As chairs of the American Bar Association Business Law Section’s subcommittee on Angel Venture Capital, Fox Rothschild is undertaking an ongoing analysis of early stage convertible notes and their current market terms. Over a series of blog installments, we will analyze the state of the market and present results of the subcommittee’s informal national survey of convertible note term trends.
As Fox Rothschild attorney Alexander Radus noted in our first entry in this series, convertible notes offer advantages to priced equity rounds for early stage companies- faster and cheaper to close, fewer terms to negotiate, and the ability to delay the ultimate question on the valuation of the company. But once a Founder has resolved to raise capital on convertible debt, the inevitable question they face is “what are the market terms on the economics for a convertible note round?”
In September 2015, Fox Rothschild conducted an informal national survey of 24 attorneys leading private equity and venture capital practices. Respondents included lawyers from the west coast (3), the southwest (1), the midwest (3), the southeast (2), and the northeast (15). One goal of this survey was to quantify market economic terms on several of the most common features of convertible notes.
Like traditional loans, convertible notes accrue interest and have a maturity date. However, unlike traditional loans, convertible note capital raises assume that a priced round of equity financing will follow the convertible note financing, typically termed the “Qualified Financing” (e.g., a new money Series A investment of $1 million). When the company closes the Qualified Financing, the note debt converts into preferred stock along with the purchase of Series A by the new money investors. Although there’s variation among structures, convertible note investors have, over time, established a market set of mechanisms to compensate them for their earlier and riskier investment- the “Discount” and the “Cap”.
- Discount. Notes typically convert at a discount (e.g., 10-30%) to the price paid by the new Series A investors. This results in investors converting the principal and interest of their notes at a lower price than the purchase price paid by the other Series A investors, thus receiving additional “bonus” shares in the Series A round. Founders want to negotiate the lowest Discount possible.
- Cap. Although the Discount is a great feature for “juicing” the number of shares a noteholder receives in the Qualified Financing, investors often also negotiate a valuation “cap” on the pre-money valuation at which the notes will convert. Caps provide a backstop on runaway increase in value of the company for the purposes of calculating the conversion price of the notes. The Cap ensures that if the company’s pre-money valuation in the Series A round is higher than the Cap, the note converts at Capped valuation. In effect, this guarantees the minimum number of shares the noteholder will get on conversion in the Qualified Financing. Founders want to negotiate the highest Cap possible, or even better, no Cap at all.
Typically, noteholders have the right to convert their note at the lower of (a) the conversion price determined by applying the Discount and accumulated interest to the pre-money valuation or (b) the conversion price determined by applying the Cap. For example, on convertible notes with a 20% discount and a $4 million valuation cap, the noteholder would receive a 20% discount on the Series A price up to a valuation of $5 million, and if the Series A investors are paying a price per share based upon a valuation higher than $5 million, the convertible notes will convert at a discounted price per share based upon the $4 million valuation cap.
Cap and Discount, therefore, are two of the main economic terms Founders and investors negotiate when offering notes. So, what’s market? Each of our survey respondents confirmed the Discounts and Caps on their five most recent convertible note financings.
A few interesting points based on these survey results:
- While Discount shows strong center at the “standard” 20% (28% of deals), a surprising number of deals (16%) reported no Discount on the offering.
- Nearly a third (30%) of note deals indicated “uncapped notes”, highlighting a market deviation from what most would consider as a “standard” feature; perhaps the growing number of “unicorn” companies (private emerging tech companies achieving a +$1B valuation) has given Founders leverage to eliminate the Cap feature from note offerings.
- For those note offerings that include a Cap, almost all Caps are at or above $3mm- a good sign for Founders typically raising their first round on convertible notes.
In addition to these economic terms, the survey produced insights related to timing of the offerings, alternative “convertible equity” offerings, and other unique features, which will be discussed in our next installment in the series.