conquering the term sheet everything you need to know about deal terms part 3
TRANSCRIPT
Mailbox: Liquidation preferences
It depends. Pro rata rights are a right, not an obligation. Things to remember: Lean on your winners. Avoid being crushed.
Important note: If you have the opportunity to buy up, why not?
Q: Should I exercise my pro rata rights?
Quick ReviewLesson 1 - Equity
Valuation Liquidation preferences
ESOP
Key takeawayNeed to look at the
WHOLE term sheet to see the full
picture
Lesson 2 - EquityPro rata rights
Anti-dilution protection Control provisions
Key takeawayNeed to have
opportunity to continue backing your winners
Today’s agenda
Convertible notes Pros and cons (investor/entrepreneur)
Amount/maturity Interest
Conversion Discount
Cap Auto/voluntary conversion
Repayment SAFE
Convertible Notes
Structured as a loan, converts to equity if certain events occur
(generally upon a future financing)
Why use a convertible loan?
• Increases STM (Speed to Money)
• Can be a “bridge” to next round, maximizing value creation and reducing dilution
• Increased flexibility with size of investment, equity stake sold
• Often no control provisions, board representation
The entrepreneur’s Perspective
Why use a convertible loan?
• Faster, easier, cheaper
• Enables securing of deal
• Get some built-in upside
• Downside protection
The Investor’s Perspective
• First investment: displaces valuation discussion onto larger institutional entity
• Follow on: provide company with bridge to next round
Use Cases
Loan AmountHow much money is going
to be invested by you +
How much money will be invested by others
(What is the timeframe for others to join)
Interest
Interest accrues rather than being paid out
Simple vs Compound Interest
8% interest per annum
Invest $1M, converts to equity in exactly
one year
Equivalent of having invested $1.08M
Example
After 2 years: $1.16M vs. $1.1664 M
Automatic vs. Voluntary Conversion
Exactly as it sounds, some conversions are forced when certain conditions are met
Others are optional
Automatic Conversion“Prior to the Maturity Date, upon
receiving notice from the Company that the Company has raised more than $X million in funds in which it
has issued preferred shares (“Qualified Financing”), then the
Note will automatically convert all principal, together with all accrued and unpaid interest under the Note,
into the shares issued in such Qualified Financing. The
conversion price will be a price per share equal to…”
Automatic Conversion“Prior to the Maturity Date, upon
receiving notice from the Company that the Company has raised more than $X million in funds in which it
has issued preferred shares (“Qualified Financing”), then the
Note will automatically convert all principal, together with all accrued and unpaid interest under the Note,
into the shares issued in such Qualified Financing. The
conversion price will be a price per share equal to…”
Threshold ensures balance between
institutional lead investor and pragmatic
fundraising plans
Automatic Conversion“Prior to the Maturity Date, upon
receiving notice from the Company that the Company has raised more than $X million in funds in which it
has issued preferred shares (“Qualified Financing”), then the
Note will automatically convert all principal, together with all accrued and unpaid interest under the Note,
into the shares issued in such Qualified Financing. The
conversion price will be a price per share equal to…”
Important because don’t want
common stock
Automatic Conversion“Prior to the Maturity Date, upon
receiving notice from the Company that the Company has raised more than $X million in funds in which it
has issued preferred shares (“Qualified Financing”), then the
Note will automatically convert all principal, together with all accrued and unpaid interest under the Note,
into the shares issued in such Qualified Financing. The
conversion price will be a price per share equal to…”
Well, it’s just automatic
Automatic Conversion“Prior to the Maturity Date, upon
receiving notice from the Company that the Company has raised more than $X million in funds in which it
has issued preferred shares (“Qualified Financing”), then the
Note will automatically convert all principal, together with all accrued and unpaid interest under the Note,
into the shares issued in such Qualified Financing. The
conversion price will be a price per share equal to…”
See Lesson 1,2 of our lecture series
Get rights and preferences of equity
round
Conversion PriceThe conversion price will be a price per share
equal to the lower of:
(i) y% of the price paid in the Qualified Financing (ii) a price per share reflecting a company pre-
money valuation of $X
DiscountCap
Conversion Price
Discount to the price/share paid in the next equity round
Typically 10%-30% (most often 20%)Discount
Cap
“(i) y% of the price paid in the Qualified Financing”
Conversion Price
DiscountCap
“(i) y% of the price paid in the Qualified Financing”
Time-triggered discount: no discount if next round w/in 90 days from closing
Escalating discount: 15% within 90 days, 25% after 90 days but prior to 180 days, 35% after 180
days
Examples of variations
Real Life Example
Conversion Price
20% discount:next round = $1.00 per share, then the note will
convert into the same shares at a 20% discount, or $0.80 per share.
$500,000 convertible note —> 625,000 shares ($500,000 / $0.80)
New $500,000 equity investor —> 500,000 shares ($500,000 / $1.00)
DiscountCap
Conversion Price
DiscountCap
(ii) a price per share reflecting a company pre-money valuation of $X
Maximum conversion valuation(regardless of valuation of next round)
Conversion Price
DiscountCap
(ii) a price per share reflecting a company pre-money valuation of $X
breakeven point is $X/Y%eg. lower of 80% of pps or $20M cap —>
$20M/8% = $25M
<$25M 20% discount
>$25M $20M cap (discount > 20%)
Next round valuation
Conversion Price
DiscountCap
Importance of a cap for investors• Protect upside on risk-adj basis • Align interests • Protection vs. tail risk
Balance with management not wanting cap to set next round’s valuation
M&A prior to conversionDon’t want to just get repaid
1. Receive multiple of investment (e.g. 2x or 3x) 2. Convert at a discount to purchase price 3. Convert at predetermined price (e.g. last
round’s post money)
3 options
What happens at maturity?Repayment or Conversion at Predetermined Price
Repayment (w/ option to convert): • entrepreneur can view as ticking time bomb • investor unlikely to get repaid anyways • inability to repay = insolvency
Automatic Conversion @ Predetermined Price:• valuation signal when trying to raise equity
round?
Issues with Convertibles
• have more downside protection than full ratchet (Lesson 2!)
• can result in >1x liquidation preference (Lesson 1!)
• have features of debt even though intention is equity
Next step?
Thanks for joining us for our Term Sheet series
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