Convertible Promissory Note Financing: Part II – Common Terms

Convertible Promissory Note Financing: Part II – Common Terms

by Shamim Mohandessi

In our first installment, we reviewed some of the use cases for issuing convertible notes and the two common formats of convertible notes. In this second installment, we review the six central terms frequently negotiated in the issuance of convertible notes between issuers and holders. Generally, issuers negotiate:

  1. Principal Amount
  2. Term
  3. Interest
  4. Conversation
  5. Discount
  6. Valuation Cap

Principal

The principal amount of a convertible note reflects the amount invested by the holder of the convertible note in the issuer through the convertible note instrument. In early stage fundraising, startup companies generally raise anywhere from $500,000 to $2,000,000, in aggregate principal amount through the issuance of convertible notes. If used in bridge funding, convertible notes can have a much higher aggregate principal amount.

When using the stand-alone note approach, each note contains its own principal amount, but when using the credit-facility approach, all of the holders are subject to a single, central, note purchase agreement which contains the aggregate principal of all convertible notes issued in the round, while the associated convertible notes only contain the holder’s investment in the round.

Term

Convertible notes are a term instrument that become due and payable on the maturity date set in the convertible note or the note purchase agreement. Generally, convertible notes are issued with a maturity date that is 1-3 years from either the date the convertible note was issued, or the date of the first execution of a convertible note pursuant to the note purchase agreement. On the maturity date, a few different things can happen. Either the convertible note will remain outstanding and continuing to accrue interest, the convertible note will become due and payable, the convertible note will become a demand note (meaning that the holder or holders must demand repayment before the convertible note is due and payable), or the convertible note may convert to equity at some pre-determined price.

More recently, some firms have begun drafting convertible notes to be renegotiated if the maturity date is reached. This is practice appears to be an acknowledgement of the fact that the vast majority of convertible notes, especially those issued in first-round fundraising, remain outstanding past their maturity date.

Interest

Because convertible promissory notes are debt instruments, they generally carry interest. The interest rate on a convertible note is usually in the range of 5%-8% but can vary widely. In early stage fundraising, investors do not heavily negotiate the interest rate associated with convertible notes, as the issuer generally has little-to-no assets for the holder to recover from in the case of insolvency. Instead, investors will focus more heavily on conversion terms (discussed below). In later stage bridge funding, the holder may more aggressively negotiate the interest accrued on a convertible note, especially when the principal is significant.

Conversion

When a convertible note converts to equity, holders of convertible notes generally receive the benefit of favorable pricing in converting to equity. Usually, holders pay the lower of the price set in the next round of equity financing, less the applicable discount, or the price implied by a pre-agreed valuation cap.

The rationale for a discount is based on the view that early investors have taken greater risk in the company, in turn reducing risk for subsequent investors. As a result, convertible note holders should be rewarded with preferential pricing over the investor in the next round of equity financing.

Conversely, the use of a valuation cap is intended to protect convertible note holders from the risk of significant dilution in the case of an unexpectedly high valuation at the time of the next round of equity financing.

Discount

In the absence of a discount, when a convertible note converts to equity at the next round of equity financing, a convertible note’s equity and accrued interest would convert to the next round stock at the same price set by the investors in the next round of equity financing. With a discount, however, the price set in the next round of equity financing is reduced by the amount of the discount, creating a “shadow class” of with a lower original purchase price than those issued to new purchasers in the next round of equity financing.

Generally, first-round financing discounts will range anywhere from 5%-25%, but in a later-stage bridge financing, the discounts can vary more widely depending on the situation.

Valuation Cap

In addition to a discount, convertible notes frequently contain a valuation cap on the pre-money valuation of the issuer at the time of its next round of equity financing. The valuation cap allows the holder to have a better sense of scale of their participation in the next round of equity financing by providing an outer limit to the pre money-valuation of the issuer at the time the holder invests in the convertible note. In the absence of a valuation cap, a convertible note holder may invest a relatively small amount (for example, $100,000) in an issuer who is leverages that investment into a $75,000,000 pre-money valuation in the next round of equity financing. Because of the substantial increase in valuation in the next round of equity financing, the holder of the convertible note will not have significant participation in the next round equity.

Commonly, in a first-round convertible note, valuation caps range anywhere from $3 million to $10 million. That said, issuers should be careful to not mis-price valuation caps, as they can be devastating to founders who raise too much money on convertible notes with too low a valuation cap.

Now that we have had an opportunity to review these major terms of a convertible note, in the next installment of this series we will explore secondary terms frequently negotiated by issuers, including:

  1. Manner of Conversion
  2. Most Favored Nations
  3. Right of First Refusal
  4. Corporate Transaction Multiples
  5. Subordination
  6. Securitization

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