Bend Law Group has helped close dozens of seed rounds for startups raising investment capital, the vast majority of which are still completed using convertible notes.
Here are the top seven provisions investors should be on the lookout for when negotiating convertible notes with startups.
1. Prepayment Of The Note
Some convertible note documents allow the startup to prepay the convertible notes.
An investor nightmare is to pick a winner, but the startup prepays the note before the note converts and the investor misses out on the company’s upside. Instead, the convertible note should provide that it may only be prepaid with the consent of the holders of at least a majority of the outstanding principal amount of notes.
2. Most Favorable Investor Provision
If the company offers better terms to other investors, you should also benefit from those terms. You can do so by adding in a provision that provides any changes in the terms of the convertible notes that are more favorable to investors shall automatically apply to all of the notes.
3. Cap On Conversion Price, aka the “Instagram Provision”
Most convertible notes provide a 20% discount if the note converts into equity compared to the price paid by the next round of investors. This conversion discount is intended to reward the risk early stage investors take for supporting the company.
However, if the company really takes off, even after a 20% discount the seed stage investment might not translate into a significant stake in the company. For example, a $25,000 seed stage investment in Instagram without a conversion cap would only have translated into a very small equity stake because the company was valued so highly at the next round of investment.
A conversion cap helps to align the incentives for the founders and the seed investors to seek as high a valuation as possible in the next round. To make sure your seed stage investment still converts into a fair equity stake, the convertible note should include a conversion cap.
4. Sale Of The Company
Some convertible notes provide that an investor will only be repaid their investment amount plus accrued interest if the company is sold before the note converts.
If you invest in a startup that is purchased before the note converts you should be adequately rewarded.
Instead, you include a provision that provides that the investor will get 1.5 or 2 times a return on the initial investment if the company is sold before the note converts.
5. Voluntary Conversion
Most convertible notes do not convert by the note’s maturity date. It is important to bake in a provision that provides the investor with the option to still have the note convert into equity at the maturity date at an agreed upon conversion price.
6. Right to Invest
One incentive to act as a seed investor is to be on the inside of a new company, and hopefully this “insider” status will give you the ability to invest more later if the company takes off. However, these investment rights are not automatically guaranteed, and if a company is hot then there will be plenty of other investors ready to buy during the next round.
Guarantee your right to invest later by adding a Right of First Offer provision into the convertible note, so that you are informed of and given the chance to participate in all equity offerings.
7. Warranties and Representations
Just as important as the above economic provisions is including strong warranties and representations to kick the tires of the company. You would, for example, certainly want to dig deeper if a company is not willing to include a warranty and representation that there are no threatened or pending actions against the company.
Every set of convertible note agreements is different and so you should consult with your legal counsel prior to making an investment. However, the above list is a good starting point to make sure that the risks of investing in an early stage startup pays off it the startup becomes successful. If you have any questions, give Bend Law Group a call at (415) 633-6841 or email at info@bendlawoffice.com.
By Doug Bend and Luthien Niland.
Disclaimer: This article discusses general legal issues and developments. Such materials are for informational purposes only and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.