Tuesday, September 15, 2015

Convertible Promissory Notes: 3 Mistakes to Avoid

To raise a Series A round these days a startup has to have a product, users, and traction. It may take a lot less money to get there than it did in 1999, but most startups still can’t bootstrap their way there. So before a company ever raises a Series A round, or even before it raises a Series Seed round, it will usually raise a convertible promissory note round, also known as a bridge financing.

While a convertible note financing is one of the simplest types of investment transactions, there are still a few nuances that, when done wrong, can really hurt a company down the road. For a very detailed write-up about convertible promissory note terms and structure, you can read my Annotated Convertible Promissory Note post. This post, on the other hand, is dedicated to some more nuanced mistakes to avoid.

All of the mistakes that we are going to discuss in this post are ones that won’t manifest themselves until there is a qualified equity financing, the note matures, or there are circumstances that require that the terms of the note be amended.

  1. Conversion into a Shadow Series of Preferred. Let’s start with what is usually seen as the culmination of a startup’s early success – it has a term sheet for an equity financing round at a valuation that is significantly higher that then conversion cap on the notes. In this situation, the investors will typically insist that, despite what the note conversion provisions state, the notes convert into a shadow series of preferred stock, rather than the same series of preferred as the new investor.

    The reason is that the certificate or the articles of incorporation, state in dollars the liquidation preference of each series of stock. If the purchase price per share of the new investors is $1.00 per share in the Series A round, and they are getting a 1x liquidation preference, then the liquidation preference of the Series A will be $1.00 per share. However, if the conversion price of the notes is only $0.10 per share, which may be the case if their conversion cap was 1/10 of the valuation of the new round, then with a $1.00 per share liquidation preference on each of their shares, the early investors would be getting a 10x return. This is not something that new investors will typically agree to. If there is no provision in the notes for conversion into a shadow series of preferred, and if the note investors don’t want to amend their notes, the equity financing can fall apart! Even if it doesn’t fall apart, the timing can slow down significantly, as management tries to work this out with their early investors.

    For this reason, we recommend the automatic conversion provision in the notes to provide for conversion into a shadow series of Preferred Stock, if so requested by the new investor.

  2. Conversion on Maturity. Convertible notes, despite the way that they are frequently being used by startups, are debt instruments, and as such, they have a maturity date. A “Maturity Date” is the date by which the debt must be returned, if not converted into equity. Startups, however, are not usually in the business of repaying convertible promissory notes, nor is repayment the result for which their investors are hoping when they make the investment.

    As we know, building a company comes with many variables, and despite everyone’s best intentions and efforts, it is neither unlikely nor uncommon for a company to fail to raise a qualifying equity financing round prior to the maturity date. If that happens, there are several ways it could play out. The investors could agree to extend the maturity date and give the company time to raise an equity round. Or, if they are disappointed with how management has been running the company, they could demand repayment. If there has not been a qualifying equity financing round, it is unlikely that the company would be able to repay this loan, even if it has revenues. Of course, if its revenues are sufficient to repay the loan, it’s unlikely that the investors would want to be repaid!

    For this reason, we recommend building into each note from the outset a formula for how the note will convert on maturity if it has not converted prior to such time in a qualified equity financing. The parties should decide on the class and series of shares into which the note will convert on maturity, which can either be common stock, a new series of preferred stock, or an existing series of preferred stock, if the company already has issued preferred stock. If the note is going to convert into a new series of preferred stock, then the parties have to agree on at least the basic rights, preferences and privileges of this series. The notes should also specify the valuation that will be used in the conversion or another algorithm that will be used to determine the number of shares that will be issued to the investors in the conversion in cancellation of the loan.

  3. Amendment Provisions. The “Amendment” section of an agreement is the section that specifies how that agreement may be changed in the future. If there are only two parties to an agreement, this is simple – the agreement can be changed with the consent of both parties. On the other hand, if we have an agreement with many parties, like a shareholders’ agreement among fifteen shareholders, in order to make it possible to ever amend that agreement, we might set some minimum threshold, e.g., the shareholders representing a majority of the voting interests must approve the change for it to apply to the agreement and bind all the other shareholders. This prevents one party from holding everyone else hostage when changes need to be made.

    Now that we understand the principle of it, let’s talk about how it applies to convertible notes. On the one hand, each note is an instrument issued by one party – the company, to the other – its investor. If there are 15 investors, then there are 15 different notes. On the other hand, we can think of these notes as part of one bridge financing transaction. They will usually have substantially the same terms, and will frequently be issued pursuant to a single note purchase agreement to which all of the investors will be parties. Finally, in the ideal world, all of these notes will convert in the company’s next equity financing into most likely the same series of stock with the same rights, preferences and privileges. From this perspective, it is in the company’s interests to make the process of amending the notes, which frequently must be done in connection with a qualified financing round, as painless as possible. If, in order to amend 15 notes, the company must get the consent of each of the 15 investors, this slows down the equity transaction and gives each of the investors a lot of leverage. For this reason, our strong recommendation is to draft the amendment provisions of the promissory notes issued by a company as part of the same bridge financing transaction, even if that transaction spans over the course of six months or a year, to allow for amendment by a majority-in-interest of the note holders.

