5. Milestone: Convertible Notes, Option, Warrant
Warrant, Convertible Note & SAFE & KISS, Option – are financial instruments which give the right to buy or sell the equity of the company.
WHEN TO CONVERT INTO EQUITY?
Convertible notes are usually received before a financing round (Pre-seed or Seed investment funding). The trigger happens once you receive the first investments for the exchange of shares. A convertible note before the next round is raised dilutes the founders more than if the debt had been converted as part of the next round. Please use the waterfall analysis to see how these changes will affect your shares.
CONVERTIBLE NOTE
Convertible Note (or Convertible debt): It is a short-term debt that converts into company shares. The conversion usually happens when there is an event like the maturity of the debt or when another investor is investing in the company through a fund round. The investor loans money to a start-up and instead of a return in the form of principal plus interest, the investor would receive shares in the company (the investor will become a shareholder once the investment is made). Convertible notes are usually simpler and less expensive than running investment rounds Pre-seed, Seed, A, B, etc. If done right, convertible notes are a simple and efficient means to close a round of financing because they contain limited rights and defer some of the more complicated negotiations until the (larger) priced round. We have also covered KISS by 500 Startups and SAFE by Y Combinator.
Conversation Cap – It sets a maximum valuation of the company at which the debt will convert into equity. The conversation cap is expressed in the liquid amount. It allows investors to convert their Investment in equity at a predetermined valuation.
HOW DOES IT WORK?
For example, let’s assume a start-up raises $600,000 from several VCs at a $6M valuation cap, and several months later, it raises a $12M Series A round. The seed investors, because of the valuation cap, will see their investment convert to shares at $6M, not $12M, which gives them a price half of onboarding Series A investors. The seed investors’ price will be $0.50/share, or $6,000,000 (valuation cap) divided by $12,000,000 (Series A total). New investors, however, only have the option of buying new shares at the offering price of $1.00/share. In this case, seed investors will receive 1,200,000 shares ($600,000/$0.50), while new investors will receive 600,000 shares ($600,000/$1.00) for the same investment.
Conversation discount – This refers to the discount from the price per share price paid by investors in the VC Series A that is used to calculate the number of shares of Series A issued upon conversion of the notes into Series A. The discount generally seems to range between 45% to 150% depending on the situation.
HOW DOES IT WORK?
For example, let’s assume a startup raises $300,000 in convertible debt from several VCs at a 20% discount, and then goes on to raise a Series A round several months later. During the Series A round, new investors are offered shares at $1.00/share, but your original seed investors would receive their shares at a 20% discount, or $0.80/share. So, the original investors’ convertible notes will convert to 375,000 shares ($300,000/$0.80), while new Series A investors will get 300,000 shares for a similar investment since they don’t receive the discount ($300,000/$1.00).
Option, Warrant, SAFE & KISS – are financial instruments. Investors provide investment to the company in exchange for the right to convert their investments to shares (equity) upon some future event when another investment round is raised and preferred shares are issued. SAFE & KISS are considered new investment concepts.
RISING CAPITAL WITH CONVERTIBLE NOTE AND HOW DOES IT AFFECT YOUR CAPTABLE?
OPTION
The holder of an option has the right (but not the obligation) to buy or sell the company’s shares. The target is to get the stroke price up so the price of the company shares creates value. If the stock rises above the strike price, the buyer will be able to acquire the stock for a lower price and receive an implicit gain. Please read our support guide to know how to set up and modify options on Eqvista.
WARRANT
Usually, it is a certificate where the holder has the right to buy the company shares at a fixed price called exercise price until the expiry date. The point is to get the strike price raised in time so the holder will gain the difference between the prices in the future vs the strike price. Warrants are in many ways similar to options, but there are a few key differences. Warrants are generally issued by the company itself, not by a third party. Unlike options, stock warrants are issued by companies during a round of financing, rather than by an individual investor or brokerage. Please read our support guide to know how to set up, issue, and modify a warrant on Eqvista.
SAFE
It is a similar financial instrument to a Convertible note. SAFE (Simple Agreement for Future Equity) is not considered as a debt. It is similar to a warrant or option, it is a promise for future share in the company. SAFE was released by Y Combinator in 2009. It is an extremely simplistic agreement and it favors founders. It has no interest or maturity date, unlike KISS which is more balanced. The start-up is not under any legal obligation to repay the investor. It is a legal agreement where the investor gives money to the start-up for future equity (company shares). Usually, SAFE has conversion caps, discounts, or both. They might have similar features as convertible notes – the math is similar to the Convertible note. A SAFE is a free document that might be used by any start-up. This document is designed to save time and money. Please read our support guide to know how to issue and modify a SAFE convertible note on Eqvista.
