Convertible Note Term Sheet

A convertible note is a debt instrument that converts into equity under predefined conditions. Typical situations leading to conversion include:

 

• a qualified financing (i.e., a 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 (i.e., a change of control or listing): the note will be converted into ordinary shares right before the liquidity event; or
• if neither of the above happens, on the maturity date (i.e., the due date of the debt): the note will be converted into shares, typically ordinary shares.

A convertible note is interest-bearing and the interest will be converted into equity together with the principal amount at conversion.

 

A convertible note typically includes:

 

• a discount to the fully diluted price per share – compared with the price paid by investors in the qualified financing or the reference price for the liquidity event; and
• a cap on the fully diluted price per share at which the conversion will occur. In the documentation you will find in the Zegal app, this cap is expressed as a cap to the post discount pre-money valuation at the conversion event.

“Qualified financing” 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 that 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. Valuation cap price is arrived at by dividing the valuation cap by the number of outstanding shares at the relevant time.

 

“Discount rate” is the percentage discount to be applied in determining the conversion price. You should note that only the lower of the 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 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” 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.

 

Pro rata right is often very important to more sophisticated seed investors because it gives them the right to follow on with their most successful investments and to potentially ‘protect’ their ownership stake during a potential down-round (round conducted at the lower valuation than the previous round). However, it could also mean reduced flexibility in negotiating with investors at subsequent rounds and can lead to renegotiation of these rights with earlier investors to facilitate the next round. This clause is offered as an option in the Convertible Note Instrument (if this right will be granted to all investors) or in the Convertible Note Subscription Letter (if you want to keep the flexibility to grant this right only to specific investors – for example depending on their level of investment).

 

“Dividend payments”. Investors in a convertible note are not shareholders and will not have 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. This clause is offered as an option in the Convertible Note Instrument you can create in the Zegal app, by which you can stipulate that the company will not pay any dividend until the convertible note is converted.