7 Do-Or-Die Warnings Before Taking A Convertible Note

Investing in an early tech company seed round costs our fund an average of $40 K to $50 K. As a result, making a $100,000 investment simply does not make sense for most VC funds. Angel investors fill the much needed “gap” in pre-Seed startup financing

Convertible notes allow angel investors to minimize their legal expenses and to defer valuation negotiations until a subsequent round of financing. This allows the startup flexibility for the timeline to develop metrics which can be used to determine a fair pre-money valuation in subsequent rounds of funding.

Here is seven things you need to know is about convertible notes.

1) Uncapped Convertible Notes. Usually means that the valuation for the note conversion will be the same as the Series A valuation.

2) Capped Convertible Notes. The note conversion caps the valuation during the Series A conversion. For example, if the term sheet has a $6 million conversion cap, even if the Series A valuation jumps up to $20 million the note will convert at a $6 million valuation. The convertible note seemed ideal to defer the valuation question till the company has metrics to determined valuations, but with caps the valuation question remains in play.

3) Conversion Rate Discounts. For example, the note holder gets a discount (ie a 15%) of or when the note converts.

4) Aggregate Proceeds. Usually required by the VC to convert all convertible debt to equity in this round. VCs usually want this so that no debt is senior to their investment.

5) A common mistake made by founders is to raise too much convertible debt without understanding precisely how much dilution that occurs when the note converts to equity. This is easy to do because of the rolling nature of convertible notes versus a “one time event” of a Seed or Series A financing. In addition, many founders forget to calculate the dilution that will occur from the convertible debt conversion to equity and how it also diluted the option pool.

6) Convertible debt is usually simpler and less costly than Seed and Series A rounds. Nevertheless, it’s still most likely considered a “security” as defined by the SEC. So be sure to always have an experienced attorney draft these documents. This is not something you want to “do-it-yourself.”

7) The VC Valuation on the term sheet is post money. Post money equals the VC investment plus the amount of the VC investment. Convertible notes are usually included in the money valuation.

For example, the term sheet post money valuation is $20 million and the VC invests $5 million for 25% equity. Let’s say that $3 million in convertible debts after caps and convertible note discounts are factored in. Here is where the cap and conversion rate discounts can have a major impact on founder dilution. Also, the employee option pool is agreed to be $2 million. Keep in mind that typically convertible notes and employee option pools dilute only the founders and not the VCs. Assuming no other variables, the founders in my example might be getting a much lower percentage of equity than they were expecting. Founders must know that the devil is in the details.

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