An article we liked from Thought Leader DC Palter:
Everything Startups Need to Know About Convertible Notes
The traditional startup investment instrument remains popular with angel investors
The SAFE and the convertible note are shortcuts for early-stage startups that aren’t ready to bite off on the time and expense required to issue preferred stock. They provide two different ways for investors to put in money now and get stock sometime in the future.
The SAFE is a kind of pre-payment for stock. The convertible note is a loan that converts to equity. There are a lot of similarities, but some critical differences.
The biggest advantage of the SAFE agreement is that it’s a simple template that requires filling in only a valuation or discount before being ready to sign. The flipside is that it offers limited flexibility and investor protection. For this reason, many sophisticated angel investors, angel groups, and early-stage VCs prefer the convertible note instead.
This flexibility makes the convertible note useful, especially for complex situations, but there is more a startup founder has to understand to avoid making critical mistakes.
What is a Convertible Note?
Also called convertible bonds and convertible debt, convertible notes have been around since the 1800’s. In their traditional use, they’re a loan with an option to convert the debt to stock under specific conditions at a set price. This makes them useful to hedge funds and distressed debt investors by adding a bit of upside potential to their loans.
Though the same documents, startup investors use the convertible note differently. Though legally a loan, nobody expects or wants repayment. They’re simply a holding device until the “equity round” when stock is issued.
However, because they’re loans rather than equity, this causes some complications that founders and investors need to understand.
First, like any loan, it has a maturity date by which it has to be repaid. For startups, that creates a hard deadline for the startup to complete the equity round.
Second, the U.S. government offers some amazing tax benefits for investing in early-stage startups, but they only apply to equity investments in C-corps. They do not apply to loans. And they require holding the equity for 5 years. So investors want the loan to convert to equity as soon as possible to start the timer ticking.
Third, as a loan it must include interest above an IRS defined minimum. Interest is paid in equity rather than cash, but the IRS considers that income on which investors have to pay tax. There’s very few things more painful than paying income tax on stock which can’t be converted to cash for many years, if ever.
Lastly, while the convertible note is far simpler than stock documents, there’s still plenty of complex details to negotiate. Before creating the loan documents, the startup and investors create a simple term sheet.
The Convertible Note Term Sheet
The term sheet is a 2–3 page document that lists the terms of the agreement in (mostly) plain English. While non-binding, the term sheet is easier for everyone to review and negotiate.
The term sheet is negotiated between the startup and the lead investor. The lead investor is usually, though not always, the largest investor in the round.
Once the term sheet is agreed, all other investors use the same documents with the same terms. Occasionally, though, there are “side letters” giving specific investors additional rights such as a guarantee of being able to invest in the following round.
Once the term sheet is complete and signed, the lawyers draft the actual convertible note document.
Conversion into Equity
The point of the convertible note is to make an investment in an early-stage company now and receive stock when the company does a “priced round” or “equity round” later.
If everything goes according to plan, the conversion to stock happens when there is a “qualified financing.” To avoid triggering this conversion when giving a small amount of stock to advisors or selling a small amount of stock, the qualified financing when the conversion occurs is usually defined by...
Read the rest of this article at entrepreneurshandbook.co...
Thanks for this article excerpt to DC Palter.
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