Here are 6 things any investor should think about before providing convertible note financing in a startup venture.
1) What is the interest rate?
A convertible note will typically accrue interest at some fixed percent. What is the interest rate being offered? Interest rates often vary, but in all instances, should be reasonably tethered to the risk of the venture.
2) Will interest be converted?
Investors should see if any accrued interest is additionally converted upon a Series A financing round. Some notes may not provide for the conversion of accrued interest. This is negotiable.
3) Does the discount rate seem fair?
A common term in a convertible note is for note holders to obtain a discount on the Series A financing. Discount rates vary, but a typical discount rate is generally 20 percent. As with the interest rate, the investor should confirm that the discount rate is reasonably tethered to the risk of the venture.
4) Is the venture likely to find Series A financing?
People new to early stage financing oftentimes overlook this very basic point: how likely is it that the venture will obtain Series A financing down the road? No investment opportunity is ever guaranteed, but an investor should feel at least reasonably comfortable that a founder or team of founders actually wants to obtain a Series A prior to the end of the term of the note. An early stage venture is under no obligation to obtain a Series A; the terms of the note simply provide an outline of what will happen if a Series A financing comes through. A venture remains free to simply pay back the loan at the end of the term.
Understanding the vision of the venture team should be a priority for any early stage investor. This will help align everyone’s interests.
5) Are corporate documents in order?
Corporate diligence in any investment is a must. The investor should examine organizational documents, contracts between and amongst the founders and any contracts with third parties (such as licensing agreements). Material terms and conditions of the investment may be included in a private placement memorandum, but if the venture is relying on Section 4(2) of the Securities Act, a formal private placement memorandum may not be provided. The investor should feel confident that the corporate documents are in order before proceeding to invest.
6) How many investors will be signing convertible note documents?
Finally, an investor should consider how many other people or entities will be involved in the convertible note financing. Depending on the terms and conditions of the individual note, this may be relevant with respect to investor dilution