Legal documents can range from the moderately annoying to the insufferably pedantic. Convertible promissory notes are no exception but are so commonplace, you are going to need at least a basic understanding of how they work.
With that in mind, I created a list of common key terms in convertible notes and what they mean. I hope you enjoy.
- Amendment – Whose consent is required to amend the terms of the note. Almost always, convertible note documents are amendable by some majority of the noteholders and the issuer. If it is a single note (not in a series of notes), the convertible note documents will typically say that the terms cannot be amended without the consent of the issuer and the noteholder.
- Assignment – Who has the power to assign their rights under the note. Typically, an investor in a convertible note may not assign the note without the company’s consent.
- Attorneys’ Fees – Notes frequently say that if an action is initiated to collect or enforce the terms of the note, the prevailing party would be entitled to recover its attorneys’ fees and costs from the other side. I consider including this provision “market.”
- Borrower – This refers to the company that issued to the note to the investor. Borrower, company, maker, issuer – these all refer to the same thing.
- Default Interest Rate – Sometimes notes specify that upon the occurrence of an event of default (e.g., the company fails to make a payment under the note), the interest rate increases sharply. This is not very common in startup land, but sometimes it does happen.
- The Denominator – This refers to the number of shares the valuation cap will be divided by in order to calculate the conversion price per share into which the debt under the note will convert. Rather than get too far into the complexities, I’ll just point you to an article my colleagues wrote on the topic that will answer most questions you have.
- Discount – The discount refers to the discount on the purchase price of the next financing round that the holder of the note is going to receive (meaning the amount of shares the holder’s note will convert into) if and when such a next financing round occurs, For example, a note might say that the holder of the note gets to convert the holder’s shares into the next round at 80% of the next round’s price. This would be referred to as a 20% discount.
- Events of Default – Sometimes convertible promissory notes specify events of default, e.g., the company filing for bankruptcy. The note may then go on to say that if this occurs, the interest rate of the note will increase to the Default Interest Rate (see above).
- Governing Law – Usually notes are governed by the law of the jurisdiction where the borrower primarily does business.
- Information Rights – Sometimes notes entitle the holder to receive certain types of information from the company. I would consider this atypical. Information rights are generally given to fixed-price round investors.
- Interest Rate – It is typical for convertible notes to bear interest at 4-8% per year. Sometimes notes don’t bear any interest. Obviously, the best deal for a startup is: (1) no valuation cap; (2) no discount; (3) no interest rate (this is basically what one of the Y Combinator SAFEs does). There is a misconception that the note has to bear interest in order to comply with federal tax law. That is generally not true unless the lender is a related party. It is possible to have a note with a zero percent interest rate.
- Liquidation Overhang – This refers to the concept that a noteholder, if they convert at a discount to the price paid by the new fixed-price round investors, they will get liquidation preferences they didn’t pay for. For example, suppose you invested $100,000 into a note. If the note reverts at an 80% discount to the price, unless there is a provision that says otherwise, you will receive stock with a liquidation preference that exceeds your $100,000 investment.
- Maturity Date – the “Maturity Date” is the date on which the note becomes due and payable.
- Maturity Date Conversion – This refers to the optional conversion of the debt under the note into equity of the company at the Maturity Date if a Qualified Financing (see below) has not occurred before the Maturity Date, or if a Non-Qualified Financing (see below) has occurred, the investor has chosen not to convert the debt into equity.
- Most Favored Returns clause– This refers to the right of a holder to receive any more favorable terms offered to other investors during the round.
- Non-Qualified Financing – The term “Non-Qualified Financing” refers to a financing with a monetary amount less than a Qualified Financing (see below). It generally triggers an investor’s right, at its option, to convert the debt under the note into equity.
- Noteholder– This just means the investor, i.e., the person or entity that owns the note. Noteholder, investor, lender, holder – these all refer to the same thing.
- Participation Rights – Sometimes convertible notes contain a right in favor of the investor to participate in future rounds of financing. I would consider this atypical. This is more commonly found in fixed-price rounds.
- Prepayment – Most convertible promissory notes disallow any prepayment by the company without the consent of either the noteholder (if there is only one) or a majority of the noteholders (if there are several).
- Qualified Financing – The term “qualified financing” is used to define when a note will be automatically converted into equity. It is a monetary amount (e.g., $1,000,000) that, when hit, will trigger automatic conversion of the debt under the note into equity of the company.
- Security Interest – It is not common in convertible promissory notes (it is much more common in straight promissory notes), but sometimes noteholders demand a security interest in the borrower’s property.
- Shadow Series – This refers to what a company might do in order to avoid giving converting note holders liquidation preference that they did not pay for (see Liquidation Overhang).
- Subordination – Note holders may be asked to agree to subordinate their note to other debt of the company.
- Tax Issues – Is the conversion of a note a taxable event? In general, no. Except for interest. Interest is taxable in all events. For this reason, sometimes investors want the right to ask that interest be paid in cash. Similarly, the company should have the right to withhold taxes.
- Tax Withholding – Sometimes a note or a note purchase agreement will contain an authorization for the company to withhold.
- Valuation Cap – A valuation cap is a cap on the valuation at which the note will convert into stock of the company issuing the note. For example, if the note has a $10M valuation cap, even if the company raises money at a valuation of greater than $10M, the noteholder’s shares will be priced based on the $10M valuation. Generally, automatic conversion via a Qualified Financing will convert either via the Valuation Cap/Denominator method, or via the Discount.
- Venue – Venue for resolution of disputes is commonly specified. Meaning, sometimes notes will state that any lawsuit or arbitration filed to enforce them it must be stated in a particular jurisdiction.
- Voluntary Conversion Price – This refers to the price at which a noteholder can voluntarily convert their note into shares of the Company.
Still with me?
Those should get you started!
If you have any questions (or if you think I forgot anything) please feel free to contact me.
By: James Graves
Disclaimer: this post is for informational and educational purposes only. It is not intended to provide any legal advice.