Dear Clients, Colleagues, and Friends:
There are many forms of debt financing available to startups and young companies. Often it is a loan from a family member. This is the most common form of debt financing. There are no other commitments involved other than the terms of the note. Usually, the terms include a low-interest rate and payment due back to the note holder either on-demand or in a short period of time. You want this loan to be from your new entity, if you can, to limit your personal liability. If only the company (LLC or Corp) signs, you are not personally responsible.
We all know about equity financing. This is where you sell stock to your investor. The hardest part of selling equity in a startup, once someone decides they want to invest, is to determine the value of the shares. Pre-Money valuation is the value of the company before the investment is made. Post-Money valuation is the value of the company after the investment has been made. You add the investment to the Pre-Money valuation to determine Post-Money valuation. Very simple. The higher your Pre-Money Valuation the less of the company that you have to give away to the investor. You determine the percentage that is given to the investor by dividing the amount of the investment by the Post-money valuation.
Sometimes you cannot get a high enough Pre-Money valuation, and therefore would have to give away too much of the company at the start. In this case, you can talk about a Convertible Promissory Note. This is money loaned to the company that upon the happening of some event is converted to stock in the company. The value of the stock at this conversion is determined by a series of rules that are built into the convertible note. It is far more complex than the simple promissory note given to a family member.
Some of the terms that are included in a convertible promissory note include:
- Amount of the note
- Outside date that the note is due, even if further funding is not met, and what happens if this date is reached
- What events need to occur for automatic conversion
- The discount that is given to the note holder upon automatic conversion
- Amount of new financing needed to automatically convert the note to stock
- Minimum Pre-money value of the company on conversion
- Maximum Pre-money value of the company on conversion
- When can the note holder convert on his own decision
- Provision that allows the note to adjust its terms for the better if a better deal is given to someone else
- Under what conditions can the company prepay the note
- Is there security for payment of the note
- What rights does the note holder have to see corporate documentation, including financials
- Under what conditions can the note holder accelerate payment
- Protective provisions regarding issuing additional stock in the company, Preemptive rights
- Class of stock to be purchased on the conversion
- Rights of that class of stock
- Appointment of board position for the note holder
- Who will pay fees for negotiating and drafting the note, and
- Other representations and warranties that are common for convertible notes
As you can see, there is a lot to think about when considering using the convertible note to raise debt capital for your company. It is not filling in a simple form. When we have a choice, we recommend issuing common stock to your investors at a fair PreMoney valuation. It is much easier to do, less costly, and reduces the probability of a severe dilution if you are unable to raise your next round of capital.