Startup Voice: securities

Showing posts with label securities. Show all posts

Tuesday, July 23, 2013

Effect on Startups of SEC Changes Eliminating the Prohibition on General Solicitation in Certain Offerings

[A Russian-language version of this article may be found on Firrma.ru]

In April 2012, Congress passed the much-awaited Jumpstart Our Business Startups Act (JOBS Act), which directed the SEC to draft regulations removing the prohibition on general solicitation and general advertising for securities offerings relying on Rule 506, provided that sales are limited to accredited investors and an issuer takes reasonable steps to verify that all purchasers of the securities are accredited investors.

On July 10, 2013, more than a year later, the SEC has finally issued the final rules that will implement the JOBS Act legislation.

Securities Laws Overview. Under the current U.S. federal securities laws, companies seeking to raise capital through the sale of securities must either register the securities offering with the SEC or rely on an exemption from registration. Rule 506 of Regulation D is the most widely-used exemption from registration. In an offering that qualifies for the Rule 506 exemption, an issuer may raise an unlimited amount of capital from an unlimited number of "accredited investors" and up to 35 non-accredited investors.

"Accredited investors," as defined in Rule 501 of Regulation D, are individuals who meet certain minimum income or net worth levels, or certain institutions such as trusts, corporations, or charitable organizations that meet certain minimum asset levels. A person qualifies as an "accredited investor" if he or she has either (a) an individual net worth or joint net worth with a spouse that exceeds $1 million at the time of the purchase, excluding the value (and any related indebtedness) of a primary residence; or (b) an individual annual income that exceeded $200,000 in each of the two most recent years or a joint annual income with a spouse exceeding $300,000 for those years, and a reasonable expectation of the same income level in the current year.

Changes to Rule 506 Generally. The final rules approved by the SEC make changes to Rule 506 to permit issuers to use general solicitation and general advertising to offer their securities provided that (a) the issuer takes reasonable steps to verify that the investors are "accredited investors"; and (b) all purchasers of the securities qualify as "accredited investors" or the issuer reasonably believes that the investors so qualify at the time of the sale of the securities. In other words, there is no restriction on who an issuer can solicit, but an issuer faces restrictions on who is permitted to purchase its securities, if general solicitation or general advertising is used as a means of capital raising. Nevertheless, issuers conducting Rule 506 offerings without the use of general solicitation or general advertising may continue to conduct securities offerings in the same manner as they did previously and aren't subject to the new verification rule.

Changes to Form D Filing. Prior to new regulations going into effect, an issuer selling securities using Rule 506 was required to file a Form D no later than 15 calendar days after the first sale of securities in an offering. Under the new rules, issuers that intend to engage in general solicitation as part of a Rule 506 offering would be required to file the Form D (a) at least 15 calendar days before engaging in general solicitation for the offering and (b) within 30 days after completing an offering to update the information contained in the Form D and indicate that the offering has ended.

The scope of Form D is also being expanded to include such additional information as:

identification of the issuer's website;

expanded information on the issuer;

the offered securities;

the types of investors in the offering;

the use of proceeds from the offering;

information on the types of general solicitation used; and

the methods used to verify the accredited investor status of investors.

Solicitation Materials. Under the new rules, as part of SEC's monitoring process, issuers will be required to submit written general solicitation materials used in the offering on the SEC website. Materials submitted in this manner would not be available to the general public.

Verification of Accredited Investor Status. The final rules provide a non-exclusive list of methods that issuers may use to satisfy the verification requirement for individual investors. For instance, an issuer may review copies of any IRS form that reports the income of the purchaser and obtain a written representation that the purchaser will likely continue to earn the necessary income in the current year. Alternatively, an issuer may receive a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant that such entity or person has taken reasonable steps to verify the purchaser's accredited status.

