Raising Your Seed Round Financing: Should You Use Convertible Notes or Preferred Stock
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This slide show outlines and discusses the basic differences between preferred stock and convertible notes and the pros and cons to the issuer and the investor in using one over the other.
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Raising Your Seed Round Financing: Should You Use Convertible Notes or Preferred Stock
- 1. Raising Your Seed Round Financing: Should You Use Convertible Notes or Preferred Stock? Presented by Bart Greenberg Haynes and Boone, LLP 2011 Business Growth Conference May 9, 2011 © 2010 Haynes and Boone, LLP
- 2. What is Preferred Stock? © 2010 Haynes and Boone, LLP
- 3. Definition • In general, a class of ownership in the corporation that has a higher claim on the assets and earnings than common stock • The terms of a corporation’s preferred stock are specific to that corporation: – Result of negotiation – One size does not fit all • Holder is a shareholder – an owner © 2010 Haynes and Boone, LLP
- 4. Typical Terms • Dividends • Liquidation Preference • Conversion Rights • Antidilution Protection • Protective Provisions • Redemption Rights © 2010 Haynes and Boone, LLP
- 5. What is a Convertible Note? © 2010 Haynes and Boone, LLP
- 6. Definition • A debt instrument that is convertible into stock of the issuer • In general, the total amount of the note converts into equity when an institutional investor (such as a venture capitalist) makes an investment • Holder of the note is a creditor – NOT an owner © 2010 Haynes and Boone, LLP
- 7. Typical Terms • Debt Features – Interest Rate – Maturity Date – Payment Terms – Ranking – Security – Prepayment © 2010 Haynes and Boone, LLP
- 8. Typical Terms • Equity Features – Conversion Stock – When it Converts – Conversion Price – How it Converts • Mandatory Conversion • Voluntary Conversion – Warrant Coverage © 2010 Haynes and Boone, LLP
- 9. Why Company Might Prefer Convertible Notes © 2010 Haynes and Boone, LLP
- 10. Convertible Note Financings are Easier! • Simpler and easier to conduct • Less documentation required • Fewer deal terms to negotiate • Less legal fees © 2010 Haynes and Boone, LLP
- 11. Convertible Notes Defer Pricing Decision! • It’s hard to value a start-up • It will be easier to value the company when it is ready to raise Series A • The Series A guys are much smarter and better able to value the company • We just have to agree upon the price discount © 2010 Haynes and Boone, LLP
- 12. Convertible Notes Protect Against Dilution! • Use of notes delays dilution to founders based on a low company valuation • If company executes with such funds, company will be worth much more at time of Series A © 2010 Haynes and Boone, LLP
- 13. Convertible Notes Don’t Vote! • Holders of notes do not vote • It will be easier for the founders to maintain control of the company • Holders of notes are not as interested in protective provisions and investors’ rights © 2010 Haynes and Boone, LLP
- 14. Why Investor Might Prefer Convertible Notes © 2010 Haynes and Boone, LLP
- 15. Convertible Note Financings are Easier! • Simpler and easier to conduct • Less documentation required • Fewer deal terms to negotiate • Less legal fees © 2010 Haynes and Boone, LLP
- 16. A Convertible Note is Safer! • Liquidation “Waterfall”: – Creditors, 1st – Preferred Stock, 2nd – Common Stock, 3rd • Obligations can be secured – Intellectual Property – Other Assets © 2010 Haynes and Boone, LLP
- 17. Why Company May Not Prefer Convertible Notes © 2010 Haynes and Boone, LLP
- 18. Convertible Note Financings Can Be Complex • What if company never has a next round of financing? – If things are going well, may want to convert into a so-called “alternative preferred stock” – If not, how will the investor get paid back without destroying the company • What if company is sold before the Maturity Date and conversion? © 2010 Haynes and Boone, LLP
- 19. What if I Can’t Service the Debt! • Balance sheet negatively impacted by the leverage • If company fails to meaningfully execute before notes become due, company loses leverage with next round of investors © 2010 Haynes and Boone, LLP
- 20. Why Investor May Not Prefer Convertible Notes © 2010 Haynes and Boone, LLP
- 21. Investor May Have no Practical Remedy • Investor may have no real remedy against an insolvent company • Collateral may be of questionable value given that the company failed © 2010 Haynes and Boone, LLP
- 22. Discount Will Not Compensate Me for Risk! • Discount may not compensate the note holder for the high risk • The greater the valuation of the next financing, the higher the conversion price could be © 2010 Haynes and Boone, LLP
- 23. Will I Get Squeezed by Next Investor? • New investors may not want to invest unless note holders agree to certain modifications • New investors may consider the deal “too rich” for note holders or object to immediate “in-the-money” aspect with respect to liquidation preference © 2010 Haynes and Boone, LLP
- 24. I Will Miss out on Certain Tax Advantages! • Certain tax advantages only apply to investments made in stock © 2010 Haynes and Boone, LLP
- 25. Questions? Bart Greenberg Partner 18100 Von Karman Avenue, Suite 750 Irvine, California 92612 bart.greenberg@haynesboone.com 949.202.3037 25 © 2010 Haynes and Boone, LLP