Convertible note cheat sheet

Convertible note cheat sheet

Need help figuring out what to offer your convertible note investors?  Here is a basic overview of convertible notes and decision making tool to help you choose the terms of your note.

First, what is a convertible note?

It is technically a debt instrument but not everyone who invests in convertible debt thinks of it as debt.  A convertible note is very popular for early stage Silicon Valley style tech companies.  Here is how it works:

Let’s say you are just starting out with a great idea.  There are some angel investors that love what you are doing and want to invest.  They could buy an equity stake in the company, but it is so early that it will be difficult to agree on a valuation.  But you do know that you plan to raise equity sometime in the next couple of years.  A convertible note is a loan from the early stage investors that generally will convert into equity when you raise your first round of equity investment.  That first round of equity investment will set the valuation as well as the terms of the equity.  In exchange for coming in early, the convertible noteholders get a discount on the price of the equity when the conversion happens.  What if conversion doesn’t happen because you don’t end up raising an equity round after all?  Generally, you will have to pay back the noteholders just as you would if it had been a straight debt investment.  In a Silicon Valley style deal, investors often think of a convertible note as an early equity investment because they are expecting the conversion to happen.  But technically, it is debt.

A very simple convertible note will contain the following basic provisions:

  1. Term – when does the note mature? This is usually 18 months to five years.  In Silicon Valley deals, it is rarely more than two years.  This can be stressful because the pressure is on to raise equity before the end of the convertible note term.
  2. Interest rate – this is usually simple interest calculated annually – it generally is not paid in cash to the investor, but accrued. Another thing to consider is whether you want accrued interest to automatically convert into equity or would you rather pay the interest back in cash?
  3. What triggers a conversion of the note balance to equity? The trigger event is usually when the company raises equity investment at or above a certain amount.  Raising that amount will generally trigger the conversion of the convertible notes (both principal and possibly accrued interest) to equity automatically.
  4. What is the conversion discount? In exchange for the risk they take by investing in the hopes that they will be able to get equity in the future, convertible noteholders generally get a discount on the price of the equity they purchase when their note converts.  This is usually a ten to twenty percent discount on the price that the equity investors pay.
  5. What happens if the conversion trigger doesn’t occur before the note term ends? This usually will mean that the principal and accrued interest become due and payable on the maturity date.  However, some convertible notes either require or provide the option for the principal and interest to convert into common equity instead at a pre-determined price.
  6. What happens if the company is sold during the term of the note? There are various ways that this can be handled.  It is common to provide the investor the option to be paid back or to convert into shares of the surviving entity.

There are a lot more variations that can be included in a convertible note.  For example, professional Silicon Valley investors will often want a “valuation cap” included in the note.  This means that when the company raises equity, the price paid for the equity by the convertible note holders is the lower of (1) the discounted price discussed above (usually a 10-20 percent discount) and (2) the price they would pay if the company was valued at the valuation cap at the time of the conversion.  This can result in a very big windfall to the noteholders if the equity investors agree to a valuation that is much higher than the valuation cap.

You can also get creative with what triggers a conversion.  For example, maybe you want your convertible noteholders to be converted into equity if you achieve a certain milestone like the purchase of a building or a certain amount of revenues.  This conversion trigger could be automatic or optional.  If it is optional, it could be at the option of the company, the investor, or both.  If conversion is triggered by anything other than a “priced round,” i.e. the sale of equity, you will have to be determined how much equity the noteholders will be able to purchase.  This could be based on a valuation done at the time of the conversion trigger or it could be based on a pre-agreed price.  The pre-agreed price could be a set amount or it could be an amount arrived at by doing some sort of calculation – for example it could be some multiple of gross revenues from the most recently completed calendar year quarter.

Another term you can include is called “most favored nation” status – this means that if you raise more money in the future in the form of convertible notes and the future investors get better terms than the current investors that the current investors have the right to switch to the more favorable note terms.

Your Convertible Note Terms

  1. Term (i.e. years to maturity): ______________________
  1. Interest Rate: ______________________
  1. Conversion Trigger
    • Raise $_____________________ equity round
    • Other
  1. Is conversion
    • automatic when triggered
    • at the option of company
    • at the option of investor
    • other
  1. Choose one of the following:
    • Both interest and principal convert into equity
    • Only principal converts, interest paid in cash
    • Interest converts at option of company
    • Interest converts at option of investor
    • other: __________________________________________________________
  1. Conversion discount: ______________________
  1. If conversion trigger does not occur during note term
    • principal and interest are due and payable
    • principal and interest are automatically converted into common equity at $______________ (valuation)
    • principal and interest are converted into common equity at $______________ (valuation) at company’s option (otherwise payable in cash)
    • principal and interest are converted into common equity at $______________ (valuation) at investor’s option (otherwise payable in cash)
    • other: __________________________________________________________
  1. Valuation cap? Yes/No
    • If yes, amount: $______________________
  1. Any other terms?

