Convertible Note Term Sheet
A convertible note term sheet informs about the intent of an investor to engage with a startup using Notes.
A convertible note is one of the handiest fundraising tools for startups. It is a seamless process where startups manage to raise reasonable funds without parting with equity right away. Typically founders bootstrap into the business, and then fundraising is always a challenging task. In such situations, notes are a convenient option. But how do these negotiations happen? How do both parties ensure clarity in their contracts?
Startup finances are typically shaky in the initial years of growth. The fundraising process becomes difficult after the founders have powered through by burning their personal resources. Besides, startups are always low on collateral. This limits their prospects of raising big funds from the market in the seed stages. Founders then must engage in intelligent networking and attractive pitches. Convertible notes act as an essential debt instrument in these situations.
What is a Convertible Note?
Convertible notes are basically short-term loans. By using these, investors can loan a certain amount of money to a startup in exchange for equity. It works well for startups because founders do not require a company valuation to access these funds. This is a huge benefit as startups are powered by brilliant ideas in their initial stages. Also, the equity promised through a note is not granted upfront. These factors make notes a popular seed funding instrument.
Though notes are a debt instrument, unlike traditional loans that operate on high-interest rates and regular payback schedules, notes are seamless. Founders don’t have to pay back the principal amount or accrued interests. Based on the agreed terms, Notes eventually convert to equity. This is usually an automatic process and happens at the Series-A round. Investors also have a manual conversion option based on the predetermined maturity date. Convertible notes always convert to preferred shares.
Example of a convertible note
Let’s consider a simple scenario. Imagine a startup raising $50,000 in seed money. This fund is granted in the form of convertible notes for a period of 3 years. Investors levy a condition that these notes will convert to equity at the end of 3 years or at the Series A round, whichever is earliest. Let’s say the startup is ready for a Series A round by the end of the second year. It undergoes a company valuation before the equity round and each share is valued at $2. Since the Notes will convert to equity, investors will gain 25,000 shares of the company at this milestone event.
This is a straightforward calculation. However, in reality, many other factors come into play. Notes are not issued with linear conditions, but they are granted a choice of five types of variations:
- Notes with an interest rate
- Notes with a discount rate
- Notes with an interest rate and a valuation cap
- Notes with a discount rate and a valuation cap
- Notes with an interest rate, valuation cap, and discount rate (least popular)
Importance of Issuing Convertible Notes
Convertible notes play an essential role in the startup fundraising journey. If these young businesses are forced to rely on traditional bank loans, there would be a heavy lag in realizing good ideas. Not all industries can afford slow growth. Especially in the ever-evolving digital marketplace, time is of the essence. A delay in business expansion because of a lack of the right funding mechanisms would be a loss. Here are some of the crucial functions of notes in this aspect:
- Company valuation not required – Company valuation is a lengthy and expensive process. Moreover, a startup in the initial stages does not have much ‘value’ per se. Stakeholders do not require a formal startup valuation for any transaction involving Notes.
- Future currency for investors – Startup investments are a matter of risk. If the idea flies, investors gain massive returns. But there is always a risk factor. Despite estimations and due diligence, sometimes startups fail, and investors lose all their money. In such a situation, Notes provide a certain degree of assurance. The money invested via Notes converts into equity with higher returns, thus compensating for the early-stage risk factor.
- Common stock not issued – Notes convert to preferred stock and not common stock. This is a huge relief as founders need not part with their shareholdings in the early stages of startup operations.
- Investors don’t have immediate rights – Since notes convert only at a milestone event, founders need not worry about investor involvement/management control in company operations until the maturity date. Investors do not have any shareholder rights until Notes convert to equity.
- Less time, low cost – Convertible notes enable a quick deal closure. It takes only about a day or two to complete the whole process. Besides, the legal fee involved in documentation is usually within $2,000.
- Flexible pricing – Since notes can be issued with varying conditions in interest rates, discount rates, and valuation caps, founders can involve multiple investors with varied pricing structures in the seed round. This provides a wide range of possibilities for a startup’s economic conditions.
