Convertible Note Seed Financings: Founders Beware!

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Editor’s note: Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, a boutique corporate law firm specializing in the representation of entrepreneurs. Check out his blog or follow him on Twitter as @ScottEdWalker.

This post is the third part of a three-part primer on convertible note seed financings. Part 1, entitled “Everything You Ever Wanted To Know About Convertible Note Seed Financings (But Were Afraid To Ask),” addressed the basics. Part 2, entitled “Convertible Note Seed Financings: Econ 101 for Founders,” addressed the economics. This part will address certain tricky issues.

What Happens If a Startup is Acquired Prior to the Note’s Conversion to Shares of Preferred Stock?

As discussed in part 1, in the context of a seed financing, a convertible note is a loan that typically automatically converts into shares of preferred stock upon the closing of a Series A round of financing. One of the tricky issues that founders must address in the note is what happens if their startup is acquired prior to the note’s conversion (and prior to the note’s maturity date, as discussed below). There are generally three different approaches:

1) Money Back, Plus Interest (Founder-Friendly).  The first approach is the most founder-friendly, and it is a provision that merely requires the startup to pay-off the loan, plus interest.  In other words, in the event of the startup’s “acquisition” (which is often broadly defined to include a merger, change of control or sale of substantially all its assets), the maturity date of the note would be accelerated, and the amount of the loan, plus interest, would become due at the closing of the acquisition.  Obviously, this is not very appealing to sophisticated investors because their return on a high-risk investment would only be the interest on the loan, which (as discussed in part 2) is typically 5%-7% annually.  In Fenwick & West’s 2011 Seed Financing Survey (the “Fenwick Survey”), the percentage of convertible note seed financings that utilized this approach was 17% in 2010 and 9% in 2011.

2) Conversion Right (Investor-Friendly). The second approach is the most investor-friendly, and it is a provision that permits the noteholders to convert the notes into equity (or otherwise grants them a certain percentage of the sale proceeds), based on an agreed-upon valuation of the startup. There are variations and complicated language that are typically negotiated to address the conversion right; however, the bottom line is that the noteholders would be able to share in any upside if the startup were acquired.

For example, let’s assume that the noteholders invested $500,000 and were granted the right to convert into shares of common stock at a $4.5 million valuation in the event the startup were acquired prior to the Series A round (or other “qualified financing”). If the startup were then acquired for $20 million, the noteholders would receive $2 million or 10% of the proceeds (not including accrued interest), by converting the $500,000 loan into shares of common stock representing 10% of the issued and outstanding shares, post-conversion ($500,000 divided by the sum of $4,500,000 and $500,000).

In the Fenwick Survey, the percentage of convertible note seed financings that utilized this approach and thus granted the noteholders a right to convert at an agreed-upon valuation was 33% in 2010 and 65% in 2011.

3) Premium (Intermediate Approach). The third approach is generally deemed an intermediate approach, and it is a provision granting the investors the right to get their money back with interest, plus a premium, which is typically drafted as a multiple of the principal amount of the loan (generally in the 0.25x to 1.50x range). Using our example above, and assuming a 1.0x premium, the noteholders would receive $1 million, plus interest, computed as follows: $500,000 (principal amount) plus $500,000 (premium) plus interest, which is obviously $1 million less than investors with a conversion right would receive.

Notice, however, that this so-called intermediate approach can actually be the most beneficial to noteholders (and the least beneficial to the founders) if the startup were sold for a relatively low price. Using our example above, but dropping the purchase price to $7 million, we can see that the noteholders would receive (i) $700,000 (10% of $7 million), plus interest, if they converted the note into shares of common stock; and (ii) $1 million, plus interest, if they were granted a 1x premium (an additional $300,000). This is why many sophisticated investors will push for both a conversion right and a premium, with the right to choose the higher amount. (Sophisticated investors will also push for a provision prohibiting the pre-payment of the loan to prevent an end-run around the second and/or third approach.)

In the Fenwick Survey, (i) the percentage of convertible note seed financings that granted the noteholders a right to receive a premium was 50% in 2010 and 61% in 2011; (ii) the median premium was 0.75x in 2010 and 1.0x in 2011; and (iii) the percentage of convertible note seed financings that granted the noteholders both a conversion right and a premium was 0% in 2010 and 35% in 2011.

What Happens If the Maturity Date Is Reached Prior to the Note’s Conversion to Shares of Preferred Stock?

This is another tricky issue. Founders must not forget that a convertible note is a loan and, like most loans, has a fixed due date (or “maturity date”) for repayment of the total amount borrowed, plus interest.  Convertible notes are thus ticking time bombs: if the maturity date is reached, and there hasn’t been a Series A round (triggering the automatic conversion of the notes into shares of preferred stock), there is the potential for disaster.

