Convertible Note Term Sheet Essentials for Startups

A convertible note term sheet is a crucial document for startups, outlining the terms of a convertible note investment. This document is often used in seed funding rounds, allowing investors to provide capital to startups in exchange for a future equity stake.

A convertible note typically has a fixed interest rate, which is usually around 5-10% per annum. For example, a $100,000 convertible note with a 5% interest rate will accrue $5,000 in interest over a year.

Startups should carefully review the maturity date, which is the date when the note becomes due. This date is usually tied to the next funding round or a specific milestone, such as a product launch.

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A convertible note is a type of financing instrument that allows investors to lend money to a company in exchange for equity in the future. It's a flexible way for startups to raise funds without giving up too much control.

The mechanics of a convertible note depend on whether the company experiences a conversion event, such as a priced equity round. If not, it functions like a traditional debt instrument with an interest rate and maturity date.

A convertible note can convert to equity at a price determined by either a valuation cap or a discount rate. A valuation cap is the maximum valuation at which a convertible note will convert, while a discount rate gives noteholders a discount to the valuation at the priced equity round.

Here are the two options for convertible note conversion:

In some cases, a convertible note may specify both a valuation cap and a discount rate, in which case the note will typically convert at the lower of the two options.

A convertible note is a type of investment instrument that allows investors to provide funding to startups in exchange for equity.

It's essentially a loan that can be converted into equity at a later date, usually when the startup raises its next round of funding.

Convertible notes are often used by startups that are still in the early stages of development, as they can provide a quick source of capital without requiring a formal equity investment.

The investor lends money to the startup, and in return, the startup issues a convertible note that outlines the terms of the loan, including the interest rate and conversion rate.

The conversion rate is the ratio at which the convertible note can be converted into equity, usually in the form of preferred stock.

For example, if the conversion rate is 20%, the investor can convert the note into 20% of the startup's equity.

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A convertible note is essentially a debt instrument with some unique features that make it attractive to investors. It's often used by startups to raise capital without giving up equity.

In the absence of a conversion event, a convertible note functions like a traditional debt instrument with an interest rate and a maturity date. This means investors get their money back with interest, but they don't get any equity in the company.

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If a company experiences a conversion event, the total amount converting into equity will include the original principal amount on the note and any interest accrued to date. This is a key aspect of convertible notes that sets them apart from other funding options.

The price at which the convertible note will convert to equity is determined by one of two things: a valuation cap or a discount rate. A valuation cap is the maximum valuation at which a convertible note will convert, while a discount rate gives noteholders a discount to the valuation at the priced equity round when they convert.

Here's a comparison of the two:

A lower valuation cap or discount rate is generally more favorable for investors. Some convertible notes will specify both a valuation cap and a discount rate, in which case the note will typically convert at the lower of the two options.

A convertible note term sheet is a crucial document that outlines the terms and conditions of a convertible note investment. It's a complex document, but understanding its key components can help you navigate the process.

The Qualified Financing is a key component of a convertible note term sheet, which specifies the minimum size of fundraising that will trigger conversion. This represents a sufficiently large amount of funding that signifies the growth of the company.

The Discount Rate is another important component, which typically ranges between 10-30%, with 20% being the most common discount rate. This discount will usually apply when the note investor converts to equity.

The Maturity Date is the duration of a convertible note, which can vary widely from 6 months to 5 years. This duration will impact which type of investors can invest in the note.

A Convertible Note Term Sheet template is a crucial starting point to learn and understand this document. The standard components included in this format are the Name of the issuer, Nature of offering, Type of stocks offered, Amount/size of the offering, Issuing price, Date of maturity, Commission percentages, Extent of capitalization, Expected dividends, Preferred liquidation rights, and Details of conversion rights.

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Here are the key components of a Convertible Note Term Sheet:

The Pro-rata right is another key component, which gives the investor the right to participate in the qualified financing, up to an amount that will result in the investor maintaining the same percentage of ownership in the company.

The Dividend payments are not applicable to investors in a convertible note, as they are not shareholders and will not have the right to potential dividends paid out before conversion.

Issuing and creating a convertible note is a crucial step in the startup fundraising process. Convertible notes play an essential role in this journey, allowing startups to access funding quickly and efficiently.

A convertible note is a type of debt instrument that can be converted into equity at a later stage, typically at a milestone event. This provides a degree of assurance for investors, who can earn higher returns if the startup succeeds. Investors don't have immediate rights, and founders can retain control of the company until the maturity date.

Here are the key components to include in a convertible note term sheet:

These components are essential to ensure a smooth and successful convertible note issuance and creation process.

Creating a convertible note term sheet is a crucial step in issuing a convertible note, and it's essential to get it right. A convertible note term sheet is a preliminary document that outlines the terms and conditions of the investment.

You don't need to be an expert in equity management to create a convertible note term sheet, but consulting experts like Eqvista can be helpful. There are also standardized formats available online, such as the SAFE created by Y Combinator, that can serve as a starting point.