If you need help with designing your offering for investors, feel free to contact us!

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How would a President Trump affect small business finance?

How would a President Trump affect small business finance?

One thing is certain.  Trump has an awkward relationship with the chair of the Securities and Exchange Commission, Mary Jo White.

According to this fascinating article in the Washington Post, Mary Jo White, when in private practice, deposed the Donald on behalf of her client, a New York Times reporter that Trump had sued for writing that his net worth was far less than what he claimed.

Apparently the deposition was quite challenging for Trump – he was caught in about 30 lies.

So, Mary Joe White is not likely to be our SEC chair for much longer.

What else might happen?

At a recent crowdfunding conference, some of the speakers expressed optimism that deregulation will make capital raising and secondary trading easier for small business.  It is certainly true that it has become so expensive to be a public company that very few companies are choosing to go public these days and some are choosing to go private.

It’s hard to know what might change under a Trump presidency, but one possibility is that the restrictions on who can invest in a small business could be loosened.

As the Republican member of the SEC says, “I want to move beyond the artificial distinction between so-called “accredited” and “non-accredited” investors and challenge the notion that non-accredited investors are “being protected” when the government prohibits them from investing in high-risk securities. . . .  Because most investors are risk averse, riskier securities must offer investors higher returns. This means that prohibiting non-accredited investors from investing in high-risk securities is the same thing as prohibiting them from investing in high-return securities. . . .  [E]ven a well-intentioned investor protection policy can ultimately harm the very investors the policy is intended to protect. . . .  Remarkably, if you think about it, by allowing only high-income and high-net-worth individuals to reap the risk and return benefits from investing in certain securities, the government may actually exacerbate wealth inequality.”

What do you think?  How do we balance the need to protect “un-sophisticated” investors with the need to make it possible for small businesses to raise capital from their communities, customers, and fans?

Interested in learning more? Get in touch!

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Investment Crowdfunding under the JOBS Act six months in

Investment Crowdfunding under the JOBS Act six months in

It’s been over four years since the JOBS Act was signed by President Obama and finally, starting on May 16, 2016, companies are raising money under the federal crowdfunding exemption that the JOBS Act created (Title III of the JOBS Act).

Here are some things to know to help you decide whether it’s right for you!

Fun Fact! What does the CROWDFUND Act stand for?

Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act.

Do I have to have a U.S. company?

Yes, only U.S. companies can take advantage of the crowdfunding exemption.

How much can I raise?

You can raise up to $1 million in any one year period.

Do I have to use an online platform?

Yes. You can only raise money under the Crowdfunding Exemption by posting your offering on an online platform that has been licensed by the Securities and Exchange Commission. In fact, communications with potential investors must take place through the platform (there are very limited things you can say about your offering outside of the platform).  Here is a list of the current platforms: https://www.finra.org/about/funding-portals-we-regulate (there may be some others that are Broker-Dealers as well – this is a list of the ones that are not Broker-Dealers).

What is the per-investor cap?

(i) If either the investor’s annual income or net worth is less than $100,000, the greater of $2,000 or 5% of the lesser of the investor’s annual income or net worth; or

(ii) If both the investor’s annual income and net worth are equal to or more than $100,000, 10% of the lesser of the investor’s annual income or net worth, not to exceed $100,000.

Note that this is a cap on what an investor can invest in all crowdfunding campaigns in a year.

How am I supposed to know if an investor is within the per year cap?

You can rely on the efforts of the crowdfunding intermediary to ensure that the aggregate amount of securities purchased by an investor will not cause the investor to exceed the limits, provided that you don’t know that the investor has exceeded the investor limits or would exceed the investor limits as a result of purchasing securities in your offering.

Are state level filings required?

Only the state of your principal place of business and the state where more than 50% of your investment comes from can require a notice filing and a fee.  Not many states are requiring anything at this time.

Can I be raising in a different way at the same time?

Yes! Unlike many other capital raising strategies, you are allowed to raise money under the crowdfunding exemption at the same time that you are raising money in another way, such as through a different kind of direct public offering or an offering to all accredited investors under Rule 506(c).

What can I offer?

Even though some people call this “equity crowdfunding,” you can offer any type of security – you don’t have to offer equity.

What filings are required?

When you set up your offering on a platform, you have to provide detailed information about your company and your offering.

If you’re raising $100,000 or less, you have to provide tax returns.  You also have to provide financials that are prepared in accordance with Generally Accepted Accounting Principles – most companies don’t have GAAP compliant financials and it can be expensive to get these done.

If you’re raising more than $100,000 you have to provide financials reviewed by a CPA. Reviewed financials can cost several thousand dollars.

After the first time you raise money under Title III, you have to provide audited financials if you’re raising more than $500,000.

