect.* A security interest is a direct interest in the assets of a company that the borrower grants to the lender. If the lender has a security interest in the company’s assets, the lender can perfect its security interest by filing a financing statement (typically, a UCC-1) to ensure that subsequent creditors are behind it in line with respect to payment from proceeds of a sale of the assets. Once the lender does this, they have priority over subsequent creditors. A secured party can take action to seize the collateral and dispose of it in the event of a default on the loan.
Secured notes are not typical in angel financings. There are a few reasons why angels rounds are rarely secured:
First, many angel rounds are pretty small financings and people do not want to take the additional time and hassle to put a security agreement in place.
Many early-stage companies do not have a lot in the way of assets to secure.
The investors frequently feel more like equity investors than debt investors in these transactions.
All parties involved in the early stages typically want to make sure that the company does not have any legal impediments to raising its next round of financing (such as having to subordinate the angel debt to a bank loan).
Secured debt adds a layer of complexity. Not having secured debt removes a layer of complexity.
But that does not mean that your note should necessarily not be secured, just that it is not a very common practice and might be viewed as aggressive by founders. If you decide you do want a secured note, make sure you consult with legal counsel to ensure that the “grant” of the security interest is adequate under the law of the jurisdiction governing the note, and that you file a Uniform Commercial Code financing statement perfecting your security interest.
founder One issue that comes up with convertible notes is that it is possible, depending on how a note is drafted, for note holders to receive shares with a liquidation preference per share greater than the amount of their actual cash investment per share. This happens when the note converts at a discount or valuation cap and no special allowance in the note is made to address this issue.
Liquidation preference overhang refers to how you might, if you invest in a convertible note or convertible equity instrument with a valuation cap or a discount (or both), ultimately might receive shares of preferred stock with a liquidation preference in excess of what you paid.
For example, if you invested $100K in a convertible note with a 20% discount on conversion. If the company ultimately sold preferred stock for $1 a share, you would buy your shares for $0.80, but you might receive shares with a liquidation preference per share of $1. Sometimes notes and convertible equity instruments are set up so that you don’t receive shares with a liquidation preference in excess of what you paid, or you receive common stock to make up the difference in the number of shares you are supposed to receive. So, instead of receiving that number of shares of preferred stock equal to $100K/$0.80 per share, in this example, or 125K shares of preferred stock, you would receive 100K shares of preferred (so that your liquidation preference matches the amount you invested, ignoring interest for the sake of this example), and you would receive 25K shares of common stock.
Another way to handle this is for the company to create two classes of preferred stock, one with a liquidation preference per share equal to $0.80 and one for $1 per share, and then issue you the $0.80 liquidation preference per share shares (and all the other terms of the preferred stock would be the same).
This problem can become especially acute when there is a valuation cap, and the cap comes into play. A note investor may receive a significant amount of liquidation preferences beyond what they invested in the convertible notes.
founder Founders may think this is problematic. Some investors think it is unfair to founders. It is not really a problem for the investors, except to the extent that the founders and other investors think it is unfair.
One solution is to have the discount shares convert into common stock. Another possibility is to have the debt convert to a series of preferred stock whose liquidation preference matches the amount of capital actually invested, but otherwise has the same rights, preferences, and privileges sold in the round. This is becoming more common and is the standard set by Y Combinator in the SAFE.
If a company is going to issue shares to you at the valuation cap, you will want to know how the number of shares will be determined. Will the number of shares be determined on a fully diluted basis or on some different measure? It is typical to exclude the debt being converted.
