Business Law Blog
Authored by Bryan Springmeyer He has worked on 70+ convertible note financings as both investor and company counsel.
The information on this page should not be construed as legal advice.

Using Convertible Notes for Angel Investments

Preferred stock is a class of stock that is sold to investors of venture scale companies. Preferred stock conventionally provides the holders with special rights, such as a liquidation preference that returns investor money prior to distributing money to common stockholders, anti-dilution protection, dividend preference, board placement, and certain contractual rights like the right to participate in future investments.

Convertible notes are loans that (ideally) convert into the preferred stock that is sold in a subsequent equity round of investmet. The note might also cover contingencies, such as what happens if the company does not get to the investment by the maturity date of the loan, or if the company is sold prior to conversion. Convertible notes (and the more recent SAFE) are a standard instrument for early stage investments in venture scale companies.

Because a convertible note does not require the same negotiation and integration of rights and privileges that a Preferred Stock round does, it is much easier and cheaper to accomplish. Investors are essentially deferring the negotiation of those rights to the venture capital firms that will be leading the preferred stock financings.

Convertible Notes Versus Preferred Stock

Convertible notes tend to work well for companies when the company can achieve a large valuation at the conversion-triggering equity round, expects to do so quickly (since the maturity date on the note creates some time pressure), and can negotiate a high price cap (or no price cap at all). Priced rounds (i.e., with Preferred Stock) tend to work well for companies that can negotiate a substantial valuation at their seed round and don't mind the extra legal expense of this transaction over a convertible note round.

[See also: Convertible Note Term Sheets]

Companies and investors choose convertible notes because they are relatively easy and cheap. Additionally, the debt treatment of the investment keeps the company's fair market value down, which has tax implications for compensatory equity awards. The biggest sacrifices with using convertible notes are valuation and investor's rights [see also Investor rights in convertible note rounds]. However, if the price cap is used strategically, the angel can value the company with the note. With regard to investor's rights, convertible note holders are creditors of the company and therefore receive liquidation preference, plus the note has some de facto protection against dilution, since its conversion is based on the pre-money capital at the time of Series A (and thus an equity pool diluted prior to the transaction would not shrink the percentage ownership at conversion). Furthermore, most angels that are not investing a large amount are comfortable deferring the negotiation of investor rights to the VC firms involved in the future Series A transaction.

Conventional thought was that preferred stock transactions were favored because they allow the angel investor to engage in business valuation. The idea is that successful investors are such because they are: a) really good at valuing businesses; b) really lucky; or c) both a and b. When an investor evaluates a promising startup, values its potential value and risk premium and establishes a corresponding present value, they should have a positive expected value if they can invest below that amount. This is the essence of value investing. Some investors are less formulaic, but the factors that they focus on - growth potential, likelihood of exiting - are the same that would be used in a more formulaic analysis.

The Price "Cap" Lets the Angel Engage in Valuation (Sorta)

Traditionally, convertible note transactions left the valuation to the Series A venture capital firm(s). In such cases (where the notes do not have a price cap) the angels lend a specified amount of money to the company, and in the event that the company reaches Series A, the investor converts the outstanding amount of the note (principal + interest) into equity at a pre-defined discount. What this means is that the higher the startup's valuation is at Series A, the less equity the note will purchase. In other words, the better the company does before Series A, the less the angel investor owns. This is a weird phenomenon that puts the interests of the business and the interests of the investor against each other until after Series A. Other things being equal, the angel is better off with a lower Series A valuation, because they will own a greater equity stake at conversion, and the business is better off with a higher valuation, because it'll keep more equity and/or be able to raise more capital. After Series A, they both benefit from increased growth. Indeed, a company could take on a ton of debt (which would not trigger conversion of the notes) to give itself a bigger runway to increase the Series A valuation.

With a price cap, which sets a maximum pre-money value that the notes can convert at, angels are protected against the company's value increasing too much before Series A. With a capped note, the investor can convert at the discounted Series A price or the capped price - whichever is better for the investor. If the investor can negotiate a price cap on the note reflective of their valuation of the company, they have effectively priced the round.

Don't Get Carried Away

The price cap realigns the interests of the investor with the business', to a certain extent, because the investor can be certain of a minimum equity stake, no matter how much the Series A valuation exceeds the cap. The conversion of the note for a company whose valuation is much greater than the cap is good for the investor, because the value of their investment has multiplied, and good for the company, because it has achieved a great Series A valuation. However, if the aggregate amount of the notes is large and the cap is much lower than the potential Series A valuation, then the investment potentially loses some appeal to potential Series A investors, since the round they lead will result in angels converting to big chunks of Preferred Stock Series A without contributing new money. Trying to retroactively negotiate a lower value for early investors in order to close with the Series A VCs may not be fun.

The most appealing part of a convertible note seed funding is the ease of completing the transaction. There are far less documents, as a majority of the transaction defers to future Series A terms. This means that investors are accepting the future investor's rights, rather than negotiating them at the convertible note stage, under the assumption that venture capital firms will do a good job of protecting their mutual interests. This saves the business a lot of money, as it is usually responsible for the legal expenses of the transaction. Additionally, the cap allows angels to engage in valuation and the convertible note, which is an unsecured loan, has liquidation preference over stock holders. The preferred stock has liquidation preference over common stock, but its holders are not on par with other unsecured creditors, as the convertible note holders are.

Related Articles:
Convertible Note Term Sheets
Investor's Rights in Convertible Note Rounds
Startup Investments 
Preferred Stock Terms - Angel Round
Term Sheet Generator
Searching for Startup Capital
Angel Transactions

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