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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.
Common provisions of a convertible debt financing include:
The interest rate. Usually somewhere between 4% and 8%.
The maturity date. Usually 12–24 months.
A mandatory conversion paragraph. Specifies the minimum size of the round that the company must close in the future (a qualified financing) to cause the debt to automatically convert into equity of the company.
An optional conversion paragraph. Gives the investors the option to convert into whatever equity securities are sold by the company in its next financing, even if the financing does not meet the definition of a qualified financing (a non-qualified financing). This term is both common and recommended.
A change of control provision. Addressing what happens if the company is sold before the note converts (highly recommended).
A conversion discount. Specifies a discount note holders receive relative to the equity price in the qualified financing (common but optional).
A valuation cap. Specifies the maximum pre-investment value that will be used to convert the note into equity in the qualified financing (common but optional).
An amendment provision. Entitles the company, typically with only the consent of holders of the majority in principal amount of the notes, to amend the terms of the notes.
No prepayment. Notes typically say that the note cannot be prepaid without the consent of either the holders or holders of a majority in principal amount of the outstanding notes.
An attorneys’ fees clause. Entitles the holder to repayment of its fees if it sues to enforce the terms of the note.
confusion Note that while the interest and maturity date only apply to convertible debt, the rest of the terms here can be found in a convertible equity financing, which we’ll cover next.
Interest on a convertible note is not typically paid in cash while the note is outstanding. Most typically, it accumulates and is paid in stock on conversion. However, sometimes note holders negotiate for the right on conversion to have the interest paid in cash. Interest rates on convertible notes typically range from 4%-8%. Startups are very high risk, and the rate of interest typically would not adequately compensate an investor for that risk relative to alternatives; so it is best to think of the interest as a sweetener to the deal, since the main reason for buying the note is to end up with the equity when it converts.
caution You should know that even if the interest on the note is paid in stock, it is taxable to you as if paid in cash. In fact, you might be taxed on interest before it is paid in stock—in other words, you may be put on the accrual method of accounting for income taxes when it comes to the interest component of your note (and be taxed even if you haven’t received anything yet). We address tax issues in detail in Part V.
The maturity of the note—the length of time before it is due—typically ranges from 12–24 months. It is common that startups take longer to achieve their milestones then they or you expect. A shorter maturity date (12 months) is a ticking clock that might pressure an entrepreneur to raise money on unfavorable terms.
If progress is slow, startups may extend the note. This is quite common—in fact, this is one of the common uses of an amendment provision. In this case, the maturity of the note would be extended with the consent of a majority of the existing note holders.
Sometimes a company will try to negotiate for the note to not come due until after the stated maturity date holders of a majority of the principal amount of the notes demand payment. This is a helpful provision for companies, because they do not have to worry about one small note holder demanding payment in cash at the maturity date. It is also a helpful provision if you are in the majority, because you can control the demands of minor note holders as well.
Convertible notes usually automatically convert to stock when the company raises money in what is typically defined as a qualified financing.
A qualified financing in a convertible note is usually defined as a fundraising of at least a fixed amount of money (for example, $1M), either including or excluding amounts raised under the note. These criteria cause the note to automatically convert into the type and number of shares being sold in the qualified financing. There are subtleties to how a qualified financing is defined.
A non-qualified financing is a financing that does not meet the definition of a qualified financing in your note, and thus does not cause your note to be automatically converted into shares of stock sold in the financing.
Here is an example of a definition of a qualified financing:*
⚖️legaleseIn the event that the Company issues and sells shares of its Equity Securities to investors (the “Investors”) on or before the date of the repayment in full of this Note in an equity financing resulting in gross proceeds to the Company of at least $__________ (including the conversion of the Notes and other debt) (a “Qualified Financing”), then…
You want to be sure the financing is a “real” financing and not a financing of some small amount by the founders to simply convert your debt to equity. You also want to make sure that there is going to be enough new money coming in to give the company the runway it needs. This is why the amount is usually on the order of at least $500K or more. The definition can be written to include the money previously raised on the convertible notes or not, but usually excludes amounts raised in convertible debt.
You may also negotiate whether the qualified financing is only triggered on the sale of preferred stock or whether the common stock financing could trigger the auto-conversion on a qualified financing as well. Many investors prefer that their notes expressly say that a qualified financing has to be a preferred stock financing.
Optional conversion clauses address the ability for the investors to convert their notes under scenarios that do not meet the qualified financing definition. For example, an optional conversion clause can be written to allow the investor to convert if the company raises money in a fixed-price financing at attractive terms, but not enough to trigger automatic conversion under the qualified financing definition.
Another optional conversion scenario is the company does not raise any money before the notes mature. In that situation, if you do not want to extend the note, you might want the right to convert into common stock or a predetermined series of preferred stock at a pre-agreed valuation.
To break it down, there are three different moving parts that can be specified in optional conversion paragraphs:
At whose option does the conversion happen? Typically the investors have the right to invoke the optional conversion, and it is what you want as an investor. The founders will not want conversion at the option of the investor in the absence of a qualified financing until the company passes the maturity date. They might also want a clause giving them the right to invoke the optional conversion, but this is not a typical formulation.