The maturity date for convertible notes typically ranges from 12 to 24 months from the closing date, with 18 months being the most common. In the Fenwick Survey, the median term was 18 months in both 2010 and 2011. Accordingly, a startup that has issued convertible notes as seed financing will generally have an 18-month window in which to close a Series A round. If the company is unable to do so during such period, it will generally be required to repay the loan, plus interest, or otherwise be in default under the note; in which case, the noteholders may force the company into bankruptcy.

As discussed below, there are two ways a startup can avoid this nightmare scenario: (i) include a provision in the note that requires an automatic conversion of the loan, plus interest, into equity on the maturity date; or (ii) negotiate an extension of the loan (i.e., a new maturity date) with the noteholders.

1) Automatic Conversion. Founders can often convince “friends and family” and less-sophisticated investors to agree on an automatic conversion into shares of common stock in the event that there hasn’t been a Series A round prior to the maturity date. Sophisticated investors, however, will push back hard against such a provision. From their perspective, requiring the loan (plus interest) to convert automatically into shares of common stock (or a new series of preferred stock) upon a default arguably rewards the founders and removes the significant leverage and rights the noteholders would have as creditors of the startup. Indeed, in the event of the startup’s bankruptcy or an assignment for the benefit of creditors, the noteholders would have priority (i.e., be ahead of the stockholders) with respect to any payments or distribution of assets. Moreover, the noteholders would likely have the leverage to negotiate a conversion into equity on terms satisfactory to them regardless of the terms of the note.

The Fenwick Survey does not address the percentage of convertible note seed financings that required the notes to convert automatically into equity at the maturity date. It is interesting to point out, however, that the convertible notes issued by Y Combinator companies to the Start Fund include an optional conversion upon maturity into Series AA Preferred Stock based on a $5 million valuation (see post here).

2) Loan Extension. The second approach — negotiating an extension — is more common and obviously depends on a number of different factors, including the startup’s financial condition and prospects, the market conditions, the relationship between the founders and the investors, etc. Moreover, for an extension to work from a practical standpoint, it is often necessary that the note include a provision permitting its amendment or a waiver of its terms upon the written consent of a majority of the holders (based on the principal amount outstanding). Founders and company counsel sometimes miss this issue, and it later comes back to haunt them – when one minor noteholder ends-up holding the negotiations hostage.

Does a Startup Have to Comply with Any Securities Laws in Connection with the Issuance of Convertible Notes?

Yes, a convertible note is a “security” under federal and state securities laws. Accordingly, founders must understand that, even though a convertible note is debt upon issuance, it is no different than issuing shares of common or preferred stock for purposes of securities-law compliance. Needless to say, a comprehensive discussion of applicable securities laws is beyond the scope of this post; however, here are two key takeaways for founders: (i) make sure all the noteholders are “accredited investors”; and (ii) don’t compensate anyone for helping you raise funds unless they’re a registered “broker-dealer.”
1) Accredited Investors.  The rule of thumb in connection with private placements (like a convertible note seed financing) is to issue securities only to accredited investors in reliance on Rule 506 of Regulation D of the Securities Act of 1933. There are two significant reasons for this: First, Rule 506 preempts (or overrides) state securities laws – which means that a startup doesn’t have to spend a lot of time and money dealing with applicable state securities commissions (other than preparing and filing a Form D). Second, there is no written disclosure requirement, like a private placement memorandum, if the investors are accredited.

There are eight categories of investors under the current definition of “accredited investor,” the most significant of which for seed financings is an individual who has (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase, not including the value of their primary place of residence; or (ii) income exceeding $200,000 in each of the two most recent years (or joint income with a spouse exceeding $300,000 for those years) and a reasonable expectation of such income level in the current year.

2) Broker-Dealers. There are lots of companies, individuals, websites and other so-called “finders” offering to help startups raise funds. Founders must understand, however, that if a finder is receiving some form of commission or other transaction-based compensation (which is often the case), the finder will generally be deemed a broker-dealer and thus will be required to be registered with the SEC and applicable state commissions. If the finder is not registered as so required and sells securities on behalf of a startup, the private placement will be invalid and the startup will be in violation of applicable securities laws.

For example, in August 2011, the California Department of Corporations issued a formal consent order against Profounder (a crowdfunding site that recently shut down) to “desist and refrain” from engaging in securities transactions without registering as a broker-dealer. Accordingly, any startup that raised funds via Profounder runs the risk of having violated applicable federal and state securities laws by utilizing an unregistered broker-dealer. (Note: Pursuant to the recently-enacted Jumpstart Our Business Startups Act, certain sites will be permitted to register with the SEC as a “funding portal” in lieu of a broker-dealer, provided that certain other requirements are met.)

The bottom line is that founders must be very careful any time they are taking other people’s money. Non-compliance with applicable securities laws could result in severe consequences, including a right of rescission for the stockholders (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution.

Editor’s postscript: We accidentally republished the second part of Scott’s series earlier this morning, rather than part three. Sorry about any confusion!

[image via flickr/Elliott Brown]