Disqualification for Bad Acts. A restriction in the new rules states that an issuer cannot rely on the Rule 506 exemption if the issuer or any other person covered by the rule had a "disqualifying event." Persons covered by the rule include directors and certain officers, 20% beneficial owners, promoters, and persons compensated for soliciting investors. A "disqualifying event" may be a criminal conviction in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries within 10 years of the proposed sale of securities, or other types of misconduct relating to the securities and trading markets. However, an exception from disqualification exists when the issuer can show it did not know and, in the exercise of reasonable care, could not have known, that a covered person with a disqualifying event participated in the offering.

Disqualification for Failure to Make Timely Filings. An issuer is disqualified from using the Rule 506 exemption in any new offering if the issuer or its affiliates did not comply with the Form D filing requirements in a Rule 506 offering. The disqualification would continue for one year beginning after the required Form D filings are made.

Impact of Changes on Startups. The JOBS Act sought to make it easier for a company to find investors and thereby raise capital. Have the regulations that have been adopted by the SEC faithfully followed legislative intent, improving the capital raising experience for companies? Only time will provide us with a definitive answer, but in the meantime, here are some factors that will weigh on the success of the legislation as a game-changer in the industry:

Demand by Investors: whether there in fact exists a large pool of "accredited investors" who would invest (more frequently and in greater amounts than they are currently) given better access to a pipeline of private offerings;

Longevity: whether, even if there is an initial spike in investments by new accredited investors, the novelty and excitement will not wear off, especially as initial investor optimism faces the harsh realities of investing in early-stage emerging technology companies;

Non-Accredited Investors: whether the "either/or" nature of the new rules, preventing companies from engaging in general solicitation along-side other fundraising activities, potentially to non-accredited investors, will cause companies not to take full advantage of the new rules;

Compliance Hardships: whether the requirements for additional filings (e.g., expanded Form D, solicitation materials), state securities laws, as well as the burden placed on the companies to reasonably ascertain the status of their investors as "accredited investors," coupled with disqualification from use of the exemption for failure to timely file, will hamper widespread use of general solicitation as a means of raising capital;

Publicity: whether the public disclosures which would be made in the solicitation materials and the associated loss of stealth-mode advantage will have a chilling effect on early-stage companies;

Involvement by Sophisticated Investors: whether sophisticated investors, such as VCs and super-angels, will engage in, or be deterred from, participating as investors in offerings through open solicitation;

Later Stage Follow On Rounds: whether successful later-stage startups will consider this an appealing alternative to additional rounds of venture capital or institutional investment;

New Investments Instruments and Goals: whether access to different types of investors than typical market players will allow previously "unfundable" companies to raise capital - e.g. LLCs, companies with solid revenues, but no exit opportunity, etc.;

Higher Valuations: whether increased competition for companies that stand-out in the open fundraising process will drive valuations, such that this will be the preferred means of raising capital even for companies that have access to venture capital money; and

Crowdfunding: whether the successes of crowd-funding platforms like Kickstarter and Indiegogo will be repeated on a larger scale with equity investment in the mix.

The rule amendments become effective on September 23, 2013 (60 days after publication in the Federal Register).

Happy company making!

Inna

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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Friday, June 28, 2013

Getting to a Reasonable Cap Table: How Many Shares to Authorize Initially? What Classes of Shares to Authorize? How Many Shares to Issue to Founders?

A new corporation is formed when a Certificate of Incorporation in Delaware (or Articles of Incorporation in California and most other states) are filed with the Secretary of State. The Certificate of Incorporation must specify the total number of shares of each class that the corporation is authorized to issue. The Certificate of Incorporation does not specify how many shares the corporation has issued or who the stockholders are.

What does it mean for shares to be authorized?
Vocabulary is important here. The authorized number of shares that goes in the Certificate of Incorporation is the number of shares that the Board of Directors may issue without amending the Certificate of Incorporation. By contrast to authorized shares, issued shares are shares that have actually been sold and are outstanding.