At what value? If the company consummates an equity financing that does not constitute a qualified financing, an optional conversion clause can stipulate that the note holders have the option to convert at the price per share or at a discount to the price at which shares are sold in that financing (this is fairly common). Another possibility is that the clause includes the valuation cap and stipulates that the conversion price is the better of a predetermined discount to a non-qualified financing or the price determined by the valuation cap.
Into what type of security do the notes convert? Some optional conversion clauses say that in the absence of a qualified financing the note will convert into a series of default preferred stock. Alternatively, the note could convert into common stock.
What if the note does not specify an optional conversion? If the convertible note does not specify an optional conversion in the event the company does not achieve a qualified financing, there is a risk to the company that the investors may make a demand that their notes be repaid in full. It also means that the parties may just have to meet and hash out a negotiated compromise. Negotiating changes to the note when things are not going well and the company is trying to secure additional funds can take up a lot of the CEO’s time, and it may jeopardize or delay the future funding due to the uncertainty. At a minimum, it is important that the notes contain a provision that they can be amended with the consent of a majority of the note holders, as we discuss below.
A convertible note should address what happens if the company is sold before the note converts to equity. Typically, this is addressed through a provision that states that if the company is sold before the debt converts into equity, the note holders get something more than just their principal and interest back (that would be a bad deal). Typically, they are entitled to the greater of some multiple on their principal and interest (for example, 2X or 3X), or a greater amount as if they had converted at the valuation cap or another value specified in the note.
A valuation cap is a term included in a convertible note that sets the maximum valuation of a company at which an investor’s note can be converted into stock of the company. An angel investor will typically want a valuation cap in a convertible note so that they are not converted at an unexpectedly high valuation.
exampleAn investor makes an investment of $50K in a convertible note with no valuation cap. The terms of the note state that the note will be automatically converted into equity of the company once the company raises $1M in equity in a fixed price financing (a qualified financing). The company raises $1M in a qualified financing at a $100M valuation. Without a valuation cap, the investor’s stock would convert at the $100M valuation. The investor believes that the increased valuation was attributable in part to their investment. However, the investor does not share in the valuation increase between the time of her investment and the subsequent round at the $100M valuation because there was no valuation cap when the investment was made.
But assume there had been a valuation cap of $5M. In that case, the investor’s note would have converted at a much better price per share and the investor would have gotten more shares and not been so heavily diluted.
Let’s do the math. Assume there had been 3M shares outstanding, and no warrants, options, or any other convertible securities outstanding except the notes. The price per share at the cap would have been $5M divided by 3M shares, or $1.66 a share, and the investor would have received $50K divided by $1.66 a share, or 30,120 shares, excluding interest. At a $100M valuation the price per share would have been $33.33 a share, and the investor would have received $50K divided by $33.33 a share, or 1,500 shares, a stark and dramatic difference.
While this is an extreme example, you can see that valuation caps can be very important.
founder There are two schools of thought on what an ideal valuation cap should be:
The first—let’s call it the “Investor’s School of Thought”—says that the cap should be the current fair market value of the company. In other words, the cap should be the valuation that you would place on the company at the time of the investment, as if you were doing a priced round.
The second school of thought—let’s call it the “Founder’s School of Thought”—says the cap should be the outside range of potential values for the company. Ultimately, this is a philosophical question for which there is no precise answer.
A conversion discount provides that the holder of the note gets a purchase price discount when the note is converted into stock. Typically, the discount is 10%-20%, but discounts higher than that are not out of the question.
exampleThe note might say that upon conversion in a qualified financing, the note will convert at a price per share equal to 75% of the price per share at which shares are sold in the offering (meaning, a 25% discount). If in the qualified financing round, shares were priced at $1, you would be getting them at $0.75; so your $25K investment in the note would result in your owning 33,333 shares rather than 25K shares.
Conversion discounts are very common in convertible notes. It is a term that you should always look for when you are reviewing a convertible note offering. However, not all convertible notes provide discounts. For example, at one time companies graduating from Y Combinator were issuing notes with no cap, no discount, and no interest rate. Of course, these are exceptional circumstances and very founder-friendly.
important If a note has both a cap and a discount, the note should read that you get the better of the two conversion possibilities. If you would get more shares at the discounted price, then you would get the discounted price. If you would get more shares at the valuation cap price, then you will convert at the valuation cap price.
Amendment provisions exist so that the investors and the startup can adjust the terms of their relationship as conditions change. It may be that a non-qualified financing opportunity comes along and the note holders want to convert. If this is not specifically addressed in other clauses within the note, the note could be amended to allow the investors to take that action. It is also possible that the lead investor in the upcoming priced round does not like some term in the note and wants to negotiate that with the note holders. The note investors may be willing to do that to get a deal to close on otherwise favorable terms.
Generally, notes are amendable with the consent of the company and holders of a majority in interest of the notes. This prevents any single investor from holding up progress of the company. Most of the time, these amendment provisions do not specify a supermajority requirement to amend. Similarly, most of the time the amendment provisions do not say anything special about minority rights—such as a provision that an amendment cannot treat a single note holder differently from other holders of the same note (although if you can ask for this you should). The only scenario in which this could be problematic is if a majority of the convertible notes are owned by someone or some entity, such as a strategic investor, with a different set of goals than yours.
Your note should contain an attorneys’ fees clause, entitling you to an award of attorneys’ fees if you have to sue to enforce the terms of the note. (There is sometimes a separate provision in which the company agrees to reimburse the investor their attorneys’ fees, usually capped.)
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.