Startup Voice: convertible promissory note

Showing posts with label convertible promissory note. Show all posts

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.

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.

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.

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!

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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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).

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.

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!

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.

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.

Tuesday, August 28, 2012

Legal Due Diligence: Investor’s Perspective

In the perfect world, anyone making an investment should retain highly qualified and specialized legal counsel to assist with the transaction. Attorneys that work on financings every day will know exactly how to approach the legal due diligence process and will be invaluable guides, scouring the company’s legal documents to protect the investor’s rights and pointing out to the investor any red flags and fixes.

However, we do not live in the perfect world, and some angel investors out there will consider their investment amount too small to engage legal counsel, and will venture out on their own.

If you are in that boat, you should at least conduct your own due diligence. At a bare minimum, there are 3 things you should request from the company in which you are investing, before you sign on the dotted line and before you initiate the wire (or write that check):

Charter Documents. A company’s charter documents are, depending on its jurisdiction of incorporation, its articles or certificate of incorporation and its bylaws. It is important to see charter documents to make sure that you are investing in a real corporation, not a corporation that the founders are planning on forming, and not in a general partnership or a limited liability company.
Cap Table. The cap table that you request should contain, in addition to the obvious, founder vesting schedules and all other convertible notes (or other convertible securities) of the company. (I’ve written about cap tables more extensively in a prior post.) If you are not sure how your convertible note converts into shares of the company’s stock and what percent of the company you stand to own, I would urge you even more strongly to consult an attorney.
IP Assignment. There are two types of inventions assignment agreements to looks for: one for pre- and one for post- formation.
- Most founders will begin generating intellectual property for their company before it is incorporated. Unless there is an agreement assigning all their inventions to the company, the inventions belong to the founders personally. Therefore, the first type of IP assignment agreement to look for is one assigning pre-formation IP to the company. Relatedly, if the company claims to have any patents and trademarks, check to see that they are registered in the name of the company. Many founders will forget to effectuate the transfer with the patent and trademark office, and this is something that should be done before your money goes in.
- Once a corporation is formed, there should be in place an inventions assignment agreement with each founder which covers all inventions developed by such founder during the life of the company. Usually, this is an agreement that goes with a consulting agreement or an offer letter, but because many companies are unfunded at the time of incorporation and the founders do not enter into consulting agreements or offer letters with themselves, at the very least a free-standing inventions assignment agreement should be in place.

Beyond the documents mentioned above, if the amount that you are investing is upwards of $100,000, I would strongly recommend having your counsel conduct full legal diligence review.

Happy investing!

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.

Sunday, August 26, 2012

Seed Financing: Equity or Debt?

Many early-stage companies that have succeeded in finding one or more interested seed investors are faced with a pleasant dilemma: should they document the initial investment as a bridge financing (or sale of convertible debt) or as an equity financing (or sale of shares in the company)? Let’s discuss some important factors to consider in making this decision. For more information about promissory notes, read my post dedicated to this topic.

Cost and Timing. The cost of documenting a middle-of-the-road bridge financing is generally going to be significantly lower than the cost of documenting a middle-of-the road equity financing.

The reason is that bridge financings, as the name suggests, are designed to tide a company over until it raises an equity round, and therefore, it leaves much of the negotiation and documentation of material terms to be done at the time of such equity round.

A very simple note financing (for $10,000 to $50,000) might entail just one document – a promissory note. On the other hand, in a preferred stock equity financing, at the very least an amended and restated certificate of incorporation is required, as well as a stock purchase agreement, and usually a shareholders agreement (or some combination of investors rights agreement, right of first refusal and co-sale agreement, and voting agreement).

A financing that requires less negotiation and fewer documents, can be completed on a shorter timeline. Therefore, on average, a bridge financing allows a company to take in money faster than an equity financing.

Control. Depending on the investor and the amount of the investment, a company may have to give up a measure of control when taking in capital. Control comes in several forms: control by equity holders and control at the board of directors level. A venture capitalist purchasing a significant stake in a company will usually require both, a board seat and special protective provisions that give him veto power as a shareholder over important company decisions. Even if special protective provisions are not negotiated, by law shareholders must approve certain decisions, which adds an administrative burden on the company.

