From Idea to Success: The Dartmouth Entrepreneurial Network Guide for Start-Ups by Gregg Fairbrothers & Tessa Winter

Author:Gregg Fairbrothers & Tessa Winter
Language: eng
Format: mobi
Publisher: McGraw-Hill Education
Published: 2011-07-18T18:30:00+00:00

Figure 12-1 Sample convertible note term sheet.

The advantages of using a convertible note instead of equity include the following:

A simple note means much lower legal costs.

Since the debt amount is fixed, valuation of the company is deferred to a later time when the company has progressed, there is more information, and (presumably) professional investors are involved in the valuation.

Convertible notes permit repeated closings. Equity offerings generally have to be closed at one time or in no more than a small number of stages. Convertible notes can be written as often as you like over an extended period, letting you raise more money as you go.

Note holders are not shareholders and don’t automatically have legal rights to participate in shareholder decision making until the notes convert.

Doing notes reduces the number of classes of stock.

Notes offer early investors some protection from later investors. Holders of the notes will convert to the same class of stock issue as the next-round investors. Otherwise, investors in later rounds often insist on classes of stock that assert privileges not conferred on stock issues from earlier rounds.

Not all angels like convertible notes. They don’t like feeling that the step-up in value between their round and the next is capped at the share price discount. However, they avoid the risk of a down round, in which the valuation actually drops, or of seeing less than the fixed step-up in the next round. You can alleviate the “capping” objection by sweetening the offer with warrants, which give the investor the right for a period of time to buy a certain number of shares at a predetermined (low) price. A new model caps the funding amount in the next round so that even if the round raises more than the cap, the conversion is capped at the defined amount, meaning that the upside gets better the higher the valuation of the company above the cap. Still, some angels want the equity and the rights to participate in decision making in the company that go with owning shares. At the friends and family stage, convertible notes are definitely preferable, especially because they defer the dicey issue of pricing the company to a later round when it’s done more at arm’s length and presumably by experienced investors.

Often the involvement of angels, which comes along with their investment, can be one of the biggest advantages you get. Many angels invest for more reasons than just the money. They often say they remember people who helped them be successful along the way and look at investing as a way of giving back. Some invest to stay active and get involved in interesting things. Good angels can provide a wealth of experience, advice, networking, encouragement, and accountability that is often what a team needs to make the leap to effective and consistent execution.

WHAT I KNOW NOW THAT I WISH I HAD KNOWN THEN

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