How to generate a Convertible Note Term Sheet
What is a Convertible Note Term Sheet?
A Convertible Note Term Sheet is a simple, non-legally binding document that records the major terms of negotiation between a company and investors for the issuance of convertible notes. Creating a Convertible Note Term Sheet helps facilitate discussion between the company and its investors in the negotiation stage. Given the non-legally binding nature of a Convertible Note Term Sheet, it is necessary for the parties to execute a Convertible Note Instrument or Convertible Note Subscription Agreement to record the binding terms in full.
What is a Convertible Note?
A convertible note is a debt instrument that converts into equity under predefined conditions. It is interest-bearing and the interest will be converted into equity together with the principal amount at conversion. Typical situations leading to conversion include:
- qualified financing (i.e., subsequent fundraising by the company which exceeds a certain minimum amount): the note will be converted into the same class of equity issued by the company at the qualified financing (typically preferred shares with additional rights compared to common equity).
- a liquidity event: the note will be converted into ordinary shares right before the liquidity event.
- if neither of the above happens, on the maturity date the note will be converted into shares, typically ordinary shares.
What are the components of a Convertible Note Term Sheet?
The various components of a Convertible Note Term Sheet are:
- Qualified financing: It is the minimum size of fundraising to be achieved by the company which will trigger conversion. This represents a sufficiently large amount of funding that signifies the growth of the company to a stage where the investor is happy to become an equity holder instead of a creditor.
- Valuation cap: Also known as “price cap” or “conversion cap”, is the ceiling for the conversion price. This figure serves as the limit on the conversion price rather than a genuine valuation, which is often not possible at an early stage of a business with too little record and data available. The valuation cap price is arrived at by dividing the valuation cap by the number of outstanding shares at the relevant time.
- Discount rate: It is the percentage of discount to be applied in determining the conversion price. You should note that only the lower valuation cap price and the discounted price will apply.
- Maturity date: The duration of a convertible note can vary widely – for example, 6 months for a bridge financing to a Series A financing to a much longer timeframe (e.g., 5 years). The duration will have an impact on which type of investors can invest in the note – for example, some funds have a mandate not to invest in debt-like instruments with a duration beyond 12 months. On the other hand, angel investors do not have such restrictions.
- Pro-rata right: It is the right for the investor to participate in the qualified financing (i.e., buying additional equity with additional cash upon the terms of the qualified financing), up to an amount that when taken together with the equity converted from the convertible notes, will result in the investor maintaining the same percentage of ownership in the company.
- Dividend payments: Investors in a convertible note are not shareholders and will not have the right to potential dividends paid out before conversion. They will typically request that no dividend is paid out prior to conversion to make sure their investment goes to growing the company and not to paying existing shareholders.
SAFEs (Simple Agreements for Future Equity)
A Simple Agreement for Future Equity (SAFE) is a contract by which an investor makes a cash investment into a company in return for the rights to subscribe for new shares in the future.
Things to remember when writing a term sheet for a convertible note
These are some of the terms to look out for in a term sheet for a convertible note.
- Financing Amount: This is the capital that the startup raises.
- Closings: negotiations could occur on multiple dates and have multiple closings; there needs to be a specific date mentioned in regard to the closing.
- Maturity Date: convertible notes have a maturity date provision when they have to be repaid. Be sure to check it is what you agreed to.
- Conversion Price: This is the convertible security that can be changed into common stock.
- Prepayment: Can the startup prepay the convertible notes without the consent of the convertible note holder? It should be defined well and both parties have to be on the same page.
- Fees and legal expenses: both parties have to agree upon the legal and other associated expenses incurred in the transaction.
Why do startups need a convertible note term sheet?
The value and importance of a convertible note term sheet are realized in seed financing rounds of startups as founders who are still learning about fundraising are able to take time and understand the funding terms before making a long-term commitment. Founders find the preliminary terms set out in the convertible note term sheet to be quite helpful in checking their positions with the board of directors in the event of dilution.
Further, startups need to focus as much of their resources as possible on growth and important stuff as they have limited funds in the initial stages and Convertible Note Term Sheet helps scan and save costs before companies are ready to invest in the final contracts. Standardized term sheets are easy to access and use and it makes the fundraising process quick and easy.
Conclusion
A Convertible Note is a short-term debt instrument that converts into equity and is widely used by startups to collect funding. A convertible Note Term Sheet is generally signed at the beginning of the transaction once the preliminary terms of the financing have been agreed upon, before commencing detailed due diligence and drafting of definitive agreements.
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