Concerns of a note holder

What angels may worry about when investing in convertible notes

Much has been written about the advantages and disadvantages of raising funding using convertible notes versus equity, both for startups and for investors. At Kima Ventures, we often choose to invest using convertible notes due to the speed, simplicity and cost of the transaction but, when a company has already agreed to use a certain convertible note template with other investors, we need to look carefully at the wording and consider what happens in every possible scenario.

Founders often pay attention mainly to the headline terms (discount, cap, interest and maturity) while assuming that the rest of the wording is largely standard across notes. However, since there are many future scenarios that a note needs to account for, what happens in each can differ greatly due to the specific wording of the note.

The disadvantages for investors of using any convertible note have been written about often; including the tax implications, the lack of rights such as board seats but mainly the risk of converting at a valuation that does not fully compensate for the risk taken by investing early in the company’s history. In this post, I would like to address a few, lesser mentioned, concerns that we have when looking at convertible notes and suggest possible solutions for them that we use at Kima:

1. Receiving worse terms than other investors

CONCERN:  since funding rounds on convertible notes are often closed in series over a period of time (rather than all at once like an equity round); it is a concern that later investors may negotiate better terms (cap, discount, other rights..) than those that we have already agreed to. In equity investments, investors tend to have anti-dilution provisions which take effect when shares are offered at a lower price, but this is not the case in many convertible notes. Even when all issued notes contain exactly the same rights, we are now seeing more and more ‘side letters' attached to notes given to individual investors, granting more rights than to the other noteholders.

SOLUTION:  we always request to include a Most Favored Nation (MFN) clause in the convertible note. This clause states that if any later investor is offered a better deal on convertible debt at any point while the note is still outstanding, the rights of the note are automatically upgraded to the most favourable ones. This includes terms in the note, any side letters or other agreements and guarantees that the investor receives the best terms given to any other investor until the note converts. This is useful if another investor in the same round negotiates better terms or if there is another fundraising on convertible notes further down the line and a lower cap or higher discount is negotiated.

2. Converting into Preferred stock without the desired rights

CONCERN:  investors investing in convertible debt are looking to participate in the next fundraising round and plan to receive the same class of Preferred shares as the new investors in that round with all the same rights and privileges. However, a note holder has no impact on the negotiations for the next round so has no control over the rights of this class of Preferred stock. Sometimes, the investors in the round where the note will automatically convert will not negotiate for all the rights that the note holder is expecting, but the note holder will have no influence on these negotiations and be forced to automatically convert regardless.

SOLUTION:  to address this we include a list of rights that we want to be guaranteed for the class of shares that we convert into. This includes “pre-emptive rights, a right of first refusal over transfers of shares by the other shareholders of the Company, and tag-along rights, all in customary form and not subject to waiver or amendment without the prior written consent of the Holder” and is regardless of the number of shares that are received upon conversion. This guarantees that the rights required to protect a minority stake are always guaranteed when converting, even if the other investors did not negotiate them.

3. Not receiving the same rights as other investors when the debt converts

CONCERN:  convertible notes are typically set to automatically convert into shares as part of the company’s future investment round of a certain size and will convert into the same class of shares as the new investors receive in that financing round. However, guaranteeing the same class of shares is not sufficient to guarantee the same rights. Occasionally the new investors will make the distinction between ‘Major Holders’ and ‘Minor Holders’ of the same class of share depending on the number of shares held. By giving more rights to the Major Holders (usually just the new investors), the Minor Holders (usually the converting note holders) will not have the same rights, despite holding the same class of shares.

SOLUTION:  to address this we include language in the note stating that the converting noteholders will have the at least same rights as the new investors and specifically that the new transaction documents in the converting round may not limit the rights of a shareholder based on the number of shares that are held upon conversion. Another solution is to be guaranteed to be included in the ‘Major Holder rights’ if such a concept were to exist in the future.

NOTE:  it can also been argued that the note holders should not necessarily receive the same rights as future investors. If the lead investor receives a board seat or special information rights, this should not automatically be transferred to the smaller note holders. If the new valuation is above the cap, receiving the same rights also creates multiple liquidation preferences, so it may be advantageous for the company to create identical classes of shares at conversion with different liquidation preferences (the same multiple of the different share prices paid).