There are four different types of SAFE:
- cap, no discount
- discount, no cap
- cap and discount
- no cap, no discount
KISS
KISS (Keep It Simple Securities) was introduced by the 500 Startups in 2014. Here the investor invests in the future equity in the company. It is also a type of convertible note.
Directly from the 500 start-ups: “We’ve put in a lot of work to make KISS docs one of the best convertible instruments on the market” The same as SAFE, this document is designed to save time and money. They might have similar features as convertible notes – the math is similar to the Convertible note. Please read our support guide to know how to issue and modify a KISS convertible note on Eqvista.
You have several options KISS:
- KISS: Debt Version
- KISS: Equity Version
COMPARISON CONVERTIBLE NOTE, SAFE AND KISS
| Convertible Note | KISS | SAFE | |
|---|---|---|---|
| Versions | Various | • Equity: Cap, Discount, no interest, no repayment • Debt: Cap, Discount, accrues interest, repayable at maturity | • Cap, no Discount • Discount, no Cap • Cap and Discount • MFN, no Cap, no Discount |
| Valuation cap | Possibly – depends on the terms of the Convertible Loan Note. | Yes | Possibly – depends on the form of SAFE. |
| Discount | Possibly – depends on the terms of the Convertible Loan Note). | Yes | Possibly – depends on the form of SAFE. |
| Equity funding round | Option to: • convert to ordinary shares at a lesser cap or discount (if applicable) • get paid back the original investment (with or without interest). | • Converts automatically to preferred stock when an equity round of new money above a specified amount occurs. • Conversion price is lesser than valuation cap or discount. | • Converts automatically to preferred stock when an equity round of any size occurs. • Conversion price is lesser of valuation cap or discount (if specified in the SAFE document). |
| Sale of Company | Option to: • convert to ordinary shares at the cap • get paid back the original investment (with or without interest) | Option to: • convert to common shares at the valuation cap • get paid a multiple on the original investment. Some KISSes provide an option for repayment. | Option to: • convert to common shares at the valuation cap • get paid back the original investment. |
| Maturity | Get paid back the original investment. | Converts to preferred shares at the valuation cap. | N/A. |
| Most Favoured Nation Clause (i.e. preferential rights for Investor) | Optional. | Yes. | No – a standard SAFE does not but one may be included (where no valuation cap or discount is specified). |
| What other rights do Investors have? | Various (as set out in the terms of the Convertible Loan Note). | • Basic information rights to company financials (major investors) • Participation rights in all future equity funding rounds | Participation right after the next equity funding round. |
| What representations does the company give? | A basic set of representations, plus intellectual property & litigation ones. | A basic set of representations and warranties, plus intellectual property and litigation ones. | A basic set of representations, plus intellectual property ones. |
| High-Resolution Financing (i.e. different terms for different investors) | Yes (unless explicitly prohibited). | No. All KISSes in each series have identical terms. | Yes. |
| Can the Investor transfer the instrument? | Yes – typically investors may transfer Convertible Loan Note to its affiliates only. | Yes – an investor may transfer KISS to any person. | Yes – an investor may transfer SAFE to its affiliates only. |
UNDERSTAND THE TERM SHEET – FINDING THE TERMS
If the entrepreneur is actively seeking a fund, they will have to find a VC firm that will invest in the company. Once the VC’s representative and entrepreneur meet, they will agree on certain conditions and under what circumstances the company will receive funds. The term sheet is negotiated once every few years. Entrepreneurs negotiate against Venture Capital firms that have more resources and skills. They might do 3-5 term sheets every month so any company accepting investments is at a disadvantage. Finding out the specifications of the terms for a cap table can be difficult if there is no experience. Articles of Incorporation (also known as Articles of Association) is the first point of call to start searching for any terms.
The term sheet is the next important document to be strictly overviewed once any investor is interested in investing in any company. It is a document that is written as a collaboration between an investor and an entrepreneur who is seeking funding from investors. It is always better to consult your terms with a legal counsel who might point out to you the most important part of the legal documents.
Understand term sheet:
- Type of Shares (Common or Preferred) – Investors usually subscribe to preferred shares.
- Option Pool – Investors would like to see that they attract the best in the industry. ESO is one of the ways to do that.
- Valuation and Milestones – Look at the terms of pre-valuation or post-valuation.
- Dividends – Preferred shares receive dividends first, unlike common shares.
- Liquidation – Preferred shareholders have higher rights to receive their money first.
- Founder Shares – Investors would like you to have enough equity so you feel committed and work hard on your start-up. This is also a very important part of the term sheet.
There might be many different terms to protect the investment such as redemption, conversion, voting rights, and anti-dilution.