A bridge financing for a small investment amount will generally allow a company to keep the most control. The founders will continue to control the entire board of directors, without having to add the bridge investor to the board. In addition, because a promissory note does not constitute a direct equity ownership and the holders of a promissory note do not become shareholders until the note converts, a company does not have to submit matters which require shareholder approval to the note holders.

Note, however, that a more sophisticated bridge financing, might include negative covenants, which would specify company acts or decisions which expressly require approval of the bridge investors irrespective of the fact that they are not shareholders. Bridge financings with a lower investment amount (< $100,000) will usually not include negative covenants.

Dilution. Before the first outside investment, founders amongst themselves own 100% of the company. With investment comes dilution—by issuing shares to the investors the founders’ share in the company decreases.

In the best-case scenario, using promissory notes will result in less dilution to the founders long-term than selling equity. In the worst, it will be the same. The determining factor, of course, is the company valuation. External factors like market conditions aside, and speaking for companies in the first several years from their formation, the later that a company is valued, the higher generally its valuation will be. In an equity financing, investors purchase shares based on a company’s valuation at the time of their investment. If the company isn’t very far along, doesn’t yet have a product, or has a product in beta and has not demonstrated traction, chances are its valuation will be low ($1,000,000 to $2,000,000) and even a small investment will significantly dilute the founders.

On the other hand, bridge investors are not purchasing shares at the time of their investment, and the number of shares that their investment will convert into will be determined based on the formula specified in the note. If a company can negotiate for the note principal and interest to convert into shares of the company’s preferred stock at a discount (of 15%-30%) of the price for such stock in the company’s next equity round, that will result in the least dilution for the company.

Many investors, however, will ask to cap the maximum valuation at which their notes will convert. In other words, even if a company’s first preferred stock financing is at a valuation of $10,000,000, if the bridge investors negotiated a valuation cap of $5,000,000 in their notes, their notes will convert into the number of shares equal to the (a) principal and accrued interest on the note, divided by (b) a price per share determined as (i) $5,000,000, divided by (ii) all of the shares of the Company outstanding at the time of the conversion.

The conversion cap has become an industry standard for even the smallest bridge financings. However, in my experience, the conversion cap does not generally reflect a company’s valuation at the time of the financing, but rather a valuation that’s somewhere midway between the valuation today and the expected valuation at the next equity financing. Therefore, even a promissory note with cap is frequently less dilutive than a priced seed equity round.

Is it any wonder that given how all these factors play out, convertible notes have become the standard investment tool for low-value seed-stage investments?!

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Saturday, March 3, 2012

Cap Tables for Startups

Capitalization tables (referred to in the industry as “cap tables”) are not difficult to grasp. But first-time entrepreneurs are often caught off-guard when they are asked to produce a cap table by a prospective investor (or his lawyer) doing diligence on the company.

In this post, we’ll talk about cap tables, their purpose, and what should be included in a cap table both for internal and external viewing.

1. Purpose of a Cap Table.

A cap table is, first and foremost, an essential internal document of any corporation. It sets out ownership of the corporation, in terms of the numbers of shares (by class and series) and in terms of percentages that those shares translate into. Ownership percentages matter (1) any time a vote of the equity holders is required, (2) for calculation of dividends, and (3) in the event of a sale or liquidation of the company, where they are used to calculate distribution of proceeds.

In addition, a cap table is one of the first documents that a company will be asked to produce in diligence. Prospective investors will request a cap table because they need to understand what the shares they purchase represent in terms of percent ownership of the company. This goes back to voting control and to upside in a sale of the company. Investors (or their analysts) will run waterfall analyses using different potential valuations of the company on a sale to make sure the investment has a realistic chance of being a lucrative one. (Click here for more information about waterfall analysis.) The cap table with waterfall analysis (or with numbers based on future financing rounds) is usually referred to as a pro forma cap table.