4 Main Financing Instruments
To better understand the importance of a convertible note term sheet, let’s explore the various financial instruments available for startup funding. Each one has its merits and demerits. Founders must learn and understand the nuances of each instrument to make the best of it.
- Convertible Notes – As the name suggests, these financing instruments are convertible in nature. They are granted in one form with a promise of change at a ‘milestone’ event. These are short-term loans and automatically convert to equity at the first equity finance round, Series A. Sometimes investors might choose a manual conversion based on their predetermined objectives. The conversion from Note to equity is governed by factors such as ‘if’, ‘when’, and ‘how’.
- Debt Financing – These are typical business loans. Equity is not involved here. A money lending institution such as a bank lends a certain sum to a startup at a particular interest rate. The loan is expected to be paid back within a certain period with full accrued interests. However, a company must produce collaterals (usually in the form of assets) to raise debt finance. Companies normally avail debt financing for acquisitions without blocking their operating capital to complete these transactions. Interests are paid off from the revenues generated by the new acquisition.
- Equity Financing – Private equity and venture capital funds are equity financing instruments. Here founders raise money for the business by selling shares in exchange for funds from these institutions. However, equity finance is not just an exchange of funds for company equity. Investors take up a prominent position within the startup management team and get involved in the day-to-day business functions. Equity financiers don’t expect to receive their money back as it is. They demand heavy ROI over a short period, something beyond usual market investments. Thus if the business fails due to unforeseen circumstances, founders are not expected to return the money.
- SAFEs – SAFE stands for Simple Agreement for Future Equity. Y Combinator introduced this in 2013 to facilitate quick and easy fundraising for early-stage startups. It is a standardized document without any maturity dates. It functions as a warrant and is the only thing to be negotiated in a SAFE between investors and founders in the valuation cap. Once this is decided, both parties can sign the agreement, complete the fund transfer, and get to work. SAFEs being a single, standardized document, eliminate the unnecessary legal cost and back-n-forth negotiations to close one deal. This is one of the most popular fundraising instruments for early-stage startups looking to quickly get the initial operating funds.
Convertible Note Term Sheet
Before understanding the concept of a convertible note term sheet here is an organic progression of the documents that are exchanged in the startup fundraising process using Notes.
- A one-pager Teaser
- A non-disclosure agreement
- A detailed presentation for the stakeholders involved in the decision-making process
- A term sheet
- A memorandum of offering, and
- An agreement of subscription
What is a Term Sheet?
As the name suggests, a term sheet is a preliminary document initiated by an investor that lays out all the terms governing an investment opportunity in a company. It is not a legal document but is treated with equal importance. The issuance and acceptance of this document is the first formal step taken by an investor and a startup to clarify the intent of a fund-equity exchange. It is non-binding in nature. This allows both parties to verify their preferences and exit if required without going through the expenses and hassles of drawing a full-form contract.
What is a Convertible Note Term Sheet?
A convertible note term sheet informs about the intent of an investor to engage with a startup using Notes. It opens a space for negotiations between both parties before finalizing a legal contract. Since these are non-binding in nature, it provides startups a wider berth to analyze their company finances and agree on what is possible and what is not. At this stage, the only binding clause could be the ‘confidentiality’ of proposed terms. It is only fair as investors would not prefer disclosing their offers. Otherwise, startups need not worry about compliance issues. If the terms outlined in this document do not suit their needs, there is always room for honest negotiations.
Why do Startups need a Convertible Note Term Sheet?
The importance of a convertible note term sheet is truly realized in seed financing rounds of startups. This is because:
- Startup founders might be brilliant in their business ideas, but they are still learning the ropes of fundraising. This document helps them to take time and understand funding terms before making a long-term commitment to an investor.
- Notes don’t grant equity upfront but will eventually convert to company stocks. Founders find the preliminary terms set out in this document helpful to check their position with the board of directors in the context of dilution.
- Startups are limited by fund flow in the initial stages. It is important to streamline expenses. Since this document is not legal in nature, they can save costs before they are ready to invest in the final contract procedures.
