What angels may worry about when investing in convertible notes
Much has been written about the advantages and disadvantages of raising funding using convertible notes versus equity, both for startups and for investors. At Kima Ventures, we often choose to invest using convertible notes due to the speed, simplicity and cost of the transaction but, when a company has already agreed to use a certain convertible note template with other investors, we need to look carefully at the wording and consider what happens in every possible scenario.
Founders often pay attention mainly to the headline terms (discount, cap, interest and maturity) while assuming that the rest of the wording is largely standard across notes. However, since there are many future scenarios that a note needs to account for, what happens in each can differ greatly due to the specific wording of the note.
The disadvantages for investors of using any convertible note have been written about often; including the tax implications, the lack of rights such as board seats but mainly the risk of converting at a valuation that does not fully compensate for the risk taken by investing early in the company’s history. In this post, I would like to address a few, lesser mentioned, concerns that we have when looking at convertible notes and suggest possible solutions for them that we use at Kima:
1. Receiving worse terms than other investors
CONCERN: since funding rounds on convertible notes are often closed in series over a period of time (rather than all at once like an equity round); it is a concern that later investors may negotiate better terms (cap, discount, other rights..) than those that we have already agreed to. In equity investments, investors tend to have anti-dilution provisions which take effect when shares are offered at a lower price, but this is not the case in many convertible notes. Even when all issued notes contain exactly the same rights, we are now seeing more and more ‘side letters’ attached to notes given to individual investors, granting more rights than to the other noteholders.
SOLUTION: we always request
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