2. Structure of a Cap Table.

A cap table is most frequently maintained in Excel, and is structured in several tabs. The first tab is a Cap Summary and looks something like this:

When speaking to prospective investors prior to a signed term sheet, a cap table request can be legitimately satisfied with a PDF of this tab alone. As you can see, the cap summary provides enough detail to enable investors to create pro formas and run waterfall analyses, without giving away potentially confidential or at the very least sensitive ownership information.

The full cap table kept by the company would have additional tabs for each of the issued classes and series of stock (e.g., Common Stock, Series A Preferred Stock, Series B Preferred Stock), a tab for the stock plan, and a tab for outstanding promissory notes with interest calculations, if any. Such tabs would break-down the ownership of the shares by stockholder, include vesting provisions for stock subject to vesting, and list stock certificate numbers and dates of issuance.

Most importantly, these tabs would have percent ownership calculations on a by-class, by-series and on a fully-diluted basis. This becomes especially important when a particular decision of the company requires the consent of the shares comprising at least 50% of the Common Stock, 55% of the Series A Preferred and Series B Preferred voting together as a class, 66 2/3% of the Series A Preferred, and 50% of the Series B Preferred. Having stock ownership laid out in a well-organized, easy-to-understand manner, allows an easy identification of the minimum necessary stockholders necessary to secure the required vote.

Happy company-making to all!

Inna

Inna Efimchik 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.

Saturday, December 31, 2011

Annotated Convertible Promissory Note

If you are working on a startup, you know how difficult it can be to secure investment from venture capitalists. By the time they are ready to invest, they want you to have a product and some decent traction, so that their investment can go towards growing your business. That means that you have to find a way to keep your business afloat while you are engaging in market research, designing and developing the product, and while you are immersed in early customer acquisition. Most entrepreneurs are not in a position to bootstrap their venture during this initial period, which can easily span over several years (depending on the product), so they will often raise a bridge financing from friends and family, angel investors, or sometimes even from venture capitalists.

A bridge financing is generally implemented by means of a convertible promissory note (for simplicity, we'll refer to it as a "Note"). Notes come in a variety of shapes and sizes, and range from being very company-favorable to downright egregious. In this post, I will walk through a fairly typical and reasonably company-favorable Note. To follow along, download my Convertible Promissory Note form (use of the form is subject to the terms of the legal disclaimer at the bottom of the post). Also note that throughout this post I will refer to the company issuing the Note as the Company and to the purchaser of the Note as the Investor.

Let's start at the top:

THIS PROMISSORY NOTE HAS NOT BEEN QUALIFIED WITH THE COMMISSIONER OF CORPORATIONS OF THE STATE OF CALIFORNIA AND THE ISSUANCE OF THIS PROMISSORY NOTE OR THE PAYMENT OR RECEIPT OF ANY PART OF THE CONSIDERATION FOR SUCH SECURITIES PRIOR TO SUCH QUALIFICATION IS UNLAWFUL, UNLESS THE SALE OF SECURITIES IS EXEMPT FROM QUALIFICATION BY SECTION 25100, 25102 OR 25105 OF THE CALIFORNIA CORPORATIONS CODE. THE RIGHTS OF ALL PARTIES TO THIS PROMISSORY NOTE ARE EXPRESSLY CONDITIONED UPON SUCH QUALIFICATRION BEING OBTAINED, UNLESS THE SALE IS SO EXEMPT.

This is called a securities legend. The reason that most convertible Notes will include this (or similar) language is because a convertible Note is a security, and securities laws apply to the offer and sale of securities. Securities laws are complex, so I will not try to explain them in this post. Suffice it to say that this language will depend on the state in which the investor resides, and that you should leave the tweaking or tinkering with this language to your attorney.

Section 1:

Principal and Interest.

[Company Name]

[state]

Company

[Lender Name]

Lender

[*]

[The term “Notes” shall refer to this Note along with all other convertible promissory notes issued by the Company in exchange for cash advances to the Company at any time from [Date Bridge Loan Begins] until [Date Bridge Loan Ends]. The terms “Lenders” may be used herein to refer to the Lender along with all other lenders, if any, who advance or have advanced funds to the Company in exchange for Notes.]

