Thursday, August 30, 2012

Convertible Promissory Notes: Investor’s Perspective

Unlike venture capitalists, who commonly dictate their own terms and present their own term sheet, angel investors are typically on the receiving end of a term sheet from the company in which they have expressed an interest. Sometimes even, there is no term sheet and the angel investor is presented directly with transaction document(s) (e.g., a convertible promissory note or a convertible promissory note and note purchase agreement).

Of course, as you will hear me repeat again and again, I would discourage anyone from making an investment without the help of legal counsel in navigating the negotiation and review of the documentation for it. Attorneys that specialize in financing work will be able to point out underwater rocks and provide invaluable negotiation advice. In this post, we’ll discuss five points that you should pay attention to in your transaction documents:

  • Preferred Preferences and Privileges. When purchasing a note, you are postponing the negotiation of the rights, preferences and privileges of the shares of preferred stock into which your note will convert and deferring it to investors who come after you. This saves everyone time and money and allows a bridge financing to be completed in short order using just a few short documents. However, that also means that you, as a bridge investor, have to be comfortable that you are leaving the negotiation of your rights in good hands. The typical way to control this is by setting the amount which must be raised by the company in its “Qualified Financing” high enough that the investors in such Qualified Financing will be serious market players, most likely venture capitalists. On the other hand, the threshold should not be so high, that your note never converts. Striking a healthy balance is key. (Mechanics of note conversion are covered in detail in another post.)

  • Maturity. As a debt instrument, a note should always specify a maturity date—in other words, a final date by which the note must be repaid. The probability is high that, if there has not been a Qualified Financing forcing conversion of the note prior to the maturity date, on maturity the company will not have the necessary funds to repay the note. I recommend a contingency plan, which provides that if there has not been a Qualified Financing prior to maturity, on maturity the note converts into [fill in the blank] based on a [fill in the blank] formula. For instance, the note can convert into common stock, such that the note holder holds 55% of all common stock and takes over the company. That’s aggressive and really only works with one larger investor, but I’ve seen it done (by east coast investors). Or, more typically, the note can convert into preferred stock with a pre-negotiated (and likely punitive) valuation. The conversion can be automatic or at the discretion of the investor. There are many ways that a contingency plan can be structured, but I do believe it wise to negotiate this up-front, rather than waiting for the note to mature and for the company to default on repayment.

  • Amendment of the Note. You should know and care about who can amend the terms of your note. Will your consent be required, or will a “majority-in-interest” of the notes (which you may not control) be able to approve amendments? If only a majority-in-interest is required, is there a provision that protects you as a minority holder against changes which impact you in an adverse and disparate manner from the other note holders? Relatedly, what other decisions can be made by a majority-in-interest? Finally, are you able to determine, based on the information provided to you, whether you will control a majority-in-interest vote and if not, which investors or what combination of investors will control it?

  • Prepayment. You should also pay attention to whether your note be prepaid without your consent. Seems like a minor point, but it can be very important. You may have negotiated the best conversion terms or the most lucrative multiplier in the event of a change of control, but if your note can be prepaid without your express approval, you stand to lose your negotiated upside and have to settle for accrued interest instead, which is certainly not why you entered this high risk game in the first place.

  • Negative Covenants; Notice Rights. Do you have the right to weigh in on or veto certain acts of the company? For instance, if the company raises money at a low valuation or a small amount that does not trigger conversion, will you have a vote? What about if the company wants to acquire assets of another company (thus spending a lot of the cash it raised in the bridge financing)? Whether you should be entitled to consent rights depends on your investment amount. If you can’t negotiate for negative covenants, you may at least wish to ask to be notified prior to an action being taken. At least you will not be left out of the loop entirely. Unlike a company’s shareholders, note holders are not entitled to statutory notice rights. Therefore, bridge investors have to negotiate for their own notice rights, if those are important to them.

Of course, what we’ve covered here just brushes the tip of the iceberg, but I do hope you find it helpful.

Happy investing!


White Summers  Inna Efimchik, a Partner at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.
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3 comments:

  1. Is a Convertible Promissory Note considered a "security" by the SEC?

    ReplyDelete
  2. Yes, it is, because it converts into capital stock.

    ReplyDelete
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