Happy company making!


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.
LEGAL DISCLAIMER

Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

No Attorney-Client Relationship. This post has been prepared by Inna Efimchik of White Summers for general informational purposes only. The information provided herein does not constitute advertising, a solicitation or legal advice. Neither the availability, transmission, receipt nor use of any information included herein is intended to create, or constitutes formation of, an attorney-client relationship or any other special relationship or privilege. You should not rely upon this post for any purpose without seeking legal advice from licensed attorneys in the relevant state(s).

Compliance with Laws. You agree to use the information provided herein in compliance with all applicable laws, including applicable securities laws, and you agree to indemnify and hold Inna Efimchik and White Summers Caffee & James LLP harmless from and against any and all claims, damages, losses or obligations arising from your failure to comply.

Disclaimer of Liability. ALL INFORMATION IS PROVIDED AS-IS WITH NO REPRESENTATIONS OR WARRANTIES, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. YOU ASSUME COMPLETE RESPONSIBILITY AND RISK FOR USE OF THE INFORMATION IN THIS POST.

Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.




Friday, January 23, 2015

What Do Startup Investors Want?

It is a well-known fact that startup investors, whether they are angels or venture capitalists, ultimately make their investment decisions emotionally, or, to say it another way, based on a gut feeling.

However, if you are an entrepreneur looking for funding for your startup, this knowledge alone does not help because it does not answer the question “what does an entrepreneur need to convey to the investor, for the investor to have the right emotional reaction which leads him to write the check”.

What then do early-stage investors in the tech sector look for when they are evaluating a project? What are the factors that make them excited about one project but not another?

People. The investor needs to believe in, in fact, be inspired by, the entrepreneur and his initial team. He needs to be convinced that this particular team has at least the following characteristics:

  1. the necessary technical skills to complete the project in the proposed timeframe,
  2. the required steadfastness, dependability, and firmness of character to see the project through, and
  3. the personalities among the founding team that will complement, rather than detract from, one another, especially when times get tough (as they often do in startups).

Some ways to demonstrate to an investor that the team has what it takes, to name just a few, are (i) a history of working together as a team on a prior successful project, or (ii) external validation of the project for which funding is being sought through market traction.

Opportunity.

Economic. To elicit the right emotional response from an investor, an entrepreneur needs to persuade the investor that, when properly executed by the right team, there is tremendous economic opportunity in the project. That may mean that the project is in a fast-growing market and that its premise is promising in light of what are perceived to be future trends. It also means that the investor can (and does) imagine a scenario where, with the right execution, the project will generate a significant economic upside, a return on investment of 10 to 30X.

Impact. Some investors will be looking specifically for projects which promise to generate a measurable, beneficial social or environmental impact alongside a compelling financial return. This is called impact investing and it is becoming more widespread. When pitching, it is critical for the entrepreneur to know whether the investor subscribes to this investment mandate. If so, he will be a lot more excited about a project that seeks to build literacy than the next “Cut the Rope” app.

Competitive Advantage. Finally, there needs to be a convincible competitive advantage, one that will allow this particular project to succeed over others in the same space. Its people, with deep specific expertise in an obscure area highly relevant to the project, for example, may be such competitive advantage. It may also be the technology behind the project, preferably protected by strong patents. Having a significant head start in an industry with a high barrier to entry might be another.

One way or another, an investor needs to feel that the horse he is asked to put his money on, the particular project that he is asked to invest in, in keeping with the metaphor, will come in first. The factors listed above, when applied to a startup especially, are highly subjective. It is the entrepreneur who is able to convince investors that his project excels in all three categories that attracts capital easily and gracefully!

Happy company making!

Inna


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.
LEGAL DISCLAIMER

Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

No Attorney-Client Relationship. This post has been prepared by Inna Efimchik of White Summers for general informational purposes only. The information provided herein does not constitute advertising, a solicitation or legal advice. Neither the availability, transmission, receipt nor use of any information included herein is intended to create, or constitutes formation of, an attorney-client relationship or any other special relationship or privilege. You should not rely upon this post for any purpose without seeking legal advice from licensed attorneys in the relevant state(s).

Compliance with Laws. You agree to use the information provided herein in compliance with all applicable laws, including applicable securities laws, and you agree to indemnify and hold Inna Efimchik and White Summers Caffee & James LLP harmless from and against any and all claims, damages, losses or obligations arising from your failure to comply.

Disclaimer of Liability. ALL INFORMATION IS PROVIDED AS-IS WITH NO REPRESENTATIONS OR WARRANTIES, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. YOU ASSUME COMPLETE RESPONSIBILITY AND RISK FOR USE OF THE INFORMATION IN THIS POST.

Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.