This section is pretty self-explanatory. Principal is the amount borrowed. Because convertible Notes are debt instruments, or loans, in addition to being securities, an interest rate accrues on the amount borrowed. States have laws about rates which are considered usurious, or illegal, and therefore you will see language in the Note specifying that, to the extent that the interest rate is deemed usurious, instead of invalidating the entire Note, the rate is reduced to the highest permissible rate.

You will notice that defined terms are underlined and displayed in quotes when initially defined and are thereafter capitalized to signify that the specific meaning attributed to the term in this Note should be used, and not a general one. For convenience, parts that need to be customized are shown in bold and are set off by square brackets in this form.

One more general point, before we move on: if you have seen other forms of Notes, you may have seen the bracketed second paragraph of Section 1 refer to a note purchase agreement pursuant to which all of the Notes are purchased. And you may be wondering whether a note purchase agreement is necessary. The answer is, there is no legal requirement to sell notes pursuant to a note purchase agreement, but depending on your Investors (and their legal counsel), they may request one. A note purchase agreement provides for representations and warranties of the Company, for one. It can also include other deal terms, such as multiple closings and/or payment by the Company of Investor counsel's fees, to name a few. If you are raising money from friends and family, you can safely save yourself the time and expense of preparing and signing an additional agreement. On the other hand, if the Investors ask for it, you shouldn't fight it, unless the amount of their investment is so small that it seems silly. :)

Section 2:

Maturity.

[twenty-four (24) months]

Maturity Date

There are a couple of things going on in this section. First, it appears to provide a deadline for when the funds must be repaid. Second, it provides the Investors with some protection, a way to accelerate the obligations under the Note in the event that the Company hits rock bottom before the Note is due.

First why does it only "appear" to provide for a deadline? Generally speaking, an Investor has no expectation that a Note (remember that we are only talking about convertible notes now) will be repaid. The reason that Investors loan money on a Note and not by purchasing stock has less to do with the advantages that an Investor has when it comes to getting his money out, and more with the ease and efficiency of using this method. Jumping ahead to Section 3(c) for a second, we realize that if the Note is still outstanding on the maturity date, it converts into common stock based on a pre-agreed formula. This means that the Company (almost) never has to repay its Investor.

Another way that maturity dates are sometimes handled in convertible promissory Notes is by making it a "demand" note, or a Note that must be repaid after a certain date upon the Investor's demand. This variation, depending on the formula used for converting principal on a Note to common stock, can be either less or more favorable to the Company than an automatic conversion into common stock. Of course, a demand Note works best with sophisticated Investors who are not going to demand to be repaid arbitrarily, when they'd like to get their money back, regardless of the financial health of the Company. I have seen this work really well when the Investors are working with the Company, allowing it some breathing room to get to a Qualified Financing (defined in the Note) after the initial loan term or to find another source of funds to repay the Investors. But this can also backfire with an impatient, inexperienced Investor.

The second point of Section 2 is self-explanatory. If the Company is doing so poorly that it's starting bankruptcy proceedings or another type of winding down activity, in other words, if they've given up, the obligation to repay the Note is accelerated and, assuming that there is no other senior debt, the Investor is first in line to be repaid out of whatever proceeds there are from the liquidation of the Company.

Section 3, my favorite and juiciest section of the Note:

Conversion: Automatic Conversion in a Qualified Financing.