To create a functional convertible note term sheet, you can use one of the following options:

A convertible note term sheet typically includes the financing amount, closing dates, maturity date, conversion price, valuation cap, prepayment terms, and fees and legal expenses. It's essential to include all these components to ensure a smooth investment process.

Here are some key components to include in your convertible note term sheet:

A convertible note term sheet can help startups save costs and streamline expenses before they are ready to invest in the final contract procedures. It's also a helpful tool for founders to understand the funding terms before making a long-term commitment to an investor.

Issuing a convertible note can be a complex process, but one key aspect to consider is the automatic and optional conversion terms.

Automatic conversion is a great benefit to the company, as it avoids having to negotiate with noteholders. This happens when the company completes a qualified preferred equity financing that meets certain terms.

Some convertible debt only converts if the noteholder consents, which is worse for the company. This is because it requires additional negotiation and effort.

Occasionally, the notes will outline optional conversion rights if the qualified financing doesn’t emerge before the notes mature. This gives the noteholder the option to convert into equity, usually at a significant discount.

The terms of the convertible note should be carefully reviewed to understand the automatic and optional conversion terms. This will help the company make informed decisions about its financing options.

Here are some areas of law that may be relevant to convertible notes:

A convertible note term sheet template is a crucial starting point to learn and understand this document. Founders must know what they are getting into and the purpose and structure of this document to use it to play to their strengths.

The standard components included in a convertible note term sheet template are numerous, but some key details include the name of the issuer, the nature of the offering, and the type of stocks offered.

A basic structure of a convertible note term sheet template includes the issuing price, date of maturity, commission percentages, extent of capitalization, expected dividends, and preferred liquidation rights.

Some popular ready-to-use examples or references of convertible note term sheet templates are available from law firms like Kendrik Partners and open-source repositories like Open legal documents.

You can find a sample template from Kendrik Partners, a law firm specializing in legal counsel for tech startups, and another from Open legal documents, an open-source repository of legal documents focused on startup businesses.

Here are the standard details included in every convertible note term sheet template:

Convertible notes can be classified as either debt or equity for U.S. tax reporting purposes, depending on the facts and circumstances.

Most convertible notes are treated as debt, but companies should consult a U.S. tax advisor to determine the best classification for reporting purposes.

It's always a good idea to get professional advice to ensure you're meeting your tax obligations correctly.

Qualified financing is a crucial aspect of financing and taxes.

Investors typically require that the future equity round be of preferred stock that is senior to common stock. This means it has priority in liquidation preference over common stock and probably senior to any existing preferred stock the company already has.

Broaden your view: Convertible Equity Financing

A company will want the automatic conversion term to be as long as possible to provide maximum flexibility. However, investors usually require that the company complete the qualified financing within a shorter time frame, typically between six months and one year.

If the company doesn't meet this timeframe, the notes will mature and investors will be free to demand repayment.

Taxes can be a complex and nuanced topic, especially when it comes to convertible notes.

Most convertible notes are treated as debt for U.S. tax reporting purposes, but the classification can depend on the specific facts and circumstances of the case.

It's always advisable to consult a U.S. tax advisor to ensure accurate classification and reporting of convertible notes.

Using convertible notes can be a complex process, and founders should be aware of the potential pitfalls. A big gap between the convertible note valuation cap and the eventual valuation in the priced equity round can lead to founders giving up more equity than expected.

If interest payments are made on convertible notes, it can strain cash flows and consume funds that could be better used to grow the company. This is a consideration founders should make when deciding whether to use convertible notes.

A messy cap table can deter future investors, so founders should be mindful of the number of convertible notes and their terms. Having too many notes with different terms can lead to a complicated cap table.

Here are some key considerations to keep in mind:

Liquidation preferences can be found in convertible debt deals, where noteholders receive their investment back or a specified multiple of their investment back upon a sale of the company before the note is converted.

This concept works similarly to preferred equity financing, where noteholders get some equity-like return since their note wasn't converted into preferred stock.

Noteholders would receive their investment back, or a specified multiple of their investment back, by way of giving them some equity-like return upon the occurrence of a liquidation event.

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This presents investors with the advantage of holding debt, while maintaining the same upside they would have if they held preferred stock upon the occurrence of a liquidation event.

Liquidation preferences can be a valuable consideration for investors, as they provide a level of protection and potential return on investment.

Taking on convertible note financing can have its downsides, especially if done at a later stage.

Investors might view it as a negative signal that the company couldn't raise a traditional priced funding round.

Founders should be aware of how much equity they're giving up in the process.

A big gap between the convertible note valuation cap and the eventual valuation in the priced equity round can lead to unexpected dilution for the founder and future investors.

Interest payments can strain cash flows, consuming funds that could be better used to grow the company.

A messy cap table with too many convertible notes can deter future investors.

Here are some key considerations to keep in mind:

Anti-dilution provisions can help protect investors' shares from losing value in a 'down round', but that's a topic for another time.

SAFES and convertible notes carry many of the same benefits for founders and investors.

Both options offer flexible funding terms and the ability to delay valuation.

However, there are key differences that founders and investors should understand.

Convertible notes typically have a fixed interest rate, whereas SAFES do not.