Convertible Notes — “Off Market” Terms
Uncommon Terms to Consider when Negotiating and Drafting One.
Convertible notes are common in Silicon Valley. Start-ups founders and investors are familiar with them and the typical negotiation points when negotiating and drafting one. These include — investment sum, interest rate and maturity dates, valuation cap, discount rate, company capitalization. However, the convertible notes, like all agreements, usually have certain terms that, while considered “standard” or “market”, may not favor the parties signing the agreement. In fact, such standard terms would require further negotiation to correspond with the parties’ intentions and prevent future disagreements on their interpretation. This article analyzes some of these “standard” terms.
Liquidation Preference premium versus Shadow Series
For investors, one of the advantages of investing via a convertible note is the “Liquidation Preference Premium”. For most convertible note offering, the convertible notes are convertible into the preferred stock issued to investors at the time of the next round of equity financing, usually at a discounted rate, either via an express discount rate (i.e., 20% discount to the price paid per share in that round) or the use of a valuation cap (which limits the company’s implied valuation at the time of the equity financing and guarantees the investors a minimum ownership percentage upon conversion). For example, if an investor invests $100,000 in exchange for a convertible note for $100,000, and this note converts at a 20% discount, then if the company issues preferred stock in its next round of financing at $1.00, the note will convert at a price of $0.80 per share. Therefore, the note will convert into preferred shares based on the calculation $100,000/$0.80, i.e., a total of 125,000 shares of preferred stock instead of 100,000 shares. This extra 25,000 shares represent the “stock ownership premium”, a premium to the investor for taking on the increased risk of a convertible note.
However, in addition to this stock ownership premium, the investor also gets an added premium — a liquidation preference premium in connection with the 125,000 shares of preferred stock. Liquidation preference is the right to be paid a certain amount per share, in the event of a company exit and preferred stock usually carries a liquidation preference, the most typical is the “1x” liquidation preference, which means that the company will pay preferred stockholders an amount equal to their initial investment (as determined by the original purchase price for the preferred stock) upon a company exit. When a discounted note and liquidation preferences intersect, a liquidation preference premium is created and investors can especially benefit. Using the above example, upon an exit, the holder of the shares of preferred stock issued would be entitled to $1.00 of liquidation preference per share for a total of $125,000 of liquidation preference in the aggregate. Therefore, in addition to the stock ownership premium, i.e., the additional 25,000 preferred shares, in the event of a company exit, the investor has also received a liquidation preference right equal to $125,000, i.e., an extra $25,000 of liquidation preference and this extra $25,000 symbolizes the “liquidation preference premium”.
In recent times, especially with the creation of SAFEs (Simple Agreement for Future Equity) by Y Combinator, an alternative to the liquidation preference premium has seen increasing acceptance in convertible note offerings. This is the “shadow series”. Here, SAFEs and, in some cases, some convertible notes, convert to shadow preferred stock. Typically, this shadow preferred stock would have the same rights as the series of preferred stock issued to new investors in the financing round that gives rise to the conversion of the SAFE and/or convertible note, except that the liquidation preference, dividend rate and conversion price of the shadow preferred stock would all be calculated based on the actual price per share of the shadow preferred stock rather than the price per share of the new investor preferred stock, i.e., no liquidation preference premium. Again, using the above example, for a shadow series, the liquidation preference, dividend rate, and conversion price, of the shadow preferred stock would be calculated based on the discounted sum of $0.80 and not $1.00.
However, it is important to note that while the shadow preferred stock is a reasonable approach to removing the occurrence of the liquidation preference premium, this approach has not yet attained the “standard” or “market” status. It is still a matter of negotiation. This is particularly so, since the creation of a series of shadow preferred stock caries its own risk. For example, Delaware law grants each class of stock of a company with the right to vote with respect to any amendment that would “alter or change the powers, preferences, or special rights of the shares of such class so as to affect them adversely” — technically, a statutory blocking right. Thus, creating and issuing shadow series may have the implication of giving the holders of these shares a veto rights in the event of a future merger or financing where all series of preferred stock need to give up certain rights as a condition to the merger or financing.
Conversion upon a Corporate Transaction
It is typical for most convertible notes to provide that a convertible note convert to equity at a next financing round and/or in the event of a corporate transaction. It is clear that any note converted at a next equity round will be converted to the shares being sold at that equity round — which is almost always preferred shares. However, it is not always clear which type of shares the note will convert to in the event of a corporate transaction. A corporate transaction includes but is not limited to a merger, or a sale of the company’s assets. In most cases, for conversion upon a corporate transaction, the parties will decide on the following options — (1) conversion to common shares, (2) conversion to the last issued shares with the most preferential rights or (3) the creation of a new set of preferred shares. The most common are Nos. (1) and (2).