Some convertible notes are written this way:
⚖️legaleseThe price equal to the quotient of [the Valuation Cap] divided by the aggregate number of outstanding shares of the Company’s Common Stock as of immediately prior to the initial closing of the Qualified Financing (assuming full conversion or exercise of all convertible and exercisable securities then outstanding other than the Notes)…
Note that the “then outstanding” language implies that you are not going to count the entire stock option pool—you are only going to count options that have been issued to workers and that are still in the hands of workers at the time of conversion. Other notes might say “including the Company’s shares reserved for future issuance under the Company’s equity incentive plans,” meaning the issued options and the available option pool.
importantFrom an investor’s perspective, you want clarity on what is going to be counted in determining your price per share—you don’t want the note to be silent on this point. You would prefer the entire available option pool plus all outstanding options be counted in the denominator. The text below provides an example of including the option pool under the definition of “Fully Diluted Capitalization.”
⚖️legaleseIn the event the Company consummates, prior to the Maturity Date, a Qualified Equity Financing, then the Principal Balance will automatically convert into shares of capital stock of the Company at a price per share equal to either: (i) the “Preferred Purchase Price”: the price per share of preferred stock sold in the Qualified Equity Financing (notice no discount here) or (ii) the “Target Price”: the price obtained by dividing the Target Valuation (where the “Target Price” is the Valuation Cap) by the Fully Diluted Capitalization (defined below). The lower of the Preferred Purchase Price and the Target Price is the “Conversion Price.”
“Fully Diluted Capitalization” means the sum of (i) all shares of the Company’s capital stock (on an as-converted basis) issued and outstanding, assuming exercise or conversion of all options, warrants and other convertible securities (other than this Note and Other Debt) and (ii) except with respect to conversions of this Note in connection with a Change of Control, all shares of the Company’s common stock reserved and available for future grant under any equity incentive or similar plan of the Company.
It is better for the note holder to count the whole stock option plan share reserve. Notice this is done in the above example but not in the event of sale of the company where it wouldn’t make sense in any event (because unused pool shares are disregarded in a company sale, just like authorized but unissued shares).
The details of dilution and ownership calculation, as well as valuations, are discussed in Part IV.
A most-favored nations clause (or MFN clause or MFN) is a clause in a convertible note or convertible equity purchase agreement (or side letter agreement) that provides that the holder of the security is entitled to the benefit of any more favorable provisions the company offers to later investors. If you are an early investor in a convertible note round, an MFN clause can be a very good idea.
The reason MFNs exist in convertible debt and convertible equity is that these investment instruments are often sold to individual investors over a period of time. If you make an early investment via a convertible note, you are taking more risk than someone who comes in later, and you want to make sure they don’t get better terms. A most-favored nations clause in a note or side letter agreement might look like this:
⚖️legaleseThe company hereby agrees that if it offers any subsequent investors convertible-note terms that are more favorable to the subsequent investor than the terms included herein, the company will provide the holder of this instrument with those more favorable terms.
Here’s the most-favored nations clause included in Y Combinator’s SAFE documents, which more clearly addresses the mechanics:
⚖️legaleseMFN Amendment Provision. If the Company issues any Subsequent Convertible Securities prior to the termination of this instrument, the Company will promptly provide the Investor with written notice thereof, together with a copy of all documentation relating to such Subsequent Convertible Securities and, upon written request of the Investor, any additional information related to such Subsequent Convertible Securities as may be reasonably requested by the Investor. In the event the Investor determines that the terms of the Subsequent Convertible Securities are preferable to the terms of this instrument, the Investor will notify the Company in writing. Promptly after receipt of such written notice from the Investor, the Company agrees to amend and restate this SAFE to be identical to the instruments evidencing the Subsequent Convertible Securities.
exampleYou want a 20% discount on a convertible note because you are the first investor. The entrepreneur resists going past 15%. To get the deal done, you agree to 15% but you add an MFN, so that if the entrepreneur grants a higher discount to any later convertible note investors you also get that higher rate.
Although convertible notes don’t typically contain pro rata rights (which are typically handled on the company’s first fixed-price financing), this is definitely something you can ask for. For an example of pro rata rights language, see Y Combinator’s pro rata side letter.
important When negotiating a convertible note financing, focus on the following elements of the term sheet:
What is the valuation cap?
What is the conversion discount? (10% to 20% typically.)