Convertible Note Financing Process

Most of my clients raise their seed round using a convertible note. Once we have determined that this instrument will be best for their seed round, my clients rightfully have questions about the process from beginning to end. The purpose of this post is to outline the process of raising your seed round using a convertible note (the process is very much the same if using a convertible equity instrument like a SAFE).

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).

For the sake of brevity, this will be broken up into 2 posts. This post will cover steps 1 and 2.

Term Sheet Stage

After pitching and gaining the interest of a few investors, you then send those investors a term sheet that describes the convertible note’s main features and economic terms. A convertible note term sheet is usually drafted by company counsel and is about 2 pages in length. The term sheet is a non-binding document that is used for informational and negotiation purposes with the seed investors. Once a term sheet has been signed, the next step is formalizing the investment by drafting and issuing the definitive financing documents.

Financing Documents Stage

This stage takes the investor’s non-binding commitment from the term sheet stage and formalizes it with the necessary legal documents that solidify the deal. In this part, we will discuss the 1) structure; 2) representations and warranties; 3) amendments; 4) ancillary documents; and 5) side letters that formalize the deal.

1) Convertible note rounds are structured either using the credit facility or stand-alone note approach. 

The credit facility approach consists of a single master note purchase agreement that is signed by all of the investors, and individual short-form notes for each investor. This common approach has all the notes’ conversion mechanics, purchase mechanics, and representations and warranties drafted in the single master note purchase agreement. The remaining key terms such as the principal amount, interest rate, and maturity date are drafted in the individual short-form notes.

The less common stand-alone note approach takes all the information contained in a master note purchase agreement and short-form note described above, and combines them into one document that is issued and signed by each individual investor.

2) The representations and warranties in a convertible note seed round are usually very light. The typical representations and warranties that a startup makes to it’s convertible note investors are i) due organization; and ii) authorization. Due organization is a representation that the startup is a legally formed entity and authorization is a representation that the startup is authorized (by board and shareholder consent, or member consent if an LLC) to enter into the transaction.

3) Convertible note rounds need to have an amendment process to allow the terms of the note to be amended by a majority-in-interest of the investors. It is needed in situations where the note has reached maturity, but a conversion event has not happened yet. In this situation, you will want to seek an extension from your investors. Most investors will agree to extend the maturity date as they know the note is more valuable when it converts. However, some less experienced investors might demand repayment, which could bankrupt your startup. Having an amendment process that allows for a majority-in-interest of the investors to amend the terms of the note will help prevent this holdout situation.

4) Aside from the convertible note, there are very few ancillary documents associated with the deal. The one that is most important is a document reflecting board approval of the deal. It is good corporate governance practice to reflect the board’s approval of the transaction in resolutions adopted either by unanimous written consent or at a meeting recorded in board minutes. 

5) The last part of the financing document stage is negotiating and drafting any side letters. A side letter is a separate agreement entered into by the company and an individual investor. This agreement gives the investor more rights and protections than what the convertible note provides.The following are rights and protections that I have seen investors try to get:

  • Most favored Nation (MFN) rights
    • The right to receive the benefit of any more favorable terms given to other seed investors.
  • Preemptive rights
    • The right to subscribe for additional shares when their securities convert in a Next Equity Financing.
  • Financial information rights
    • The right to regularly receive financial statements or other information about the company’s business.
  • Director designee or board observer rights
    • The right to appoint a director or a non-voting observer to the company’s board of directors.

It is important to note that none of the above rights are normally given to investors in a convertible note financing and you should not grant them lightly.

To Be Continued

We will continue discussing the convertible note process with stages 3-5 in the next blog post.