Companies have two basic options available when raising money from outside investors: (a) issuing shares (or an equity financing); or (b) issuing debt. However, venture-backed companies are likely to encounter a hybrid form of financing that exists somewhere in between those two concepts and relies on “convertible instruments” that have some of the elements of debt but will convert at some point into shares. In the venture world, the two most prevalent of these instruments are convertibles notes (sometimes called convertible debentures or convertible debt) and simple agreements for future equity (known more commonly as SAFES).

Background

For many years, convertible notes were the main (and arguably only) instrument you would use if you didn’t want to issue shares to an investor but they weren’t willing to take straight debt in your company. They were used as a bridge between rounds of financing (or before the first equity financing), especially where the current valuation of the company was not easy to discern or the investor had reservations about owning shares outright in an early stage or financially unstable company. Convertible notes have many of the common features of debt: an interest rate, maturity date, events of default, even security provisions in some cases, but the key difference is that the convertible note would convert into shares upon the occurrence of certain events or at the discretion of the holder of the note.

Over time, it became apparent that the conversion factor was the primary source of value for convertible note investors and that features of debt such as an interest rate and maturity date were not always necessary to achieve investment goals. From a company’s perspective, traditional debt features were also undesirable, since debt features like interest and maturity dates could sometimes create unrealistic deadlines for developing the business or raising the next round. With the goal of simplifying early-stage financing for startups and eliminating some of these company concerns, Y Combinator, a startup accelerator out of Silicon Valley, came up with a new form of convertible instrument called a simple agreement for future equity or a SAFE. SAFES are just a contract that does away with the standard characteristics of a debt instrument, but keeps the right to convert into shares at some point in time.

These days, both convertible notes and SAFES are widely used in venture finance. Which instrument is used will largely depend on the preference of your lead investor and both have some advantages and disadvantages. As a general rule, though, SAFES are more commonly used for financing very early-stage companies, while convertible notes are more commonly used by slightly more mature companies, either as the last financing round before a Seed round or as a “bridge” round between equity financings (for example, a bridge financing between a company’s Series A and Series B round).

Key provisions

Modern SAFES and convertible notes have some variance to them, but generally follow a similar structure. Both have significant optionality in the terms, which are typically negotiated between the company and the investor(s) depending on mostly on leverage and bargaining skills. We look at a few of the common negotiated points here, but if this topic is new to you, we encourage you to also look at some of the “further resources” included at the end.

Discount rate

Because convertible instruments defer assigning a valuation to the securities being received (usually until the next priced round), there is typically some sort of discount on conversion (as compared to the price of the next round) in order to induce the investor to invest now, rather than just waiting for the next priced round. After all, why put in your money today if you can wait six months for the next round, put in the same amount of money and get the same number of shares? The discount on the price of the next round gets you extra shares (typically between 10-20%) in return for your early investment.

Valuation cap

A valuation cap is the second type of inducement for an investor to participate in a convertible instrument financing. A valuation cap implies that the investor will receive a certain minimum percentage of the company’s shares once the convertible note or Safe converts¹. If the valuation of the company at the next round of financing company exceeds the amount set as the valuation cap, the valuation cap replaces the actual valuation for the purposes of calculating how many shares an investor gets. For instance, a $50,000 investment might generate a 1% stake in a company with a valuation of $5 million, but if the valuation cap is set at $1 million that investment is divided over the $1 million instead, giving the investor a guaranteed 5% regardless of what the company’s valuation ends up being.

Cap and discount

Convertible instruments will frequently contain both a valuation cap and discount rate. This is designed to manage company incentives so that there is a cost associated with both trying to force an early conversion or delaying conversion.

In the case of an early conversion, the application of the discount rate means that the investor gets a return on their investment almost immediately, while the effectiveness of that return dwindles over time. A 20% discount on an investment six months before the next priced round is equivalent to a roughly 40% imputed annualized return, but a 20% discount on an investment five years is equivalent to a roughly 4% imputed annualized return (we say imputed recognizing that liquidity can be hard to come by in this space). The time horizon matters for the investor. With a discount rate alone, the company gets the most bang for its buck on the investment by delaying the conversion as long as possible.

In the case of a late conversion, the application of the valuation cap means the investor gets a fixed percentage of the company, regardless of how big it has grown, while the effectiveness is limited on an early conversion. A $5 million valuation cap means nothing if the company does its next priced round at a valuation of $4 million, but it means a roughly 8x return on investment if the company does its next priced round at a valuation of $40 million.

These two features work together to encourage the company to not try to time its next round based on the convertible instrument terms and instead focus on pursuing financing when the company next independently decides a financing would be prudent. For this reason, they are both commonly included in convertible notes.