Amending the Certificate of Incorporation to increase the authorized number of shares requires a vote of the stockholders of the corporation. It also requires a state filing and associated fees. This is somewhat tedious. When thinking about the number of shares that you need to authorize, plan so that number of shares initially authorized is sufficient for your purposes for the foreseeable future, until a significant event in the life of the corporation, such as a financing, for example, when you will go through the trouble of amending the Certificate of Incorporation.

What classes of shares should be authorized initially?
Generally speaking, unless the company is being incorporated concurrently with taking an investment, only Common Stock needs to be authorized.

While online searches for sample Certificates of Incorporation may return some Certificates of Incorporation with "blank check" Preferred Stock, the best practice for a startup is not to include it. Investors keep a close eye on the company's authorized and unissued shares of each class and series, allowing only a very small cushion.

This is because a stockholder's share in a company is calculated as such stockholder's shares divided by the sum of all issued and outstanding shares of the company and the shares reserved under the company's stock plan. Note that a stockholder's share is not based on the company's authorized shares. Therefore, if a significant cushion exists, an investor's share can be easily diluted by the company issuing shares from the pool of authorized shares, without seeking the investor's consent.

While most investors expect to be diluted at some future time, for example, in connection with the next investment into the company, they try to structure their investment in a way to delay the dilution to a time when the value of the company has increased as well. To better understand dilution, read my blog post on dilution.

How many shares should be authorized initially?
For my startup clients, I typically recommend that 10,000,000 shares of Common Stock be initially authorized. There is no magic to this number, but it tends to result in a Series A price per share that is of a familiar/standard magnitude.

Typically, at a Series A stage, a startup is going to be valued between $2M and $12MM, broadly speaking. At the time of investment, the Series A price will be calculated as pre-money valuation divided by the total number of then issued and outstanding shares, plus the shares reserved under the company's stock plan (including an increase to the stock plan reserve for the Series A round). Simplistically, a $10MM pre-money valuation, divided by $10MM shares (which include shares already issued to the founding team and the unissued shares reserved under the stock plan), equals a Series A price of $1.00. Individual numbers will vary of course, but it makes it easy and convenient to stick to conventions, so that the Series A price per share isn't 1/100 of a dollar nor hundreds of dollars.

There is an additional consideration. When a startup is recruiting, optically, it is better to be offering 15K, 30K, or 75K shares to employees than 15, 30, or 75 shares. It requires an additional conversation with the recruits about the company's capital structure, about the number of shares that are authorized, and about why that is the case. Most likely, a company that starts out with a very small number of shares will end up doing a stock split at a future point. It's not particularly difficult, but it complicates matters. If you can authorize the "correct" number of shares from the start, the number that will make your life easier, why wouldn't you?

I recently heard from a company that was incorporated by their CPA, that they were advised to authorize no more than 5,000 shares. The logic behind this suggestion was to save the company money on Delaware franchise taxes. It is true that using the "authorized shares method" a company's franchise tax liability can be as low as $75.00 per year for so long as the company does not authorize more than 5,000 shares. And for a regular small business (not a startup), that's a perfectly acceptable logic to follow. But startups need room to grow. No VC will understand the logic behind keeping the authorized share number extremely low to save a couple hundred bucks. It will seem very short-sighted to them, not smart and frugal. A typical startup uses the "assumed par value capital" method to calculate its Delaware franchise tax liability. The minimum tax that may be owed under the assumed par value capital method of calculation is $350.00. The actual formula to calculate franchise tax liability using this method can be simplified to the following:

Total Gross Assets (as reported on the U.S. Form 1120, Schedule L) X (Authorized Shares / Issued Shares) X $0.00035.

How many shares then should the founders issue to themselves initially?
Founders have a very natural inclination to want to issue amongst themselves all the shares that they authorize in the initial Certificate of Incorporation. However, if the company plans to use equity in the near-term to incentivize its consultants and employees, then a reserve of authorized but unissued shares should be left for this purpose. A typical reserve, even without a formal stock plan, is 10-30% depending on the company's hiring plans. So, in our typical scenario, the founder or the founders would be issued, in the aggregate between 7M and 9M shares of Common Stock, with 1M to 3M authorized and unissued shares remaining available for future issuance.