Conversion to common shares (option №1) is most common where the convertible note offering is an early stage round and there are no existing preferred shares in the company. However, even in an early stage round, where the parties agree that conversion of the note shall be at a “qualified” equity financing, i.e., the parties agree that a specific sum must be raised at the next round to trigger the conversion, it is usually in investors’ interests to apply option №2. This is because, prior to a corporate transaction, the company may have issued shares with more preferential rights than common shares as a result of conducting one or more equity rounds which did not meet the requirement of the “qualified” equity financing. However, if the parties agreed to option №1, the investors will be limited to converting to common stock at a corporate transaction. This is not favorable to the investor. This is because, the concept behind liquidation preference is to ensure that preferred shareholders are paid first from the sum received from an exit, i.e., the corporate transaction, before the common stock holder is paid. And the disadvantage of using option №1 is that the investor misses the chance of getting any such preferential payment during any such corporate transaction.
On the other hand, option №3 may be more favorable to the investors since, upon conversion, they would have the right to negotiate for better preferential rights than already existing shares. However, this is not in the company’s interest. This is because it gives the noteholders a veto on any future corporate transaction, i.e., a new series of shares need to be created, with the terms agreed to by such noteholders before any such corporate transaction can be carried out. Therefore, the company may be forced to agree to unfavorable terms just to close the transaction. This may lead to further complications, delays and may even lead to the withdrawals of offers for mergers or a future corporate transaction. However, if the parties agree to option №2, the inherent risks in opting for options Nos. 1 and 3 do not appear because there is a measure of certainty on what shares will be converted to and the price of such shares, with little to no negotiations on these items.
Interest rate and Usury
It is very typical for convertible notes to have an annual interest rate. In fact, it is more uncommon to see one without it. Interest rates tend to ranges from 2% to 12%, with between 4% and 8% being standard. Interest rates have two accrual methods — simple or compounding — and they usually carry a time frame for when and how the interest rate is calculated. While, from an investor standpoint, the interest rate term may not be as impactful as other convertible note terms such as the valuation cap and/or discount rate, it is an important one, especially if the parties agree to a compounding accrual method. This is because of the concept of “usury” — the charging of interest in excess of what is allowed by law. Most states in the U.S. have statutes that dictates how much interest can be charged before it is considered usurious or unlawful and due to the different circumstances and parties involved in lending, usury laws in each state are complicated and there are many exceptions to the general rules.
For example, in California non-exempt lenders can charge a maximum of: (i) 10% interest per year (.8333% per month) for loans used primarily for personal, family or household purposes and (ii) for other types of loans (i.e., home improvement, home purchase, business purposes, etc.), the greater of 10% interest per year, or 5% plus the Federal Reserve Bank of San Francisco’s discount rate on the 25th day of the month preceding the earlier of the date the loan is contracted for, or executed. A convertible note with a high interest rate with a compounding accrual method may surpass this maximum. The good news is that there are various exemptions from the California usury laws. One of which is for commercial transactions like convertible note financings that applies to loans in excess of $300,000, or if the indebtedness is pursuant to a written commitment for the lending of at least $300,000. Another exemption applies to situations where the borrower has assets of at least $2 million at the time of issuance. However, to qualify for these exemptions, certain requirements have to be met — such as the borrower cannot be an individual or a partnership that has a general partner; the lender must also have a preexisting relationship with the borrower (or its officers or directors) and each of the parties to the loan must reasonably appear to have the capacity to protect its own interests in the transaction; and lastly, the loan also cannot be used primarily for personal, family or household purposes.
In most cases, where there’s no applicable exemption, if a lender charges above the lawful interest rate in an applicable state, the courts may preclude the lender from suing to recover the unlawfully high interest, while in some states, all any amount paid that is considered over the lawful interest rate will be applied as payment for the principal balance. In some states, however, usurious loans are voided. In California, usury may lead to a forfeiture of all interest on the loan, i.e., not just the usurious part; and payment to the borrower of triple the amount of interest collected in the year before the borrower brings suit. Even worse, it could also lead to a conviction for loan sharking, a felony punishable by imprisonment for up to five years.
Where the parties agree to a compounding accrual method for the interest rate, it is important to verify the interest rate for the applicable state. This would ensure that the investors do not run afoul of the laws and are also able to recover their investment via the court systems in the event of a default on the note. The parties may also include a clause in the convertible note that provides that any sum paid under the agreement shall be prorated, allocated, and spread throughout the full stated term of the convertible note until payment in full so that the rate or amount of interest does not exceed the maximum lawful rate of interest from time to time in effect. This may help protect the note holder from violating the law while still obtaining value for the investment sum.
In summary, while the above terms are not the most commonly negotiated terms, they are important terms to note when negotiating convertible notes. This is because, they may have far reaching consequences other than what was intended by the company and investors. It is therefore important to take these terms into consideration when negotiating a convertible note and before finalizing the convertible note.
