The most successful serial entrepreneurs in the world may found three or four, perhaps even eight or ten venture-backed startups over the course of their careers. By contrast, venture capitalists and angel investors typically make scores or even hundreds of investments over the course of their careers. It should therefore come as no surprise that an asymmetry of information exists, mostly gleaned from experience, between founders and investors in a venture financing deal. In recent years, startup accelerators such as Y Combinator, TechStars or 500 Startups, blogs including Venture Hacks, Fred Wilson’s A VC and Mark Suster’s Both Sides of the Table, and other resources have contributed to closing this knowledge gap. (See my blogroll for links to many of the best resources.) Nevertheless, a key advisory role of startup lawyers in my opinion is to level the playing field by bringing our own perspectives to bear, having gone through the twists and turns with many clients over the years. Knowledge is power.(For more on working with startup lawyers, see Mark Suster’s classic post, How To Work With Lawyers At A Startup.)
For a traditional VC financing round structured as a sale of preferred stock, the best resources I can recommend are the Term Sheet Series by Brad Feld and Jason Mendelson and Startup Company Lawyer by Yokum Taku. Every installment or post in those series is a good read, and I won’t attempt to reinvent the wheel here. Given that convertible debt financing has become the de facto standard for small (<$1MM), seed stage deals in recent years, I thought I would write a primer on the elements of a term sheet and definitive documents for entrepreneurs looking at the earliest stage financing rounds.
Let’s take it from the top: Why convertible notes? There are two principal reasons. The first is that they are the easiest deals to bang out quickly and cost-effectively, keeping the amount of legal work and negotiation on both sides to a minimum. Experienced investors often don’t feel the need to involve legal counsel in most typical convertible debt seed or angel round investments. A term sheet for a convertible note deal may run two or three pages, versus 8-10 pages for a typical Series A Preferred Stock financing. (I’ve posted a sample convertible note term sheet on my website.) The definitive deal documents are concise (at least by lawyer standards), whereas a full Series A deal will generate a stack of new paperwork of a hundred pages or more.
The second reason, perhaps nearer to both entrepreneurs’ and investors’ hearts, is the ability to punt on valuation at a stage in which it is hardest to determine using any objective criteria. A quick historical explanation is in order here: For decades, the convertible note structure was commonly used as a bridge financing to an upcoming priced equity round — for example, a VC firm that invested in a startup’s Series A round would make an additional investment on a bridge basis to help keep the lights on while the company went out and raised a Series B round led by another investor, a process that could take several months. Another use of convertible note bridge financing is to make a quick injection of seed capital into a new startup when the investor and entrepreneur already know and trust each other; it’s better than a handshake, but far quicker and easier to complete than a real Series A round. In a convertible debt financing, the investment is made without placing an explicit valuation on the startup; instead, the investor makes the company a loan which will convert as part of the next priced equity round into the type of security issued to investors in that round, whomever they may be.
In recent years, particularly as the amount of seed capital needed to launch new Internet and software businesses has decreased, deals have gotten smaller and a whole new class of “super-angels” and “micro-VCs” has emerged; this existing bridge structure was adapted to become what is now the most common type of deal for seed financing rounds of less than $500,000. (A group led by Ted Wang is trying to change that with the innovative Series Seed documents, which I’ll discuss in a future post.) Others have discussed in detail the pros and cons of convertible debt vs. seed equity rounds. For my own perspective on why convertible notes have become the de facto standard for small deals, see this previous post at Mashtag. For better or for worse, most entrepreneurs and angels are likely to encounter a convertible debt term sheet—if not many of them—sooner or later.
We’ll get into specifics and begin dissecting a sample term sheet for a convertible note financing below. For starters, here is a brief outline of how these deals work for a typical startup:
- An investor lends the company some amount of principal (say $100,000), documented as a convertible promissory note. The note is one of a series issued under a note purchase agreement entered into between the company and each investor.