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Understanding Convertible Note Term Sheets in Early Stage Funding

Once an angel has decided to invest in a startup, they will either seek a convertible note or equity in the form of preferred stock. In either case, a term sheet is often used to communicate the basic details of the transaction. A term sheet is a letter of intent that states the proposed material terms and conditions for a particular investment. If the angel will become the lead investor, the term sheet should be carefully negotiated before the deal is consummated. Depending on the angel and other characteristics of the transaction, the term sheet may be prepared by the startup or the angel.

The needs and preferences of the investor and the founders determine whether the transaction will involve preferred stock or a convertible note. During early stage financing, companies and investors often choose convertible notes, which are loans that will convert to equity during subsequent equity financing rounds. Convertible notes work well with companies that expect to achieve a sizeable valuation upon the conversion-triggering equity round and can do so within the maturity date on the note.

Convertible notes can also be advantageous for companies able to prevent a price cap or negotiate a very high price cap because caps can eat into the money from subsequent rounds when the valuation exceeds expectations. Startup companies may prefer convertible notes for other reasons as well. For one thing, convertible notes are relatively simple and inexpensive compared to preferred stock. The debt treatment of the investment also has positive tax implications for equity compensation because it lowers the company’s fair market value.

The content of a term sheet for a convertible note transaction covers several essential topics, therefore, understanding convertible note term sheets is crucial to understanding the true value at stake. The term sheet will usually address the maximum amount of notes that will be sold during the round. Investors may want to establish what portion of the overall interests they represent because important decisions affecting the note are made by a majority. Those decisions can include whether a note may be prepaid and whether amendments to the note will be allowed.

A term sheet will also indicate the interest rate and the discount rate. The latter is significant to investors because they are deferring investment negotiations to a later funding stage. To compensate, the noteholder who is to receive the future equity receives a discounted price for the loan that will eventually convert the equity offered in the next round.

Next, the term sheet will probably include a price cap. As the valuation of the company increases, the investor’s ownership share suffers a corresponding decrease. Price caps address this problem, providing an absolute limit on the investor’s dilution if the company obtains an expectation-exceeding pre-money valuation at the converting round.

The maturity date will indicate the date upon which the loan becomes due. Related provisions may address what happens in the event that the company is not able to repay upon maturity. Practically speaking, it is generally not beneficial to the company or to the investor for a forced repayment to occur in such a situation. Instead, the parties may agree to an optional conversion upon maturity. As one example, the term sheet might direct that the optional conversion would give the investor common stock in the company.

Finally, the investor may want to address what happens if the company is sold prior to the maturity date or conversion of the note. The note itself should specify the remedy, which could include an option allowing the noteholder to elect repayment of the loan with interest, or conversion to common stock at a stated valuation.

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