More convertible debt questions
(Note: Any numbers below are hypothetical and for illustrative purposes only.)
UPDATE: In italics below…
About to have a call with our lawyer about our convertible debt round. Some of the questions we’re going to bring up. With permission I’ll post some of the discussion after the call…
#1 - What should the payment be if there is a liquidity event (e.g., sale of the company) during the term of the note? Currently, it’s 120% of the value of the note. We feel that’s probably low. One of our investors suggests 200% in the first 12 months, 300% in the next 12 months, etc. with a cap of 40% of the sale price (if we sold we’d receive at least 60% of the sale price). Is this fair?
We’re going to go with 200% and no cap. Seems pretty fair…
#2 - After the term of the note what happens? Currently our note expires after 1 year. If we haven’t raised a Series A then what do we do? The note would be due and so legally we’d be obligated to repay our investors would own the company in its entirety. However, they probably wouldn’t want that as we as the entrepreneur would have little incentive to continue. Our thought is that the fairest thing to do would be to allow the debt to convert to equity at an agreed-upon valuation. Another possibility would be to convert the note into a new note (presumably with an additional discount going forward).
It seems best to just have this be a conversation/negotiation if it gets to that point. Ultimately we want investors we can trust and who can trust us. If we don’t feel comfortable that we can work something out in 12 months if things don’t go as planned then it’s probably a pretty good sign we’re talking to the wrong types of investors.
#3 - Do we convertible investors the opportunity to “ride along” for future financings? The ability to re-up in future rounds would definitely benefit the early investors. So if someone invests $100K in the seed/convertible round and ends up with 2% of the company at the time of Series A (a post-money of $5MM) do we give them the opportunity to “double down” and invest another $100K at the time of the Series A closing so they would own 4%. Good for the investor, potentially not so good for us especially as it relates to our overall ownership of the company.
Also, even more favorable for the investor would be the opportunity to take any “double down” opps that other seed investors don’t take. For instance, Investor A above doubles down and invests another $100K for an additional 2% of the company. However, Investor B (who has also invested $100K) can’t afford to or doesn’t want to. Can Investor A invest another $100K and end up with 6% of the company?
The feedback we received is that adding these terms would be fairly non-standard and could cause some hitches in our Series A financing. Anything that makes a Series A more difficult ultimately harms our seed investors and so while in some ways this is favorable to the earlier investors we think it’s best to leave these terms out. To the extent that we can give our seed investors the opportunity to raise their stake in Series A and future financings we would love to give them that opportunity. However, to give them that right definitely lessens our flexibility.
#4 - What exactly determines a Series A financing? We’ve set a minimum amount which determines whether an equity financing qualifies as “Series A.” What is a fair number? Certainly many Series A financings for web companies are smaller these days because the costs of creating a web business are lower. Also, is there an intention that Series A mean institutional money? If we banded five angels together who put in $500K each would that be our Series A round. Might seem like it is but at the same time the terms the angels agree to could be very different than the terms of a typical VC term sheet. So it’s not just amount that matters but also who’s investing.
In the end this could be pretty complex. So we’re just going to go ahead and say as long as the aggregate amount of the Series A is greater than $1.5 million it qualifies as a Series A financing.
That’s all for now. Update coming soon…
3 Comments
- 1. sundeep said:
wickedly helpful…THANK YOU.
posted April 18th, 2007 at 2:03 pm
- 2. patrick said:
very cool to see other entrepreneurs going through the note purchase drafting process. we set our trigger financing round (or Series A) as the first equity financing which exceeds $1mn in aggregate funding (including convert debt issued).
posted April 20th, 2007 at 8:37 pm
- 3. Nitin Malhotra said:
Just found your blog with a google search for ‘convertible debt’ and it’s really helpful to read the details from a startup perspective going through the motions. Very insightful … thanks!
posted June 13th, 2007 at 7:10 am