[*]

Qualified Financing

provided

however

[*]

Subsection (a) of Section 3 deals with the best case scenario--within the time frame contemplated by the Company and the Investor, the Company raises more money and the Note converts. There are a number of variables in this section. First, the parties need to decide how much money the Company needs to raise at a minimum to warrant automatic conversion of the Note. If the Note is for $150,000, and the company raises another $150,000 through sale of its stock, it's probably not enough because the Investors do not negotiate for any preferred stock rights at the time when they buy the Note. They are counting on the venture capitalists or the super-angels who are going to buy equity in a Qualified Financing on doing this for them. That means, that the amount that the Company raises which forces a conversion into the same security purchased in such round should be substantial. One million of new money is an amount I see frequently. However, it also depends on the initial investment amount. Notice that the amount is "inclusive of the amount represented by the Note". If an aggregate amount of $750,000 is raised via the Notes, then the Qualified Financing threshold should be at least $1,500,000 or even greater to be meaningful.

The other important variable is the extra bonus that the Investor gets upon a Qualified Financing for taking the early risk. There are several ways this can be handled, and our language exemplifies a best-of-both-worlds approach. It was once the case that Investors received only a discount of 15-20% off the preferred stock price in a Qualified Financing. This approach tends to be less common now, as Investors are asking for more upside for taking risk early.

Traditionally, Investors were not setting a valuation, with the idea that it was too early to tell. Now, Investors lending the Company money on a Note often request a valuation cap for conversion purposes (which is kind of like setting a valuation). If, upon a Qualified Financing, the Company valuation is lower than the cap specified in the Note, the Investors convert at the actual valuation in the Qualified Financing. However, if the Company valuation in a Qualified Financing is valued higher, even a lot higher, than the valuation cap in the Note, the Investors convert at the valuation they fixed when they invested.

One other small point on this section: as you will notice, it provides for the conversion of principal and interest. Financings generally never happen on the date they are supposed to and get moved by a day and then another day and another day. This means that the interest on the Note changes and, therefore, the number of shares into which the Note converts changes. Most likely, this also affects the price per share for preferred stock in the Qualified Financing. For simplicity, the Note can provide that the principal only converts and the interest can either convert or be repaid at the option of the issuer. Sometimes, this little tweak can save a lot of attorney hours.

Conversion: Optional Conversion on a Change of Control.

[*]

provided

however

Change of Control

Section 3(b) describes what happens to the Note in the event that the Company is sold prior to the maturity of the Note. In the event of a successful exit, the Note will convert at some pre-determined valuation into common stock. In the event of a bad exit, the Investors have the option to accelerate the Note and be repaid out of the proceeds.

This provision tends to be left out of Notes with friends and family and generally is found in more heavily negotiated Notes with sophisticated Investors. Another way that a premature sale of the Company is sometimes handled is by providing the Investor with a multiple return on his investment (like 3X the principal amount). If you are not working off a term sheet provided to you by the Investors, and are providing a draft Note to your Investors, I would leave this out for simplicity's sake. If they ask for it, you can add it.

Conversion: Mandatory Conversion into Common Stock on Maturity.

[formula for calculating the number of shares]

If Section 3(a) was the best possible scenario, then Section 3(c) is the second worst scenario (after the winding down of the company provided for in Section 2). The Notes have matured and there is no money to repay them, there has not been a decent-sized equity financing, and the Company has not been sold.

Sometimes mandatory conversion of Notes on maturity is into preferred stock of the last issued series, if applicable, or into the next series, created just for this purpose. If the Note converts into preferred stock, then the parties need to think through the rights of the preferred stock now, since there will not be a bonafide third party investor to negotiate these rights as there would be in a Qualified Financing. Having to agree on preferred rights at the time of the bridge financing complicates matters, which is why I prefer conversion into common stock. The main question is, at what valuation will the Note convert in that case? I have seen cases where the Note provides that it will convert into as many shares as are necessary for the Investors to own 55% of the Company. That's pretty egregious, but it's also the Investors' way of saying "you have failed and we are taking over."

Keep in mind, by the way, that Notes, like any other agreement of the Company, can be amended (subsequently changed) with the mutual consent of the parties. So even if your Notes provide for mandatory conversion on maturity and even if that conversion is not on terms that you love, when your Notes are getting close to maturity, if your Investors still believe in your and think you just need more time, they may agree to amend the Notes to extend the term. Legal documents are frequently amended to fit the reality of the business. But while it is technically possible, the trick is being on good terms with your Investors, so that they are motivated to amend the Note and keep your Company in business.

