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If you want to raise capital for your business, convertible notes are an attractive option because they combine features common to both debt and equity. In practice, your business and the outside investors will negotiate the terms of the convertible note financing. The negotiated terms will then be included in the convertible note term sheet. This article examines critical due diligence considerations when reviewing a convertible note term sheet prepared by a potential investor.
Convertible Notes
Convertible notes behave like a loan from an investor to your business when you first execute the convertible note agreement. According to the convertible note term sheet, the investor will give your business cash to be repaid. However, it differs from a conventional loan because the term sheet will set out certain conditions that convert the loan from a debt obligation to shares in the company. At this point, the convertible note holders cease to be lenders and become shareholders.
Founders’ Warranties
All financing term sheets contain warranties. These are statements of facts the business and its owners give investors about the state of the business, such as its value and liabilities. If the investor later determines the statements are incorrect, they can sue you and your business for damages.
Convertible term sheet warranties are likely to contain warranties common to both traditional loan agreements and equity investments. These include warranties related to:
- the value of the business and valuation method used;
- disclosure of all known and potential liabilities like contractual obligations and debts; and
- ownership rights of valuable assets, such as a statement that the business’ intellectual property vests with the startup company and not the founders.
You want to ensure that these warranties are reasonable. For instance, say you agree to a warrant that there is no litigation in contemplation against your business. At the time you make it, you believe this to be true. But, unbeknownst to you, a former employee intends to sue you, which they do after you execute the convertible agreement. As a result, the investor could hold you liable for breach of warranty because it is unfairly worded to hold you liable for circumstances outside your control and knowledge.
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Trigger Events
Trigger events refer to the conditions that convert the loan to shares if satisfied. You should ensure such trigger events align with your business’ long-term goals. For instance, if the trigger events entitle the note holders to exercise their conversion rights absolutely in five years, this may adversely impact a future fundraising round. You may therefore wish to negotiate a provision that entitles you to delay the trigger event if a Series A financing round is due to close.
Valuing the Conversion Rights
When the convertible notes convert to shares, the holders become shareholders in your company. This impacts existing shareholders’ proportion of share ownership. Therefore, you want to ensure that the conversion formula does not grant the convertible notes too many shares in your business.
Confidentiality and Exclusivity Clauses
The purpose of a term sheet is to specify the key terms the parties have agreed to in principle. Parties rarely intend term sheets to have a legal effect because there is often a lot to negotiate before parties execute the agreement.
Investors require access to most of your business’ sensitive information to investigate your business adequately. As a business owner, you want to ensure that even if negotiations fall apart, the investors cannot disclose the contents of your business to third parties. Accordingly, a term sheet often contains a legally binding confidentiality clause.
Negotiating a convertible note investment is time-consuming and costly. They want to ensure you are not negotiating with other potential investors. Therefore, they may implement an exclusivity clause. This obligates you to deal with them throughout the negotiations.
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Key Takeaways
Convertible loans are one form of financing available to your startup. It combines debt and equity financing. Hence, you want to conduct proper due diligence when reviewing the term sheet, which includes the:
- value of the investment;
- repayment schedule; and
- trigger events.
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Frequently Asked Questions
When negotiating a convertible loan, a term sheet is a critical document that details the essential commercial terms of the investment. However, it does not usually have a legal effect, which means it is not binding on the parties.
Typically, a convertible note term sheet will detail the value of the investment, the repayment schedule, the interest rate, and the trigger events.
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