As counsel to both early-stage companies and the investors who invest in them, a lot of questions are posed to me about convertible notes. Here is one such Q&A:
Q: I did a convertible note round where my noteholders will get a 20% discount off the per share price of an equity round or a valuation cap of $3,000,000 when they convert the debt to equity. My company has not progressed as quickly as I’d hoped. I need more money, but my valuation will still be too low if I do an equity round. Can I just do another convertible note round to put off setting the valuation?
A: In true lawyer fashion, I once again come to you with an “it depends” answer, but let me explain what factors you should consider:
1. First, how confident are you that your valuation is going to be meaningfully higher if you push off an equity raise into which existing noteholders convert, relieving the debt on the company? Being diluted a bit more than you’d like is better than being out of business.
2. Second, you need to review the Note and Note Purchase Agreement that was signed by each investor. It should state the amount of a raise that will qualify as a “Next Equity Financing.” For example, it may say something like:
a. “Next Equity Financing” means the next sale (or series of related sales) by the Company of its Equity Securities following the date of this Agreement, in one or more offerings relying on Section 4(a)(2) of the Securities Act or Regulation D thereunder for exemption from the registration requirements of Section 5 of the Securities Act, from which the Company receives gross proceeds of not less than US $1,000,000 (excluding, for the avoidance of doubt, the aggregate principal amount of the Notes).
So, if you are going to raise $1,000,000 (or close to it) in a convertible note round instead of an equity round, your investors are going to wonder why you’re doing another convertible note round instead of an equity round into which they can convert if you are raising the full threshold amount for conversion. You need to be prepared to address that question. They may agree that it would be overly dilutive or unwise for other reasons to do an equity round at this stage. They also may end up offering to give you some more money as a cushion to get you through a period of time needed to get the valuation up, in exchange for better note terms. In contrast, if you are doing another note raise of only $250,000 because you only need that much to get your valuation up for an equity round (and you gave the existing noteholders the right of first refusal to invest more in the new notes), that is far less likely to raise eyebrows and cause friction.
3. Third, make sure you consider how much time is left before the existing notes mature. If they have a 2-year maturity date and it has already been 18 months, you really need to look at doing an equity raise or seeking an extension of the maturity date from your existing noteholders. You don’t want to raise money in a convertible note round only to use it to pay off debt to existing noteholders months later.
4. Fourth, are you going to offer less of a discount (such as 15% instead of 20%) and a higher valuation cap (such as $3.5m instead of $3m) in this next convertible note round than to your first investors? If not, the investors in your first note round are not going to be pleased. And they will be angry if you provide better terms to this next convertible note round of investors. Keep in mind, what impression are you giving new prospective investors if you are not treating your earlier investors fairly?
In summary, a great approach is to have this verse in mind: “do unto others what you would have them do to you.” Building a business on ethics and fairness will build loyalty. In the business of entrepreneurship and its uncertain journey, you would be wise to earn loyalty and build trust with your investors. This does not mean you should not also be fair to yourself and your co-founders and holders of sweat equity. This is definitely one of those decisions to seek advice about from trusted advisors and your attorney.
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