The Convertible Noteholder Standoff

For founders, raising that first equity round is a true milestone. It is not only an opportunity to bring in meaningful dollars from professional investors to fuel a start-up’s growth but, if you have had outstanding notes running interest since the early days coming out of inception, it also serves as a chance to clean up your company’s cap table by converting outstanding convertible instruments in connection with the round. With angel investors’ broad adoption and comfort of investing into early stage companies through convertible instruments, companies are delaying the need to sell preferred stock in an equity round, in some cases, for the first couple years of a company’s development. The fallout from this reality, however, is that when you do head toward closing that first equity financing, a founder will have the task of coordinating with the (sometimes, many) noteholders in connection with the conversion of those noteholders’ outstanding notes.

With a syndicated noteholder base, the risks of holdout (or unreachable) noteholders is elevated and without collection of all signatures from that constituency in connection with the equity round, the new money investors in the financing will inevitably be spooked. To combat the potential negative effects and risks of a “standoff” down the road at the time of the equity financing, initially when preparing and issuing your convertible notes, your counsel should be advising you on the appropriate language to include in the instrument to ensure there is zero room for interpretation in the event the noteholder does not provide its signature at the time of a triggering financing and resulting automatic conversion. Without an air tight documented mechanism, you will otherwise risk taking the “automatic” out of automatic conversion and open up potential delay in the closing of you ever-so-important equity financing.  

Amending Convertible Notes in connection with a Qualified Financing: A Word of Caution.

For some time convertible notes have been, and remain to this day, the preferred vehicle for an early stage company raising initial capital. A known commodity in the marketplace, the barriers and expenses of closing note bridge rounds continue to be less than opting for the sale of an equity security. What early stage investors might not be aware of, however, is a trend gaining steam of late – as company valuations increase in earlier investment rounds, a growing number of sophisticated lead investors in “Qualified Financings” (ie the company’s equity financing that triggers conversion of the notes) are applying increasing pressure to condition their investment in the round on the company amending the terms of their outstanding convertible notes to carve back a portion of the economic windfall received by noteholders in the Qualified Financing.

Setting the stage: The terms of a vast majority of convertible promissory notes in the marketplace provide that a note investor’s principal (plus interest) under a convertible note will, at a Qualified Financing, convert into the security sold in the Qualified Financing (ie Series Seed or Series A preferred stock) at the lower of (i) a discount to the price in the Qualified Financing or (ii) a pre-negotiated capped valuation.

The economic problem: Particularly in early friends and family note rounds, the pre-negotiated capped valuations are often times significantly lower than the valuation in the Qualified Financing. If the terms of the note are honored as-is, note investors would get the benefit of receiving not only the actual dollars (plus interest) invested under the note in the form of the same shares issued in the Qualified Financing, but also the (in most cases, material) discount premium as a result of the discount or capped price. This became known as the “phantom liquidation preference problem” – referencing the layered liquidation preference received on the lot of shares which had been converted into as a direct result of the cap piece of the conversion. 

The Lead investor’s fix: Condition the closing of the Qualified Financing on the company obtaining the requisite approval from their noteholders to amend the notes to either (i) convert the discount portion of shares received in the round into common stock, as opposed to preferred stock or (ii) convert into a shadow series of preferred with the same rights as the preferred stock sold to new money investors in the Qualified Financing with the exception that the liquidation preference on the shadow security is carved back to the conversion price at which the notes converted in the round.

The note investor’s dilemma: Either (A) don’t approve the amendment and the company you are invested in doesn’t receive the capital to continue operations or (B) approve the amendment and lose out at the deal originally bargained for which credited the note holder for making a risky investment in the first place.

The Conclusion for early stage investors: The lead investors in a Qualified Financing wields significant power in setting the terms for the new money round, which includes potentially forcing early note investors to adopt alterations to their initial note conversion deal. As an early stage note investor, however, there are precision drafting protections your lawyer can help institute at the time of the original investment which have the effect of returning at least some of the power back in the hands of a company’s earliest investors at the time of conversion. In any event, don’t be naïve: the suppressed valuation cap you successfully negotiate for in your note investment documents, if left naked, may end up taking on a much different economic outcome than you originally bargained for.