A convertible debt financing, like a preferred stock financing, is usually negotiated at first as a non-binding term sheet, rather than a full set of financing documents. The advantage of this is that it allows parties to wait and only invest in the higher cost of negotiating and preparing a full set of investment documents when the business principals have achieved consensus regarding the convertible debt offering’s material terms. Conducting the negotiation at a high or summary level in a term sheet (relative to the greater degree of precision of language reflected by a full set of financing documents) also makes the negotiation over convertible debt terms more manageable, reduces the time required for each side to determine whether the match between company and investor is a good one, and makes it easier to achieve preliminary agreement, generating momentum in favor of doing the transaction.
There are exceptions. It is not unusual for a startup which generates a lot of positive buzz and has immediate interest from more investors than it cares to deal with—for instance, a startup that stood out at a Y Combinator Demo Day—to resent the investor with a full set of financing documents which the presents on a more or less a take it or leave it basis. Similarly, when a startup is dealing only with friends and family, it might be both unnecessary and somewhat cumbersome to begin the dialogue with a term sheet – largely because such investors have an existing relationship of trust with the one or more founders, are often more interested in either simply helping the company or getting into it early rather than haggling over terms, and are thus willing to sign a full set of financing documents substantially as presented.
That said, most convertible note financings begin with a term sheet. This is true whether the financing represents a startup’s first outside investment or is a bridge round between preferred stock rounds.
Because a convertible note is a common structure for a startup’s angel round, we set forth below, with comments, an example of an angel round term sheet for a startup issuing promissory notes convertible into equity. This is presented for educational purposes only illustrating items typically addressed. It is not intended to reflect any opinion as to “standard” terms relative to any particular item presented.
THIS TERM SHEET SUMMARIZES THE MAIN TERMS OF THE PROPOSED FINANCING OF XYZ STARTUP INC. THIS TERM SHEET IS FOR DISCUSSION PURPOSES ONLY. THERE IS NO OBLIGATION ON THE PART OF ANY NEGOTIATING PARTY UNTIL A DEFINITIVE AGREEMENT IS SIGNED BY ALL PARTIES. THIS TERM SHEET DOES NOT CONSTITUTE EITHER AN OFFER TO SELL OR AN OFFER TO PURCHASE SECURITIES.
[Date] Nonbinding Term Sheet
Convertible Note Financing
XYZ Startup, Inc. a Delaware corporation (the “Company”)
[comment: what is the maximum amount the Company can raise on these terms? Is there a time limit within which the last closing may occur?]
[comment: like the items covered in a term sheet, certain items tend to be included in what is referred to here generally as “customary representations and warranties” – however, the precise language in the definitive agreement can, and does, vary, and not all counsel agree on what is customary.]
(i) that number of shares of Preferred Stock (the “Number of Shares of Preferred Stock”) equal to (a) the Principal Balance divided by (b) an amount equal to 80% of the price per share paid by other purchasers of Preferred Stock and (ii) that number of shares of Common Stock equal to the Total Number of Shares minus the Number of Shares of Preferred Stock.]
[Comment – the bracketed provision reflecting a valuation “cap” is optional. It is intended to benefit the Investors by guaranteeing a minimum percentage ownership of the Company regardless of how high the Company’s pre-money valuation might be at the time of a Qualified Equity Financing; it is also negotiable, whether the “extra” shares issue as common or preferred stock.]
[Comment – the alternative to the bracket language would read: “…the Notes shall no longer convert but rather shall be due and payable.” ]
(i) If prior to the earlier of (x) the Company’s being acquired (“Change of Control”) or (y) the Maturity Date, the Company sells Preferred Stock in a financing that does not qualify as a Qualified Equity Financing, Investor shall have the option to convert some or all of the Principal Balance into such Preferred Stock at 80% of the price per share paid by other purchasers of such Preferred Stock.
(ii) If a Change of Control occurs before a Qualified Equity Financing, the Investor shall [be paid an amount equal to 1.5 the Principal Balance within 30 days after such acquisition.]
[Comment: an alternative to the bracket language might read: “…have the option (A) to convert the Principal Balance into shares of Common Stock at a price per share equal to the lesser of (x) the fair market value of the Common Stock at the time of such conversion as determined by the Company’s Board of Directors in good faith, and (y) the quotient obtained by dividing (a) the Target Valuation by (b) the Fully Diluted Capitalization of the Company as of immediately prior to the Change of Control, as applicable; provided, however, in lieu of converting his Note to Common Stock, the Investor may elect to cause the Company to repay the Principal Balance thereunder as of such Change of Control.”]
Authored by Andrew (Drew) Piunti, email@example.com, ©2014
|| Read Further: Venture Capital & Angel Investment Transactions.