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.

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