Section 4:

Mechanics of Conversion.

Section 4, as its name suggests, walks through the mechanics of the conversion. The main takeaway is--the Investor will have to turn over the Note to get shares. Even though the conversion is automatic, the Company does not have to issue a share certificate until it has received (and cancelled the note). Some Notes will provide more detail around the process for dealing with lost, stolen and destroyed Notes. I like to keep Notes simple and don't include this. Bottom line is, it can be worked out if it comes up.

Section 5:

Payment.

Whenever any payment hereunder shall be stated to be due, or any other date specified hereunder would otherwise occur, on a day other than a Business Day (as defined below), then, except as otherwise provided herein, such payment shall be made, and such payment date or other date shall occur, on the next succeeding Business Day. As used herein, “Business Day” means a day (i) other than Saturday or Sunday, and (ii) on which commercial banks are open for business in [City, State].

The main takeaway from this section is that the Note cannot be prepaid without the consent of the Investor. Why not? If it could be prepaid, and there was a lucrative sale of the Company in the works, the Company could repay the Note and leave the Investor without the upside. The same is true for a Qualified Financing. In a convertible Note, the investors bargain for more than just interest as their upside. But terms are negotiable, so if you'd like to try to make the Note prepayable by the Company without penalty and without Investor's consent, go for it. Depending on the specific terms of your Note, that might be the right approach.

Section 6:

Representations and Warranties of Lender

(a) Authorization. Lender has full power and authority to enter into this Note and such agreement constitutes its valid and legally binding obligation, enforceable in accordance with its terms.

(b) Purchase Entirely for Own Account. This Note (and any securities issued upon conversion of the Notes, herein, collectively, the “Securities”) has been purchased by the Lender for such Lender’s own account, not as a nominee or agent, and not with a view to the resale or distribution of any part thereof, and such Lender has no present intention of selling, granting any participation in, or otherwise distributing the same. Such Lender does not have any contract, undertaking, agreement or arrangement with any person to sell, transfer, or grant participation to any person with respect to the Securities.

(c) Disclosure of Information. Such Lender acknowledges that it has received all the information that it has requested in connection with the purchase of the Securities. Lender further represents that it has had an opportunity to ask questions and receive answers from the Company, as well as to consult their own legal, tax and other advisors, regarding the information provided and the terms and conditions of the offering of the Securities.

(d) Investment Experience. Lender is an investor in securities of companies in the start-up or early development stage and acknowledges that it is able to fend for itself, can bear the economic risk of its investment and has such knowledge and experience in financial or business matters that it is capable of evaluating the merits and risks of the investment in the Securities. If other than an individual, such Lender also represents it has not been organized for the purpose of acquiring the Securities.

(e) Restricted Securities. Such Lender understands that the Securities are characterized as “restricted securities” under the federal securities laws inasmuch as they are being acquired from the Company in a transaction no involving a public offering and that under such laws and applicable regulations such securities may be resold without registration under the Securities Act of 1933, as amended (the “Act”), only in certain limited circumstances. In this connection, such Lender represents that it is familiar with SEC Rule 144, as presently in effect, and understands the resale limitations imposed thereby and by the Act.

(f) Accredited Lender. Lender is an “accredited investor” as that term is defined under the Act.

(g) Further Limitations on Disposition. Without in any way limiting the representations set forth above, the Lender further agrees not to make any disposition of all or any portion of the Securities unless and until each of the following have been satisfied:

(i) There is then in effect a Registration Statement under the Act covering such proposed disposition and such disposition is made in accordance with such Registration Statement, or (i) the Lender shall have notified the Company of the Proposed disposition and shall have furnished the Company with a detailed statement of the circumstances surrounding the proposed disposition and (ii) the Company shall have obtained an opinion of counsel, reasonably satisfactory to the Company, that such disposition will not require registration under the Act.

(ii) If such transfer is not being made pursuant to Rule 144 or a registration statement under the Act, the transferee shall have agreed in writing, for the benefit of the Company, to be bound by this Section 6.

