In this post, I am going to discuss something that is less understood than caps, but in exit scenarios where the note has not converted have a VERY material impact on investor returns. Specifically, optional conversion features.
One of the biggest complaints about convertible notes from angel seed investors is “What happens if the company never does a conversion event and the company is sold, or the company is doing great but the note matures before a conversion event? I don’t want to just get paid back interest and principal!” In our experience, these concerns can be addressed by using convertible notes which include the investor option to convert into common at a pre negotiated valuation, as well as a liquidation preference.
The optional conversion into common may take the following form in a term sheet: “In the event of a change in control of the company prior to conversion or at the maturity date, the Investor shall have the right, in the Investor's sole discretion and option, to convert the principal and accrued interest into common shares of the company at an amount equal to one percent (1%) of the Company’s capital for each X thousand dollars ($X,000) of loan balance under the Notes (determined as of the date of Closing and adjusted for any stock splits)”. “X” of course is something that gets negotiated. What is a fair amount for X? It depends on the stage of the company, the risk, the amount of money going in on the note(s), and how hard both parties want to push to negotiate it. In our experience, “X” can range from 1% for every $3,000, up to 1% for every $10,000. The implied valuation of the company under these two scenarios would range from $300,000 to $1,000,000 – but this is still for very early stage companies. Another guideline to use is that this conversion value should be somewhere between 5-15% of the conversion cap on the note. If a company has already done a 409A valuation (although very few have at this stage), the 409A per share price should be used. In no event should this conversion allow the noteholders (combined) to have more than about 25% of the common stock of the company. Keep in mind that many accelerators today take anywhere from 6-10% of common stock right up front for only $15,000-30,000. And remember – this optional conversion stuff all goes away if the company does raised a qualified round of financing and the notes convert into preferred stock at a valuation set by a new investor.
The liquidation preference may take the following form in a term sheet: “In the event of a change in control of the company prior to conversion, the Investor shall have the right, in the Investor's sole discretion and option, to be repaid an amount equal to X times the sum of the original principal balance of the Note plus accrued interest.” Again, “X” is something that gets negotiated. We insist on 3 times if it is our note and we are leading, but can agree to 2 times if the note is being led by other investors we trust.
We like to have both the optional conversion into common and the liquidation preference in our notes. Why? They address 2 different possible outcomes. The conversion into common is good to have if it is an early home run where the company has created significant value using the capital raised from the notes, and is being acquired at a significant markup. The optional conversion is also very helpful if the company has done very well but the company has not raised a priced round to trigger conversion and the noteholder wants to actually own a piece of the company. The liquidation preference is good to have if the proceeds from the sale of the company are, well, less than a home run. And for early stage companies doing early exits – often the “acquihire” – this allows the note holder to get a reasonable return – say 2-3 X – as recompense for the risk taken.
So any downsides to these conversion features? Sure. First, they do complicate the note. One of the great things about a convertible note versus priced preferred is that they are simpler to get done; while these conversion features are additional elements that are subject to negotiation and need to get papered and potentially explained going forward, we believe the tradeoff is worth it. The other issue sometimes raised is that this is actually setting a valuation for the company. We think that is a red herring. Any sentient future investor looking to do a priced preferred round in the company will not put much weight in the optional conversion value of the common stock.
Net, we believe that with a combination of reasonable conversion caps and optional conversion features, convertible notes remain a very effective tool for early stage seed investment – they offer an appropriate mix of risk, reward, and simplicity to work in most first-capital-in investment scenarios.