Convertible Note and Equity Investor Protections
Holders of convertible notes or equity in your seed round do not normally receive any of the investor rights or protections that a Series A VC would. However, each seed round is different and some convertible note or equity holders are able to negotiate side letters that provide them additional rights or protection beyond their notes converting into equity at the next round. The purpose of this post is to highlight these sometimes negotiated rights or protections so you are better informed to handle the negotiation if your convertible note or equity investor is asking for them.
Investor Rights and Protections
The rights and protections that convertible note or equity holders may try to negotiate are as follows:
- Preemptive Rights
- Board Seats and Observer Rights
- Information Rights
- Most Favored Nation Rights
Preemptive Rights allow the investor to purchase new securities offered by your company at your Series A round. The purpose of these rights is to prevent dilution. The investor does not want to be shut out of future financing rounds and wants to maintain a certain percentage of ownership in the company. You should be reluctant to grant these rights to your convertible note or equity investors as it can hinder your ability to structure future financing rounds in a manner that is favorable to your company.
Board Seats and Observer Rights allow the investor to appoint a director or a non-voting board observer. The purpose of these rights is to exercise direction and control over the company. This is a right that is pretty uncommon to give to a convertible note or equity holder in your seed round. If the convertible note or equity holder is someone you hold in high esteem who will bring value to your company, you should consider making them an advisor versus giving them board seats or observer rights.
Information Rights give the investor the right to regularly receive financial statements or other information about your company’s business. The purpose of these rights is to keep the investor informed about the financial health and other dealings of the company. It is also uncommon to give this right to convertible note or equity holders because they tend to invest in smaller amounts than the Series A VC’s who will demand this right. Also, as a seed stage company, you probably don’t have meaningful financial information to give to the investors.
Most Favored Nation Rights give investors the right to receive the benefit of any more favorable terms given to other investors in your seed round. The purpose of these rights is to ensure that the investor receives the best economic terms a company is offering. For example, your startup closes a convertible note round and gives the lead investor a valuation cap of $5mm and 3 months later you close another convertible note round where the lead investor has a valuation cap of $3mm. If your first lead investor had the most favored nation right, your startup would be contractually obligated to give that investor the more favorable valuation cap of $3mm. Typically you don’t want to give this right to an investor if you do not have to, however some startups do offer this right to earlier seed investors as a matter of maintaining a good relationship with them.
Should You Give These Rights?
The short answer is no. I generally advise my clients against giving any of these rights to seed investors as you do not want to give away the farm to investors who do not put in as much money as a Series A VC would. If you have a seed investor who will not concede, then the best course of action is to walk away. However, if you really want the investor due to some other reason besides their money (influence, contacts, etc.), and they demand some or all of these rights, you should offer to make them an advisor instead. If you are looking to raise your seed round, please speak with a startup attorney as they will be able to help you navigate these issues.