Business Law Blog
Authored by Bryan Springmeyer He has worked on 100+ convertible note financings as both investor and company counsel.
The information on this page should not be construed as legal advice.

Investor Protections in Convertible Note Seed Financings

Seed financings up to about $2 million are most often accomplished with convertible notes or similar instruments. The standard instrument for later stage venture finance is preferred stock. In preferred stock transactions, investors’ rights are negotiated into the round through the inclusion and negotiation of provisions in the investors’ rights agreement, such as inspection rights, and the right to participate in future investment rounds. Furthermore, the preferred stock itself, through the amended certificate of incorporation, has protective provisions, such as anti-dilution protection, liquidation preference, and board placement.  All of these things are negotiated by the lead investor and their counsel.

Convertible note seed financings, on the other hand, do not typically have the same sort of contractual investor rights as preferred stock deals. There may be provisions about the issuance of senior debt, but otherwise the note purchase agreement is thin on explicit investor rights, in comparison. The instrument does offer good liquidation treatment, because it is a debt instrument that has preference over equity. While there is not explicit anti-dilution protection, the conversion price will be lower if more equity is issued, which effectively works as an anti-dilution protection.  Board placement is not usually part of the deal.

When investors accept or propose the use of convertible notes as the investment instrument for a seed round financing, they are essentially agreeing to defer the negotiation of many investor rights until VCs get involved at Series A, because their notes will convert into the Series A Preferred Stock.  This is usually okay for most angel investors, because they feel comfortable deferring the negotiation of investors’ rights to professional investors (VCs) who are investing a large enough amount that: (a) they have leverage to push for favorable terms; and (b) the deal size is large enough that the higher transaction costs of negotiating back and forth are economical.

Even if investors are okay with deferring some of their protection until Series A, there are some things that early investors are very focused on in seed round using convertible notes. Conversion mechanics must work correctly for investors to know that they will get equity or repayment as desired.  This means defining the Qualified Financing, which is the equity deal that triggers automatic conversion, to encompass all equity deals that should trigger conversion, providing appropriate mechanics for conversion if no Qualified Financing is reached (if this option is included), and if a sale of the company occurs while the note is still outstanding.  Investors may also seek contractual protection against senior debt being issued while their notes are still outstanding.

Related Pages:

Term Sheets for Convertible Notes
Using Convertible Notes in Seed Financings