Discussion of convertible notes and some thoughts on priced rounds.

1. This presentation is made possible by the support of the American People through the United States Agency
for International Development (USAID). The contents of this presentation are the sole responsibility of Rick
Rasmussen and do not necessarily reflect the views of USAID or the United States Government.
Financing The Early Stage
Company

2. Investment Vehicles
• Self-investment
• Friends, family and fools
• Accelerators and Incubators
• Angels
• Angel groups
• Two common forms
– Convertible Notes
– Seed (Priced) Round

3. Convertible Notes
• Convertible notes convert at a negotiated discount
into a future equity financing- usually Series A
– Avoids valuing the company
– Notes are simple, quick and inexpensive
– Typically no legal fees involved

4. Convertible Notes- Terms
• Convertible at next round
• Contain a discount as investor is
earlier in the risk/reward cycle
– Warrants (rights to purchase additional stock at same price)
– Discount rate (able to buy next round at less than others)
– Either one or the other. 20% discount is typical
• Interest Rate
• Maturity date
• What happens upon a Company sale or liquidation
• Most honest investors will abide by “Standard Terms”. Sample agreements
can be found online

5. Convertible Notes- Conversion Terms
• Mandatory conversion of notes at a discount to price paid
– Discount is typically 20-25%
– Accrued interest also due (typically 6% to 8%)
• Conversion triggered upon a “Qualified Financing”
– Typically preferred stock/capital stock financing above a
minimum size (e.g. >$1M)
• Optional conversion upon a “non-Qualified Financing”
– (e.g. <$1M) upon vote of majority of the principal amount of the
notes

6. Convertible Notes: Conversion Price “Cap”
• Conversion price is often “capped” at a particular valuation
– “20% discount to the price paid by investors in a Qualified
Financing; provided that the Conversion Price shall not be greater
than a price equal to $5,000,000 Divided by the Fully Diluted
Capitalization of the Company.”
• Protects investors in the event the Company’s valuation
takes a significant jump before the notes convert
• Sophisticated investors generally require but can create
problems with VCs if it results in too significant a discount
(40-50% has been done)
• Issuing value of the discount in Common Stock can help
mitigate this concern

7. Convertible Notes: Sale of Company
• Protects investors if the Company is sold before a
Qualified Financing
– Repayment at a premium (150%, 200%, etc.)
– Conversion into Common Stock at a pre-determined
valuation- usually same valuation as conversion cap
• Sometimes investors given the option to choose their
cash out strategy

8. Convertible Notes
• Advantages:
– Avoids valuing the Company
– Simple, easy to implement and inexpensive
– Easy to have subsequent “rounds” at a different price (i.e., a
different discount)
– Investors get the protection of being a creditor
• Disadvantages:
– Accumulates debt (liability) on balance sheet
– Can require repayment at maturity depending on terms
– Conversion price caps not a benefit to the Company
• Can create issues upon conversion if too steep a discount

9. Convertible Notes: Note Purchase Agreement
• Agreement consists of note as well as reps and
warrantees (+ Warrant if used in lieu of a conversion
discount)
• Multiple Notes often issued under one Note Purchase
Agreement
• “Majority vote” amendment is very common
– Holders of a majority of outstanding principal amount can
amend terms

10. Derivatives of the Convertible Note
• Series Seed
– “Open source” documentation
– Simple, “middle of the road” – designed for low legal cost
– Requires establishing a valuation for the Company
• Convertible Securities
– New approach recently introduced by Founders Institute
– Provides many of the popular features of Convertible Notes without the
disadvantages of debt (repayment, debt on balance sheet, etc.)
– Similar to Convertible Notes but not a debt instrument
• Not treated as debt on the balance sheet
• No interest or maturity date
• Most investors will treat these as new and “strange”

11. Seed Round Preferred Stock- Terms
• Same structure as a venture round, only lower $ and
typically less onerous terms
• Purchase Agreement + Investor Rights Agreement
– No Voting Agreement, Co-sale Agreement, etc.
– Liquidation preference: Series Seed gets 1X, then all proceeds
go to Common Stock
– No anti-dilution protection or registration rights (MFN clause)
– Election of directors if desired
– Right to participate in future rounds; information rights
– “Drag-along” provision (all shareholders must sell if board +
majority of common + majority of preferred approve)
– No legal opinion

12. Seed Round Preferred Stock
• Advantages
– Values the Company (generally good for investors)
– Avoids any issues around conversion down the road
– Avoids loading the balance sheet with debt
– Avoids other issues associated with debt (repayment at
maturity, CA Finance Lenders Law, etc.)
• Disadvantages
– Sets value for the Company (generally bad for Company)
– More complicated and expensive then Convertible Notes
– More expensive to do subsequent rounds at a different price
– Requires filing an amendment to articles/certificates of
incorporation

13. Federal Securities Laws
• Regulation D, Rule 506 is best
• Safe harbor; certainty
• Requires accredited investors
• 4(2) can be used if Reg D not available
• Can include non-accredited investors (but this can create major
problems down the road)

14. Which way to go?
• Convertible Notes
– Common, cheaper, simpler
– Convertible Notes avoid valuing the Company
• Investors often won’t/can’t
• Helps justify low FMV for stock options
• However, conversion price cap can be an indirect indication of
value
• Seed Round
– Good choice where “priced deal” is desired
– Tend to be more expensive
– Require filing in State of Incorporation (i.e. Delaware)