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Term sheet for a convertible debt financing

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 determiine 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.

Circumstances where a convertible debt term sheet might be skipped

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 YCombinator 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. 

Example of a convertible debt term sheet for an angel investment round

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”)
 

  1. Amount of Notes – Up to $[750,000] in aggregate principal amount of convertible notes which may be issued to investors (the “Investors”) in multiple closings (the “Notes”). The Notes will be unsecured. The final closing shall occur no later than [3 months] after the initial closing.

[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?]

  1. Definitive Agreement – The Notes will be issued and sold pursuant to a convertible note purchase agreement prepared by Company counsel and will contain customary representations and warranties of the Company and the Investors (the “Note Purchase Agreement”).

[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.]

  1. Maturity Date – Principal, together with all accrued but unpaid interest under the Notes (the “Principal Balance”) will be due and payable [comment: generally between twelve months] from the date of the Note Purchase Agreement (“Maturity Date).
  1. Interest– [6.5%]/year, simple interest. [Comment – rates tend to be between 6 and 10%/year]
  1. Conversion Features –  
  1. The Principal Balance shall convert at 80% of the price per share paid by the other purchasers of Preferred Stock in the Qualified Equity Financing.
    [Comment -   Part of an Investor’s incentive to participate in a convertible note financing is that their Note will convert into equity securities at a discount to the purchase price paid by the investor in a later Qualified Equity Financing. The typical range of discounts that we see is 10-30%]
  1. Automatic Conversion: Qualified Financing. In the event the Company completes, prior to the Maturity Date, an equity financing pursuant in which it sells shares of its preferred stock (expected to be Series A Preferred Stock (the “Preferred Stock”)) with an aggregate sales price of not less than $[2,000,000], excluding indebtedness under the Notes that is converted into Preferred Stock (a “Qualified Equity Financing”), the Principal Balance shall automatically convert [(i)] into Preferred Stock at 80% of the price per share paid by the other purchasers of Preferred Stock in the Qualified Equity Financing [; or (ii) in the event that the Company’s pre-money valuation in such Qualified Equity Financing exceeds $[8,000,000] (the “Target Valuation”), into shares of Preferred Stock and Company Common Stock (the “Total Number of Shares”) at the “Maximum Conversion Price,” with such price being equal to (x),the Target Valuation, divided by (y), the fully diluted capitalization of the Company, as of immediately before the initial closing of the Qualified Equity Financing. The Total Number of Shares shall consist of Preferred Stock and Common Stock as follows:

(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.]

  1. Automatic Conversion: Maturity.   If Investor’s Note has not automatically converted in a Qualified Equity Financing before the Maturity Date, then on the Maturity Date [the Principal Balance plus accrued interest shall automatically convert into that number of shares of Common Stock determined by dividing the Principal Balance by the per share priced obtained by dividing (i) the Target Valuation by (ii) the Fully Diluted Capitalization of the Company as of immediately prior to the Maturity Date.]

[Comment – the alternative to the bracket language would read: “…the Notes shall no longer convert but rather shall be due and payable.” ]

  1. Optional Conversion.

(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.”]

  1. Prepayment – Company may prepay the Note and accrued interest at any time prior to a Qualified Equity Financing with the consent of a majority in interest of the Investors.
  1. Subordination – The Notes shall be subordinated to any Company borrowings from banks or other financial institutions.
  1. Securities Compliance – Each Investor must be an “accredited investor” or the issuance of a Note to the same must otherwise be exempt from registration under the Securities Act of 1933, such as pursuant to Regulation “S”.

Authored by Andrew (Drew) Piunti, drew@dpalawyers.com, ©2014

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