(iii) Notwithstanding the provisions of paragraphs (i) and (ii) above, no such registration statement or opinion of counsel shall be necessary for a transfer by the Lender which is a partnership to a partner of such partnership or a retired partner of such partnership who retires after the date hereof, or to the estate of any such partner or retired partner or the transfer by gift, will, or in testate succession of any partner to the partner’s spouse or to the siblings, lineal descendants, or ancestors of such partner or spouse, if the transferee agrees in writing to be subject to the terms hereof to the same extent as if he were an original Lender hereunder.

(h) Foreign Investors. If Lender is not a United States person (as defined by Section 7701(a)(30) of the Internal Revenue Code of 1986, as amended), Lender hereby represents that it has satisfied itself as to the full observance of the laws of its jurisdiction in connection with any invitation to purchase the Securities, including (i) the legal requirements within its jurisdiction for the purchase of the Securities, (ii) any foreign exchange restrictions applicable to such purchase, (iii) any governmental or other consents that may need to be obtained, and (iv) the income tax and other tax consequences, if any, that may be relevant to the purchase, holding, redemption, sale or transfer of the Securities. Lender’s payment for, and his or her continued beneficial ownership of the Securities, will not violate any applicable securities or other laws of Lender’s jurisdiction.

(i) Standoff Agreement. Lender agrees, in connection with the Company’s initial public offering of its equity securities, and upon request of the Company or the underwriters managing such offering, not to sell, make any short sale of, loan, grant any option for the purchase of or otherwise dispose of any shares of the Securities (other than those included in the registration, if any) without the prior written consent of the Company or such underwriters, as the case may be, for such period of time (not to exceed one hundred eighty (180) days) from the effective date of such registration as may be requested by the Company or such underwriters; provided, that the officers and directors of the Company who own stock of the Company also agree to such restrictions.

(j) Legends. It is understood that in addition to or in place of the legends currently on the Securities, the Securities may bear any legend required by the laws of the State of California, including any legend required by the California Department of Corporations and Sections 417 and 418 of the California Corporations Code or other applicable state blue sky laws, and a legend referring to the restrictions on transfer described in this Section 6.

Section 6 is a long section that I am actually not going to spend a lot of time on. These are representations of the Investor and most of them are mandated by securities laws. Note that my sample Note does not contain any representations by the Company, but if your investors are represented by legal counsel they will likely either add Company representations to the Note or add a note purchase agreement to the transaction documents(as discussed earlier in this post).

Generally, Investors are asked to complete an accredited investor questionnaire at the same time when they are sent a draft of the Note (unless you know that they are not accredited, in which case you should consult with your attorney to make sure there is another securities law exemption that can be used).

Section 7:

Miscellaneous.

(a) Assignment. This Note, and the conversion rights described herein, shall not be assignable by the holder without the prior written consent of the Company, which consent shall not be unreasonably withheld. Subject to the restrictions set forth in the foregoing sentence, the rights and obligations of the Company and the holder of this Note shall be binding upon and benefit the successors, assigns, heirs, administrators and transferees of the parties.

(b) Waiver and Amendment. Any provision of this Note may be amended, waived or modified upon the written consent of the Company and the [Lender][Lenders holding Notes with cumulative outstanding principal amounts representing at least a majority of the total principal amount of all Notes, so long as such amendment, waiver or modification applies equally to all Notes].

(c) Interpretation. Whenever possible, each provision of this Note shall be interpreted in such manner as to be effective and valid under all applicable laws and regulations. If, however, any provision of this Note shall be prohibited by or invalid under any such law or regulation in any jurisdiction, it shall, as to such jurisdiction, be deemed modified to conform to the minimum requirements of such law or regulation, or, if for any reason it is not deemed so modified, it shall be ineffective and invalid only to the extent of such prohibition or invalidity without affecting the remaining provision of this Note, or the validity or effectiveness of such provision in any other jurisdiction.