You also have to file an annual report (including your financials) which is required to be posted on your web site.  You have to continue to post your annual report for as long as you have investors that invested under Title III (there are some exceptions that allow you to stop reporting sooner than that).

Can people who buy securities in my offering re-sell them to someone else?

Yes, but not before one year after the initial purchase.

What are some examples of successful campaigns?

Here are some that I’m following:

Spotlight: Girls

Farm from a Box

Maestroconference

Be sure to subscribe to my newsletter below to get up to date information as the crowdfunding exemption starts to get tested in the real world!

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New easier ways to raise capital – Part 2 – Multi-state Offerings up to $5 million

New easier ways to raise capital – Part 2 – Multi-state Offerings up to $5 million

The Securities and Exchange Commission just amended Rule 504 to increase the amount you can raise from $1 million to $5 million.

Rule 504 is an exemption that allows you to raise capital in as many states as you want and does not limit who can invest or how the offering can be advertised.

So, for example, you could do an offering under Rule 504 and register to do a public offering in both Massachusetts and Vermont.  This is what my former client Real Pickles did.  But back then, they could only raise up to $1 million.  If they did it now, they could raise up to $5 million.

This is huge!!!  Keep in mind that you can only raise up to $1 million under Title III of the JOBS Act (the investment crowdfunding exemption).  So Rule 504 offers an alternative way to raise investment capital from the crowd that allows you to raise five times more.

If you’d like to learn more about raising money under Rule 504, please contact us.

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New easier ways to raise capital – Part 1 – Intrastate Offerings

New easier ways to raise capital – Part 1 – Intrastate Offerings

The SEC just adopted a new rule called Rule 147A that allows companies to raise capital from investors within a single state (it is a new safe harbor under the intrastate exemption from the registration requirements of the 1933 Securities Act).

We already had a safe harbor for the federal intrastate exemption (Rule 147), but this one is new and improved!

Who can use it?

The company making the offering has to be “resident” and “doing business within” the state or territory in which all of the sales are made.

“Resident” means that the company has its principal place of business within that state (this is wherever the officers, partners, or managers of the business primarily direct, control and coordinate the activities of the issuer).

“Doing business within” means that one of the following is true:

  • The company derived at least 80% of its gross revenues from business operations located within the state;
  • The company has at least 80% of its assets located within that state;
  • The company intends to use and uses at least 80% of the net proceeds from the offering in connection with the operation of a business or of real property, the purchase of real property located in, or the rendering of services within that state; or
  • A majority of the company’s employees are based in that state.

Who can invest?

All of the purchasers of securities must be residents of that state.  You need to do some due diligence to establish a “reasonable belief” that the purchasers are actually state residents.[1]

Where can you advertise?

There are no restrictions on where the offer can be made, just the sales.  This means that you can promote the offering online, using press releases, etc.

Can the securities be resold?

For a period of six months from the date of the sale of a security, any resale of such security shall be made only to persons resident within the same state.  After that, resales are unrestricted under federal law.

The company is required to place a legend on the security stating that

“Offers and sales of these securities were made under an exemption from registration and have not been registered under the Securities Act of 1933. For a period of six months from the date of the sale by the issuer of these securities, any resale of these securities (or the underlying securities in the case of convertible securities) shall be made only to persons resident within the state or territory of [identify the name of the state or territory in which the issuer was resident at the time of the sale of the securities by the issuer].”

The company must also make a notation in its records of the transfer restriction and obtain a written representation from each purchaser as to his or her residence.

Required disclosures

The issuer is required to prominently disclose to each potential investor the following:

“Sales will be made only to residents of the state or territory of [identify the name of the state or territory in which the issuer was resident at the time of the sale of the securities by the issuer]. Offers and sales of these securities are made under an exemption from registration and have not been registered under the Securities Act of 1933. For a period of six months from the date of the sale by the issuer of the securities, any resale of the securities (or the underlying securities in the case of convertible securities) shall be made only to persons resident within the state or territory of [identify the name of the state or territory in which the issuer was resident at the time of the sale of the securities by the issuer].”

Timing with other offerings

Unlike before, you don’t have to have a six-month separation between another offering and your offering under this exemption.  You can use this exemption anytime after another type of offering.  So, for example, you could do a private offering and then immediately start an intrastate public offering.

State level compliance

You still have to make sure you comply with state level requirements for your offering.  So, for example, if you want to do a public offering in California, you need to comply with the California registration requirements for public offerings.

If you’d like to learn more about using this new tool, contact us!

[1] This can be established through a pre-existing relationship between the issuer and the prospective purchaser that provides the issuer with sufficient knowledge about the prospective purchaser’s principal residence; evidence of the home address of the prospective purchaser, as documented by a recently dated utility bill, pay-stub, information contained in state or federal tax returns, or other documentation.

Interested in learning more? Get in touch!

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