- Standardized term sheets such as SAFE are now readily available for startup founders. This makes the fundraising process quick and easy.
What Should be Included in the Convertible Note Term Sheet?
Though a convertible note term sheet template is a preliminary document, it has certain mandatory aspects. These features form the basis of all terms and conditions to be followed during the investor-startup funding engagement. A template without sufficient clarity about these pointers fails to serve its purpose. Some of the important points covered in these documents are:
- Financing Amount – This is otherwise known as the ‘Aggregate Principal Amount’. It is the sum of all the convertible promissory notes raised by a startup during the seed round. It is the maximum amount an investor plans to grant a startup using convertible notes during the debt financing round.
- Closing – This aspect defines certain dates. It includes the end of the funding period as well as all the milestone events proposed in between the start and end date of the funding period. Clarity and agreement on these dates are important so that both parties are well aware of their deliverables.
- Maturity Date – This is the date on which a convertible note becomes eligible for equity conversion. It can be viewed as a trigger date after a holding period during which a Note will not convert to equity even if the startup manages a premature equity finance round. A maturity date is usually set at least 2 years after the issue date. This gives startups enough time to focus on using those funds instead of worrying about repayment or equity conversions.
- Conversion Price – Convertible securities by design convert to equity at a milestone event. The conversion price is the price per share value during such a trigger event.
- Valuation Cap – The price at which a Note converts into equity is known as the valuation cap. This is an important feature of this type of financing format as it primarily protects the interests of investors. Startup financing is a risky affair. Especially in the seed stage, the startup is still an idea with a promise of success. So investors who agree to fund a business at this stage must have a safety net. The valuation cap feature of a convertible note covers this aspect.
- Prepayment – This is a unique feature of Notes. Normally Noteholders gain from the event that triggers equity conversion of these debt instruments. But by using the ‘prepayment’ feature, founders may present a clause in the term sheet where they can prepay the Notes without the Noteholders’ consent. This clause can work only if both parties agree to it.
- Liquidity – This clause protects investor interests. It is a contingency plan in case a startup gets acquired by another company before the milestone or trigger event for Note conversion. In such a case, the amount of funds mentioned in this section is returned to the investors. This is a matter of discussion as both parties must make a plausible commitment in case of unfavorable conditions.
How to Create a Convertible Note Term Sheet
To create one, a person must know what a convertible note term sheet is. Though many formats are available online, creating a functional one is a technical task. Here are some options to go about it:
- Consult experts in equity management such as Eqvista
- Use standardized formats such as SAFE created by renowned startup accelerator Y Combinator
- If an experienced player, use the format created internally and tested in various investment scenarios
- If using an online/referred format, consult legal experts in startup business to create a thorough document
Example and Template of Convertible Note Term Sheet
A convertible note term sheet template is a crucial starting point to learn and understand this document. Though investors take the initiative to create and share this document, founders must know what they are getting into. They must know the purpose and structure of this document to use it to play to their strengths. Here is a basic structure and the standard components included in this format are:
- Name of the issuer
- Nature of ‘offering’, whether brokered or non-brokered
- Type of stocks offered
- Amount/size of the ‘offering’
- Issuing price is otherwise known as the price per share
- Date of maturity
- Commission percentages if any
- Extent of capitalization
- Expected dividends
- Preferred liquidation rights
- A clear definition of ‘liquidation event’
- Details of conversion rights in case it is included
- Details of anti-dilution clauses
- Clarity about voting rights
- Structure of fund utilization
- Conditions for ‘closing’
- Details of the agent facilitating the process
- Date of closing
These are the standard details included in every convertible note term sheet template. Some popular ready to use examples or references of these documents are:
- Kendrik Partners – This is a law firm specializing in legal counsel for tech startups. From years of experience of working with early-stage startups, they have come up with this template.
- Tech Coast Angels (TCA) – TCA is an angel investors group. They are one of the largest seed funding bodies in the USA. From their rich and diverse investing experience they have come up with this template.
- Open legal documents – This is an open-source repository of legal documents focused on startup businesses. It is a diverse collection of knowledge across the startup marketplace. Here is their sample template.
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