Presentation explaining the differences between Convertible Notes and Seed Stage Equity, the important terms of each funding structure and the pros/cons of each.
Before Series A - Convertible Note and Series Seed Funding for Startups
1. Before Series A - Convertible
Note and Series Seed Funding
for Startups
Dror Futter David Teten
SorinRand LLP ff Venture Capital
dfutter@sorindrand.com david@ffvc.com
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2. Biographies
Dror Futter (sorinrand.com)
• Partner, SorinRand LLP, a NY/NJ law firm focused on the representation of
startups and technology enabled companies
• Previously, General Counsel of Vidyo, Inc. (a venture backed software
company) and New Venture Partners LLP (a venture capital firm specializing
in corporate speaker)
• Co-founder of PLI’s Venture Capital Law Program and
frequent speaker on topics related to venture finance and
technology
• Columbia JD, Princeton AB
• dfutter@sorinrand.com
• @dfutterlaw 2
3. Biographies
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David Teten (teten.com)
• Partner, ff Venture Capital, early-stage technology venture capital fund
• Founder and Chairman, Harvard Business School Alumni Angels of Greater
New York .
• Lead author, The Virtual Handshake: Opening Doors and
Closing Deals Online (TheVirtualHandshake.com)
• Lead author of first-ever research study on best practices in private
equity/venture capital deal origination
• Lead author of first-ever research study on best practices of
venture capitalists in increasing portfolio company value
• Harvard MBA 1998, Yale BA
• david@ffvc.com
• @dteten
4. Definitions
•Convertible Notes – debt
instruments that convert into
equity when a defined event
occurs
•Series Seed Equity – stock in a
venture with enhanced rights
to the common stock 4
5. Stage of Venture Development
•Typically ventures face this decision
as they try to raise amounts
between $150,000 and $1,500,000
•Smaller amounts are usually raised
through simple notes
•Larger amounts are usually raised
through equity financing under
normal Series A terms 5
6. Deal Documentation
•Convertible Note
•Note Purchase Agreement
•Note
•Series Seed
•Amendment to Certificate of
Incorporation
•Stock Purchase Agreement
•Investor Rights Agreement
(depending on form used)
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7. Critical Terms – Convertible Note
•Discount Rate –
•the discount on share price Note
holders will receive on
conversion
•Typically 20-30%
•Valuation Cap
•Maximum company value at
which the Note will convert 7
8. Impact of Valuation Cap
Common Shares Preferred Shares % Ownership
Case - 1: Note Conversion, No Cap
Raising $2M with a $6M valuation
Founders 5,500,000 69%
Debt Holders (conversion of 500K note) 500,000 6%
Equity Holders @ $1.00 2,000,000 25%
Case - 2: Note Conversion, $3M Cap
Raising $2M with a $6M valuation
Founders 5,000,000 63%
Debt Holders (conversion of 500K note) 1,000,000 13%
Equity Holders @ $1 2,000,000 25%
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9. Key Terms – Convertible Note
• Maturity – date on which the loan comes due unless a
conversion event has occurred
• May require repayment of principal and interest or conversion at
a predetermined value
• Conversion Events
• Qualified Financing – a financing event that meets specified
criteria usually based on:
• Amount raised
• Nature of Investor(s)
• Usually a requirement of an equity rather than a debt financing
• May have a provision for optional conversion on financings that
do not qualify as Qualified Conversions
• Interest Rate – typically 5-8% 9
10. Key Terms – Seed Stage Equity
• Non-participating Preferred Liquidation Preference
• Board Seat
• Minimal Representations and Warranties
• Limited Protective Provisions
• Actions that require approval of the Board or the Shareholders
• Right to Subsequent Terms –
• Right to get any pro-investor terms given to investors in subsequent
financing rounds
• Participation Right in Future Financings
• Information Rights
• Drag Along
• Requires shareholders to sell if a potential acquisition meets several
requirements
• Payment of Investor Legal Fees 10
11. Seed Stage Equity vs. Series A
Terms – What Is Missing?
•Anti-Dilution Protection
•Preferred Dividends
•Registration Rights
•Extended Protective Provisions
•Co-Sale Rights
•Legal Opinion 11
12. Convertible Notes – Pros/Cons
• Pros
• Usually quicker and less expensive than equity rounds
• A solution when the Company and the Investors
cannot agree on valuation
• Rewards early investment through discount
• Cons
• Uncertainty of final value/cost of loan
• If loan is too large, conversion may “crowd out” too
much of the next financing round
• Investors have no control over the terms of the equity
they will get at conversion/Note holders will get the
same terms as larger investors in the next financing
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13. Seed Stage Equity – Pros/Cons
• Pros
• Clearly values the Company
• Does not burden the company with
debts on its books
• Cons
• Higher transaction costs in terms of time
and expense
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14. Best Use Case
• Convertible Notes are most appropriate:
• Financings where the parties cannot agree on a valuation
• Smaller financings where it is harder to justify the added
cost/time of an equity financing
• Seed Stage Equity is most appropriate:
• Financings where the parties have agreed on valuation
• Larger financings which can justify added transaction costs and
where the size of the debt could adversely impact future
financing rounds
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15. Legal Diligence
• Startups at this stage often have limited, inconsistent
documentation.
• Diligence Review will be limited, should focus on:
• Corporate - Accuracy and completeness of the cap table
• Financial – Review of financial statements. These will frequently
not be maintained in accordance with GAAP. Investors should
understand how they were prepared.
• IP – Assignment of IP rights by all employees and contractors.
Absence of any known infringement concerns
• Employment – Proper documentation of all employees
• Commercial Agreement – significant agreements with either
customers or suppliers usually do not exist at this stage.
However, if such agreements do exist, they should be reviewed 15
16. Disclaimer
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