Note that the share reserve needs to be sufficient for the company's hiring needs until the next time that the Certificate of Incorporation is amended, and as we've said before, a natural time for the Certificate of Incorporation to be amended is in connection with an equity financing.

Finally, just a reminder that for founder shares to be properly issued, the following formalities should be observed:

there needs to be board authorization (either at a meeting or by written consent) for the issuance,
there should be a stock purchase agreement (preferably with vesting) documenting the sale and issuance of the shares,
there must be consideration in some form paid for the shares (by assignment of technology is very common),
stock certificates should be prepared and signed to evidence ownership of the shares (but kept in escrow by company secretary, and not distributed to the stockholder, if the shares are subject to vesting),
the sale should be made in compliance with both a federal and a state securities exemption (which sometimes require a filing, like the Section 25102(f) filing in California), and
there may need to be a 83(b) filing made as well, if shares are being issued subject to vesting.

Happy company making!

Inna

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.

Monday, November 12, 2012

Antidilution Protection FAQs

"Dilution" is a very frequently heard word in startup circles. And I think most people have a pretty good general sense of what dilution is--it's when you have a piece of the pie and something happens which decreases your piece.

What I think is less understood, are (1) the implications of something happening which results in dilution to existing equity holders, and (2) the rights to protect against the resulting dilution (also known as "antidilution protection").

What Triggers a Dilutive Event.

So what has to happen to decrease your piece? Let's run through the simple algebraic analysis first. You (the founder or the investor) have x shares and the company has a total of y shares outstanding. So your piece is x/y. Then the company issues more shares so that it has y+n total shares outstanding, but you still have only x shares. x/y > x/(y+n), so you had a higher percentage of the company before the dilutive issuance.

But now let's see what's happening from a business perspective. Why is the company issuing more shares? Not every dilutive issuance is equal in its impact on the company. If the issuance serves to increase the value of the company, your smaller piece of the pie might in fact have a higher value than the bigger piece of the smaller pie that you had before.

Example: Suppose you are a 10% equity holder in a company valued at $5,000,000. The company subsequently raises another $5,000,000 at a $15,000,000 pre-money valuation--a dilutive event. Prior to the financing you have 10% of $5,000,000, which is $500,000, and post financing you have 7.5% of a $20,000,000 company, which is $1,500,000. Your stake decreased, and your percent ownership was diluted, but you are doing ok!

The example above demonstrates that what you should watch out for is not securities issuances which dilute your percentage interest, but securities issuances that decrease your total value. The latter are the instances where equity is being issued without a corresponding increase in the value of the company. Examples of those might be (a) warrants with a low exercise price that are issued as part of a loan transaction, (b) shares issued to investors at a discount or a price lower than the company's last valuation, or (c) shares issued to employees.

Protection Against Antidilution.

Now that we know how to distinguish between different kinds of dilution, how do we protect against the bad kind, the kind that dectracts from your value?

As disappointing as this may be for founders and other holders of common stock to hear, really the only equity holders who ever get antidilution protection are the investors (holders of preferred stock). I am sure there are exceptions to this rule, in the way that there are exceptions to every rule. But 99.99% of the time this holds true.

It may not seem fair to someone who has earned his sweat equity with... well, sweat and hard work. But investors are the ones that pay the full market price for their shares (usually 3x or more the price of Common Stock), and they are the ones who are more typically able to successfully negotiate some protection for themselves. Note, however, that even their protection does not lock their initially purchased percentage for perpetuity. Generally speaking, with each new sale of securities, their percentage, too, will be effected. However, they will get an adjustment (the conversion rate at which they Preferred Stock converts into Common Stock will increase, such that the same number of Preferred shares will be convertible into more shares of Common Stock) for issuances made at a price below their entry point, with certain exceptions. The list of exceptions to investors' antidilution protection is frequently the subject to heavy negotiation between company and investors' counsel.

Happy company making!

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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