(d) Jurisdiction. The Company and each Lender hereby (i) submit to the exclusive jurisdiction of the courts of the State of California and the United States Federal courts of the United States sitting in the State of California for the purpose of any action or proceeding arising out of or relating to this Note and any other documents and instruments relating hereto, (ii) agree that all claims in respect of any such action or proceeding may be heard and determined in such courts, (iii) irrevocable waive (to the extent permitted by applicable law) any objection which it now or hereafter may have to the laying of venue of any such action or proceeding brought in any of the foregoing courts, and any objection on the ground that any such action or proceeding in any such court has been brought in an inconvenient forum and (iv) agree that a final judgment in any such action or proceeding shall be conclusive and may be enforced in other jurisdictions by suit on the judgment or in any other manner permitted by law. This Note shall be governed by the law of the State of California, without regard to choice of law principals.

(e) Notices. Any notice required or permitted by this Note shall be in writing and shall be deemed sufficient upon receipt, when delivered personally or by courier, overnight delivery service or confirmed facsimile or confirmed electronic mail, or three business days after being deposited in the U.S. mail as certified or registered mail with postage prepaid, if the notice is addressed to the party to be notified at the party’s mailing or email address or facsimile number as set forth below or as subsequently modified by written notice.

To the Company:

To the Lender:

(f) Arbitration. Any claims arising under this Note, except for any such claims for which injunctive relief is sought, shall be resolved in binding arbitration with a duly authorized representative of the American Arbitration Association (“AAA”) in accordance with the provisions hereof and thereof. Either the Company or the Lender may submit the matter to binding arbitration before the AAA in [San Francisco County, California], which arbitration shall be final and binding on the parties and the exclusive method, absent agreement between the Company and the Lender, for purposes of determining the ability of the Company or the Lender to satisfy such claim. All claims shall be settled by a single arbitrator appointed in accordance with the Commercial Arbitration Rules then in effect of the AAA (the “AAA Rules”). The arbitrator shall render a final decision pursuant to the AAA Rules within thirty (30) days after filing of the claim. The final decision of the arbitrator shall be furnished to the Company and the Lender in writing and shall constitute the conclusive determination of the issue in question binding upon the Company and the Lender, and shall not be contested by any of them. Such decision may be used in a court of law only for the purpose of seeking enforcement of the arbitrator’s decision. The prevailing party shall be entitled to reasonable attorneys’ fees, costs and necessary disbursements in addition to any other relief that such party may be entitled. For purposes of this Agreement, the prevailing party shall be that party in whose favor final judgment is rendered or who substantially prevails, if both parties are awarded judgment.

(g) Counterparts. This Note may be executed in two or more counterparts, each of which shall be deemed an original and all of which together shall constitute one instrument.

(h) Entire Agreement. This Note is the entire agreement between the parties hereto relating to the subject matter hereof and supersedes any prior arrangement or agreement, written or oral.

Section 7, the last section in our Note, is what is sometimes referred to as "General Provisions," or boilerplate. This is not to diminish the significance of this section--it certainly contains a number of very important provisions--they are just not as interesting for the Company founders to read about.

I will just make a note here about Section 7(b), the amendment provision. If you are selling multiple Notes (and using that bracketed paragraph in Section 1), it is in your best interest to think carefully about this section. Most agreements, as I've mentioned, can be amended by mutual consent of the parties. However, if a Company has issued 10 Notes, having to chase down 10 signatures to amend the same term in all those Notes (whether it be the threshold amount for a Qualified Financing or the Maturity Date) can be a nightmare. It can be especially silly if one of the Investors loaned $500,000 to the Company and the others, in total, merely $100,000. For the situation where a substantially identical agreement is entered into by the Company with multiple parties, I always advise my clients to allow for amendment, on the Investor-side, by a majority-in-interest.

I find Notes to be a fascinating subject, and I could keep talking about them on and on. If you have further questions, you must have more than a mere philosophical interest in the subject. Call (650-298-6014) or email me, and we'll talk through the details of your specific bridge loan financing.

Inna Efimchik

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