Most favoured nation

Some convertible instruments include most favoured nation (“MFN”) clauses that stipulate that if a subsequent investor gets better terms, the instruments will be amended to include the more favourable terms. While this seems highly desirable from an investor point of view, MFNs can be problematic and should be considered carefully by the company, the founders and investors prior to accepting. For investors, an MFN could make the company more reluctant to raise funds when needed if only unfavourable terms are available. For founders, MFNs can result in significant dilution if they are triggered. For the company, MFNs present a logistical hurdle for tracking and updating and it’s not always apparent what is a “better term”. For these reasons (as well as growing interest and competitiveness in venture capital investing in Canada), MFNs are becoming rarer in the Canadian market.

Pre-emptive rights

Pre-emptive rights or pro rata rights give an investor the right to participate in one or more future financing rounds of the company upon conversion of a convertible instrument. While these used to be quite common (for example, the original form of SAFE that Y Combinator produced had pre-emptive rights included), they are becoming less common and present a number of challenges. For example, pre-emptive rights can be difficult to administer, particularly if given to investors who are only investing a small amount. Moreover, many companies will have shareholder agreements in place that contain potentially conflicting pre-emptive rights. However, larger institutional investors may still insist on receiving pre-emptive rights. Where this is the case, separate side agreements can be negotiated. Pro rata rights can also sometimes be used to “top up” an ownership percentage following conversion. Y-Combinator has a standardized side agreement addressing this situation.

Security

Convertible instruments can be secured against the property of the company. Doing so involves legal registrations, including periodic maintenance of such registrations, and (typically) negotiation of a separate security agreement. Given these extra costs and that fact that many early stage companies have limited assets, the benefits of securing a convertible instrument often do not justify the costs. Security is seen most frequently in convertible note rounds (not SAFES), particularly when bridging between two equity financing rounds (since the target company will typically have some tangible assets at this stage).

Maturity date

While the general idea of a convertible instrument is that it eventually converts, some investors want to know that the time horizon for it to do so is not infinite. While maturity dates are a necessary part of convertible notes, they sometimes appear in SAFES as well to provide an outside date by which the company must receive financing. Because a company will typically be required to repay the principal following a maturity date (which could create significant financial hardship for the company), it’s important to negotiate a maturity date that will give the company enough time to secure an equity financing to force conversion of the convertible instruments.

Financing threshold

When an instrument converts can also matter. The standard answer is that a convertible instrument will convert “on the next preferred share financing”; however, there are a few of reasons why some investors will insist on a minimum size for the financing that triggers conversion.

1. A company could try to “game” the conversion. For example, if there is a convertible instrument that only has a discount rate, a company could possibly find someone willing to pay a very high price per share but only for a small investment. This would make the dilutive impact of the discount rate much smaller. Likewise, for convertible instruments that only have a valuation cap, a company could raise a small round at a lower valuation to reduce the dilutive impact of the valuation cap. While there are practical reasons why most companies won’t (or can’t) game the conversion scheme, some investors are still more comfortable having a clear expectation of when the instrument will convert.
2. In the case of convertible debt financings, a financing threshold, where the company must raise a minimum amount at a specified valuation, allows investors to keep their debt priority while also being protected against unfavourable conversion. As a general legal principle, debt ranks higher than equity in bankruptcy or liquidation. This principle means that lenders will get paid out before a company is permitted to make any distributions to its shareholders. As such, an investor holding convertible debt will generally want to keep that priority (and the right to accruing interest) until the company can demonstrate that it can achieve its growth and financing objectives, which is accomplished by establishing a financing threshold.

Financing thresholds are common in convertible debt financings and will also appear in negotiated Safe financings, although having a financing threshold departs from the terms of the Y Combinator Safe and is becoming less common.

Interest rate

An interest rate is one of the key parts of a convertible note that you will typically not see in a Safe. In a survey of Canadian deals we have done in the past two years, the median interest rate was around 6%; however, there is a fair deal of variance here and the actual interest rate will depend on the circumstances and general market conditions. In most convertible notes, interest will accrue but only become payable on maturity or conversion and will also convert into shares of the company along with the principal amount.

Conclusion

These aren’t all of the factors that go into deciding the terms to a convertible instrument, but they are the ones we see most frequently negotiated among the parties. If you’re looking to create a term sheet for a convertible instrument, the concepts discussed here will be key considerations; however, there is still a lot of nuance and a having good understanding of the variability and impact on your cap table is important before going into negotiations. An experienced venture lawyer can assist with many of these questions, but we have also linked to some further recommended reading, as follows:

• The Y-Combinator SAFE User Guide
• The CVCA Model Convertible Note

Please note that the information provided in this article does not constitute legal or professional advice or a legal opinion of any kind. If you require any assistance regarding specific legal issues with respect to equity financings of private companies, please contact Matthew Literovich, another member of Dentons’ Venture group or other legal counsel.

¹ There is quite a bit of nuance around this calculation, though, because the minimum ownership percentage needs to be calculated at a point in time. For example, the original SAFE converted on a pre-money basis, which included any option pool top-up but didn’t include subsequent convertible financings. The current version of the Y Combinator SAFE, though, converts on a post-money basis, which doesn’t include any option pool top-up but does include subsequent convertible financings. As such, it’s important to review and understand the conversion mechanics thoroughly when doing a convertible instrument financing.