MLA Convertible Debt For Early Stage Investments

C O N V E R T I B L E D E B T

www.mapleleafangels.com | [email protected] | 416.646.6235 | @mapleleafangels

AGENDA

WHAT?

CONVERTIBLE DEBT

PARAMETERS

TYPICAL TERMS

WHY?

TROUBLE IN PARADISE

PRICE CAPS

SUMMARY


CONVERTIBLE DEBT

Paul Graham (Y Combinator) tweeted in 2011:

“Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”


WHAT?

• Debt (typically a promissory note) issued by an investor to a startup…… where the principal and accrued interest convert into equity under certain conditions

• Used when the investor’s intention is ultimately to own equity, rather than to earn a return through interest payments


PARAMETERS• $ amount• Interest rate• Conversion upon next financing

• Minimum trigger amount• Discount or warrants• Optional: price cap

• Conversion price if no next financing• Conversion on exit before financing or maturity

• Merger premium (multiple)• Maturity date and repayment terms• Secured? Against what?• Board rights• Information rights• Pre-emptive rights on next financings• Right of First Refusal• Co-sale rights• Protective provisions• Fancy stuff, e.g. discounts that increase over time


TYPICAL TERMS

• Conversion into Series A preferred• Median conversion discount: 20%• Median interest: 5.5%• Median maturity: 18 months• Merger premium: 2x (Fenwick and West, 2012)• Secured against company IP• No board set


TYPICAL TERMS - DETAILS

Fenwick and West, Seed Finance Survey 2012 http://www.fenwick.com/publications/Pages/Seed-Finance-Survey-2012.aspx?WT.mc_id=2012.SEED_BK_email


WHY?

• Punts on negotiation over valuation and many pref share terms• Simplifies legals

• Simplifies and speeds up negotiation over terms• Lower transaction costs• Some angels will even do them without legal counsel

• Avoids taking on liabilities of Directors and Shareholders (because you aren’t one)

• As a creditor, near the front of the line in case of adverse liquidation (after employees)


TROUBLE IN PARADISE

• Can be a bad deal for angels• Does a 20% discount

sufficiently compensate for a year or two of additional risk vs. the Series A investors?

• Series A investors will generally veto higher discounts, may sometimes resist even 20%

• Misaligned incentives vs. founders on Series A valuation• Founders want it high• You want it low


PRICE CAPS

• Solution proposed for the risk/reward and alignment issues: conversion price

• Sets a maximum conversion price, e.g.“20% discount to Series A, not exceeding a price per share based on a valuation of$5M”

• Most sophisticated angels post 2010 will not do uncapped converts• Still not perfect

• Valuation negotiation with founders has come back into the deal

• Founders have sometimes received the (bad) advice to refuse capped converts• This has become a contentious enough issue that early-

stage convert deals have actually begun to decline in number again after peaking in ~ 2011

• Some VCs look at the cap and see it as a price ceiling for the A round!


SUMMARY

• Cheaper and easier, but:• Without a price cap, not fair to angels• With a price cap, not quite as easy

• Capped converts are often a good choice• But there are also good alternatives: simplified standardized equity

terms• Series Seed (Fenwick & West)• Series AA (Y Combinator)• Plain Preferred (Founders Institute)• TechStars model documents• Etc.


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MLA Convertible Debt For Early Stage Investments

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