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Convertible Promissory Note Financing: Part I – Introduction
This series explores the convertible promissory note (referred to in this article series as a "convertible note"). A convertible note is an instrument frequently used by startup companies to: (1) finance early growth activities, before the formation of capital through the offering of priced equity, or (2) bridge financing, allowing the issuer to achieve certain key performance indicators (KPIs) in advance of, or in between, a round of equity capital raised at a valuation agreeable to all parties.
In general, convertible notes come in two varieties. The first, can be described as "stand-alone" convertible notes, in which all salient terms of the convertible promissory note are captured in the body of the convertible note. In a stand-alone convertible note, the note is the transaction document and the evidence of debt at the same time. Each stand-alone convertible note is negotiated with the person holding the debt instrument (usually referred to as the "holder," "debtholder," "note holder," or "purchaser"), and offers the startup company (referred to as an "issuer") a great deal of flexibility in negotiating advisable terms with each note holder in a round of fundraising on convertible promissory notes. For purposes of defining a “round” of fundraising, stand-alone notes can still be issued in a common series denoting similar terms the convertible notes, or notes issued in a confined period of time.
The second convertible note variety can be described as a class or series of convertible notes issued pursuant to a central note purchase agreement. This is sometimes referred to as the “credit facility” approach. This manner of fundraising is commonly used when a single person or entity is the primary or sole negotiator in the establishment of terms surrounding a round of fundraising through the issuance of convertible notes. In this method of fundraising, all of the terms of the class or series of convertible notes in the same issuance are established in the note purchase agreement and all of the note holders execute a central note purchase agreement (analogous to a stock purchase agreement). In turn the company issues each note holder a convertible note which serves solely as evidence of the principal amount owed and the convertible note references the note purchase agreement for the purpose of establishing all other terms associated with the convertible note.
By and large, the reason for selecting one method or the other of issuing convertible notes is a dealer's choice. However, if you're an issuer lucky enough to have an advocate helping you to shake the proverbial capital tree, you may find it advantageous to negotiate terms with your principal investor and simply allow others participating in the round to follow those terms in a note purchase agreement. If however, you're taking investment from different, persons, entities, or groups who each have different reasons for investing in your startup, using stand-alone notes may be advisable, as you can offer different terms to each investor, meeting each investors’ strategic needs and/or wants.
Now that we've discussed the two methods of fundraising using convertible notes, it would be prudent to consider the other negotiated provisions commonly contained in a convertible note. Again, the terms commonly negotiated in a convertible note can be divided up into two categories, the first category is the central considerations in a convertible note:
- Principal Amount
- Valuation Cap
The second category of terms meriting discussion is highly dependent on regional custom, investor concerns, and willingness of the issuer to offer certain concessions or benefits to its investors to incent or reward investment. This list is fluid, but for the moment we will consider:
- Manner of Conversion
- Most Favored Nations
- Right of First Refusal
- Corporate Transaction Multiples
In addition to these two tiers of consideration, an issuer may consider offering additional benefits or rights to certain investors through a side-letter. These include rights such as information rights, major investor rights, board seats and the like.
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