4. Converting into Common stock instead of Preferred stock

CONCERN:  investors investing in convertible debt are looking to participate in the next fundraising round and plan to receive the same class of shares as those new investors with all the same rights and privileges. However, the maturity date of the note may be reached without this new fundraising taking place. When the maturity date on the convertible note is reached, if the investor opts to convert to shares rather than demand repayment or extend the maturity, the only class of shares that exists is the Common stock held by the founders which will not have the rights the investor needs to protect their minority stake.

SOLUTION:  extending the maturity so that the note converts at the next qualified financing guarantees receiving the higher class of shares but if we would like to convert prior to this (maybe because the company has no intention of raising more funding), we request the right to convert into a newly created class of shares with certain rights and protective provisions for the investors which have been agreed to in advance. These rights can be in the form of an exact equity term sheet attached to the note or a reference to a standard set of terms (such as to the Series Seed documents) so that the rights are agreed to in advance and known by all parties. If a suitable class of Preferred stock is already outstanding, it may be easier to give the investors the option to convert into this rather than creating a new class or converting into Common.

5. Having the loan repaid despite a successful exit

CONCERN:  in the case of a ‘Change of Control’ where the company is acquired prior to the the note being converted, the note will often become due and the investors will only receive their investment back (plus interest) while the founders receive all the remaining proceeds of the sale. In equity investments, the investors typically have the right to refuse an acquisition offer, as note holders this is often not the case; the founders take the decision without the approval of the investors holding notes.

SOLUTION:  it is becoming common to have an agreed to minimum multiple of the investment to be paid to the investors in the scenario where there is a change of control prior to conversion. We often see investors request the higher of a 2x ‘acquisition premium’; where they receive the greater of two times their investment or what they would have received had they converted to shares at the cap prior to the acquisition. This is similar to the note holder having a a 2x liquidation preference until the note converts. If the acquisition price is greater than 2x the cap, the note holder will be better off converting and taking their prorated share of the proceeds of the sale. The conversion price in case of a change of control can also be lower than the cap; for example being set as the discount multiplied by the cap, or any other pre-determined price. This premium guarantees that the investor also receives some return if the company exits after their investment.

6. Having the loan repaid despite the company doing well

CONCERN:  convertible debt is usually set to convert automatically at the next qualified financing, however this financing round may not occur before the note reaches maturity (typically between 12 and 24 months). This could be because the company has been unable to raise funding, has raised a series of small investment rounds (that don’t qualify for automatic conversion) or has been successful enough to not need further funding. If the company is doing well, the note holder will want to convert into shares rather than extend the maturity date or have their loan paid back (although if the company is not doing well they may want to pull their money out).

SOLUTION:  we always ask for the option to convert at any time after maturity if the note is still outstanding or wait until the next qualified financing or change of control after the maturity date to convert automatically. Since there has been no new valuation set, the conversion price in this scenario is usually agreed to in the note document (it could be at the cap, cap x discount, or another agreed price). The situation is complicated by the fact that the investor was intending to convert into the new Preferred class of shares created at the fundraising (with more rights than the current existing Common stock), a solution to this is explained in point 4.

7. Having other investors force unfavourable decisions

CONCERN:  in some convertible notes, all decisions about conversion or repayment of the note are made by the majority in interest of the outstanding notes rather than the individual noteholder. While this might make it easier for the company, an individual investor may wish to convert to shares while others wish to get their money back. An extreme example would be a singular investor who holds the majority of the notes, forcing all the notes to be repaid to remove the other investors, and then investing in the next equity round to make sure they are the only shareholder in a successful company.

SOLUTION:  we always request that decisions about conversion, redemption or amendments to the note are left to the individual noteholder. It is rare that the noteholders will take different decisions but this will avoid the possibility of having a majority exploiting their power over the minority. If the company refuses to allow each noteholder make decisions individually then it’s important for the investor to understand who else will hold notes in this round to understand the dynamics of who could make up a majority and how their interests may differ.