Convertible Note Financing Process Continued

For the sake of brevity, this topic was broken up into 2 posts. If you missed the first post, you can read it here. The purpose of this post is to continue our discussion of the process of raising your seed round using a convertible note.

The Stages

When raising your seed round using a convertible note, there are 5 stages in the process:

  1. Preparing a term sheet and getting investors to informally agree to the key terms (Term Sheet Stage).
  2. Drafting and negotiating the transaction documents (Financing Documents Stage).
  3. Providing investors with any due diligence materials they may require (Due Diligence Stage).
  4. Conducting one or more closings (Closing Stage).
  5. Complying with post-closing obligations, such as securities law filings (Post-Closing Stage).

This final post on the topic will cover stages 3-5.

Due Diligence Stage

Convertible note investors do not usually require the startup to provide much information or diligence materials. Normally they are comfortable only receiving an executive summary, pitch deck, and term sheet for the transaction. Due diligence is light because the investor is usually i) a close family member or friend; ii) there is very little information about the company in this early stage of its life; iii) investor cost of hiring counsel to conduct a due diligence review is unwarranted when compared to how little they will be investing; iv) product market fit and founder execution cannot be uncovered in a due diligence review; and v) most convertible note investors rely on the due diligence leg work that a VC will put in when it comes to the company’s Series A.

Newer Angel investors might request a private placement memorandum (PPM). This should never be agreed to as it is exorbitantly expensive for the company to create one, and it is not a market norm in seed financing.

After due diligence has been completed, we are ready to close the round.

Closing Stage

Convertible note financings are typically structured to sign and close simultaneously. The transaction documents are usually signed by the company and the noteholders on the same day that the investors transmit the purchase price to the company.

Seed-stage deals tend to have more investors than later stages which makes it difficult to get everyone to close on the same day. Therefore it is prudent to engineer the convertible note round to have multiple closings over an extended period of time. Your goal should be to schedule an initial closing with as many investors as possible, and then accommodate those who cannot close on that day with additional closings within a 30 to 90 day window after the initial closing.

Once the documents are signed, and the money is in the company bank account, the post-closing stage ties everything up.

Post-Closing Stage

The post-closing stage usually consists of 2 necessary actions; the issuance of original securities and securities law compliance.

The issuance of original securities is where you provide to the convertible note holders evidence of the security they now hold in your company. This is done by either giving the original signed promissory notes, or signed PDF copies to the investors at/after closing.

Finally, and most importantly, you must ensure securities law compliance. Without diving into the weeds of securities law, a convertible note is considered a security by the SEC. Therefore it must either be registered (which is expensive and akin to an IPO) or qualify for an exemption. Most startups issuing convertible notes conduct the offering under the Rule 506(b) safe harbor exemption at the Federal level. Then you will want to comply with State level regulations. This subject is much more complex and deserves more explanation that will take up another series of blog posts. For now, just be sure your counsel knows that certain exemptions need to be met and notices filed at both the Federal and State level.

Whats Next?

At the end of this process, you will have the necessary funds to help refine your product or service and gain traction to get you to your Series A. In a previous post, I discussed how this money should be used. Don’t fall into the trap of thinking this is an exit because it isn’t. If anything, your journey is just beginning.