mla convertible debt for early stage investments
DESCRIPTION
This content was delivered during a lunch and learn session on July 3, 2013 by Dr. Richard Reiner.TRANSCRIPT
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
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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.”
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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
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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
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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
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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
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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)
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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
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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!
www.mapleleafangels.com | [email protected] | 416.646.6235 | @mapleleafangels
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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