Due to their apparent simplicity, convertible notes are an attractive option for both founders and early investors. However, when it comes time to convert them in equity financing, notes can have unforeseen complexity for founders and investors alike.
Here we touch on just a couple of these complications.
When notes convert at the financing, they usually dilute both the new equity investor and the founders. However, the equity investor might not be willing to share in the dilution and might require that the
notes convert “pre-money.” Effectively there would be two, iterative transactions: the note conversion followed by the equity investment.
This approach can drastically increase the dilution borne by founders, but could also be viewed as more fair to the new investors. Both sides should be aware of the potential negotiation point and should understand the impact of either approach on their ultimate ownership interests—one of many reasons the parties should produce and agree on a capitalization table at the term sheet stage.
If a Series A investor pays $1.00/share, and a note converts into preferred stock at a 20% discount, then unless the terms of the note provide otherwise, the note investor would have $1.00 of liquidation preference for every $0.80 actually invested. Arguably, this result is inequitable: liquidation preference is intended to serve as downside protection and conversion should not lock in this $0.20 of “liquidation preference overhang,” i.e., dollars of preference above dollars invested. However, the overhang can be prevented by specifying in the notes that the conversion shares will have a liquidation preference based on the conversion price. Founders should consult with counsel to make sure their notes are properly drafted on this (and, of course, every) point.
About Hill Ward Henderson: Hill Ward Henderson started with a vision of a unique law firm — one that would combine the expansive talent, resources, capabilities and technologies of a larger firm with the responsiveness and personal attention of a smaller firm, to deliver powerful, personal service to every client. This idea for an innovative, client-focused firm grew out of the longstanding relationships and collective experience of three of the area’s leading attorneys, Benjamin H. Hill, III, David E. Ward, Jr., and Thomas N. Henderson, III. Acting on this vision, on May 1, 1986, these three and four others established Hill Ward Henderson. Since inception, Hill Ward Henderson has grown steadily based on our continued allegiance to this founding, client-centered philosophy. Today, with over 100 attorneys offering a wide range of premier commercial legal services in nine different practice areas, our firm’s superior reputation for results-oriented service continues to fuel that growth.
Hill Ward Henderson counsels various practice areas, if you are interested in seeking legal counsel, you can find an attorney here.
Article written by: Nick Outman, Hill Ward Henderson Shareholder.