More Related Content Similar to Raising Your Seed Round Financing: Should You Use Convertible Notes or Preferred Stock (20) Raising Your Seed Round Financing: Should You Use Convertible Notes or Preferred Stock1. Raising Your Seed Round Financing: Should
You Use Convertible Notes or Preferred Stock?
Presented by Bart Greenberg
Haynes and Boone, LLP
2011 Business Growth Conference
May 9, 2011
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3. Definition
• In general, a class of ownership in the
corporation that has a higher claim on
the assets and earnings than common
stock
• The terms of a corporation’s preferred
stock are specific to that corporation:
– Result of negotiation
– One size does not fit all
• Holder is a shareholder – an owner
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4. Typical Terms
• Dividends
• Liquidation Preference
• Conversion Rights
• Antidilution Protection
• Protective Provisions
• Redemption Rights
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5. What is a Convertible Note?
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6. Definition
• A debt instrument that is convertible into
stock of the issuer
• In general, the total amount of the note
converts into equity when an institutional
investor (such as a venture capitalist)
makes an investment
• Holder of the note is a creditor – NOT
an owner
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7. Typical Terms
• Debt Features
– Interest Rate
– Maturity Date
– Payment Terms
– Ranking
– Security
– Prepayment
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8. Typical Terms
• Equity Features
– Conversion Stock
– When it Converts
– Conversion Price
– How it Converts
• Mandatory Conversion
• Voluntary Conversion
– Warrant Coverage
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10. Convertible Note Financings are Easier!
• Simpler and easier to conduct
• Less documentation required
• Fewer deal terms to negotiate
• Less legal fees
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11. Convertible Notes Defer Pricing Decision!
• It’s hard to value a start-up
• It will be easier to value the company
when it is ready to raise Series A
• The Series A guys are much smarter
and better able to value the company
• We just have to agree upon the price
discount
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12. Convertible Notes Protect Against Dilution!
• Use of notes delays dilution to
founders based on a low company
valuation
• If company executes with such funds,
company will be worth much more at
time of Series A
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13. Convertible Notes Don’t Vote!
• Holders of notes do not vote
• It will be easier for the founders to
maintain control of the company
• Holders of notes are not as interested
in protective provisions and investors’
rights
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15. Convertible Note Financings are Easier!
• Simpler and easier to conduct
• Less documentation required
• Fewer deal terms to negotiate
• Less legal fees
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16. A Convertible Note is Safer!
• Liquidation “Waterfall”:
– Creditors, 1st
– Preferred Stock, 2nd
– Common Stock, 3rd
• Obligations can be secured
– Intellectual Property
– Other Assets
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17. Why Company May Not Prefer
Convertible Notes
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18. Convertible Note Financings Can Be Complex
• What if company never has a next
round of financing?
– If things are going well, may want to
convert into a so-called “alternative
preferred stock”
– If not, how will the investor get paid back
without destroying the company
• What if company is sold before the
Maturity Date and conversion?
© 2010 Haynes and Boone, LLP
19. What if I Can’t Service the Debt!
• Balance sheet negatively impacted by
the leverage
• If company fails to meaningfully
execute before notes become due,
company loses leverage with next
round of investors
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21. Investor May Have no Practical Remedy
• Investor may have no real remedy
against an insolvent company
• Collateral may be of questionable
value given that the company failed
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22. Discount Will Not Compensate Me for Risk!
• Discount may not compensate the note
holder for the high risk
• The greater the valuation of the next
financing, the higher the conversion
price could be
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23. Will I Get Squeezed by Next Investor?
• New investors may not want to invest
unless note holders agree to certain
modifications
• New investors may consider the deal
“too rich” for note holders or object to
immediate “in-the-money” aspect with
respect to liquidation preference
© 2010 Haynes and Boone, LLP
24. I Will Miss out on Certain Tax Advantages!
• Certain tax advantages only apply to
investments made in stock
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25. Questions?
Bart Greenberg
Partner
18100 Von Karman Avenue, Suite 750
Irvine, California 92612
bart.greenberg@haynesboone.com
949.202.3037
25
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