Thoughts on startups by investors that
fund them & entrepreneurs that run them

Knowledge Is Power: Convertible Note Financing Terms, Part V

As we conclude our convertible note financing series, there are assorted terms commonly seen in term sheets and deal documents that are worth touching on briefly. What seem like boilerplate provisions can be meaningful in some situations. As I’ve noted before, readers joining this series in progress may find it helpful to download the sample term sheet from my firm’s website and review the earlier posts covering the basics. Having made it almost to the end of our sample term sheet:

Documentation.  The transaction will be documented by counsel to the Company with the documents containing the provisions described above and consisting of the following:

  • Note Purchase Agreement
  • Convertible Promissory Note(s)
  • Investor Questionnaire

Why is this of interest to anyone other than the lawyers? First, it’s worth noting that we’re proposing to have Company counsel draft the documents. This is the norm for West Coast deals, but it’s often the case in dealing with East Coast investors (more commonly for VC financing rounds rather than angel seed rounds) that the lead investor wants its lawyers to draft the documents. I have to admit my West Coast bias here, having learned the ropes at a large Silicon Valley firm; it makes little sense to me to have investor’s counsel drafting documents that are woven into the fabric of a company’s governance and capital structure, with which the company will likely be living for years after the investment is made. Regardless, assuming both parties are well represented by competent legal counsel, the documents will end up in good shape, so to me it’s primarily an issue of efficiency. A firm that cranks out these deals in large numbers is likely to be using fairly standardized documents that require relatively few changes to reflect the terms of any particular transaction.

The Note Purchase Agreement and Convertible Promissory Note are essential documents for any convertible note financing. Returning to our sample term sheet:

Note Purchase Agreement. The Notes will be issued pursuant to a definitive Note Purchase Agreement containing customary covenants, representations and warranties of the Company.

The purchase agreement may be a single-use document covering a single investor’s note, but more commonly it contemplates a series of identical notes to be issued to multiple investors within some period of time and/or up to a specified dollar limit comprising what the Company views to be the same “round.” Often this proves to be a moving target, and there’s no reason the agreement can’t be amended to increase the size or lengthen the time period, provided the necessary consents are gathered. (See discussion of amendments below.) The purchase agreement sets forth the terms of the investment, often including the mandatory and voluntary conversion provisions we’ve covered in this series, as well as customary representations and warranties of the Company and the investors.

On the Company side, this document often becomes the impetus behind a startup’s need to catch up on deferred “corporate housekeeping.” When a company is asked to make legal representations about its standing, prior equity and debt issuances, corporate governance formalities and so forth, if taken seriously, matters of “deferred maintenance” often surface and must be handled before closing.  Common examples include papering founders’ stock issuances, catching up on Board minutes, and ensuring that all members of the team have entered into IP agreements with the company assigning rights in their work to the startup.

On the investor side, representations and warranties in the purchase agreement primarily relate to securities law compliance. Without going down the deep rat hole of securities regulation, suffice it to say that the Company risks being held liable for violating securities laws unless it qualifies for applicable exemptions that are tied to the nature, knowledge and intentions of the investors. In most VC and angel financing transactions, there are three pieces to this puzzle: (1) the Company requires investors to make certain representations in the purchase agreement (e.g., that the securities are being purchased only for investment rather than resale); (2) investors are asked to complete an investor questionnaire substantiating that they meet the net worth, income or other requirements necessary to qualify as “accredited investors” under the Securities Act; and (3) the Company will make one or more securities filings at the state and federal levels reporting the transaction as exempt, based on this information. It’s common to skip the questionnaire when dealing with “known quantity” institutional investors provided they are willing to make the representations in the purchase agreement.

Next section:

Amendment. The Majority Holders may amend or waive any provision of the Notes and such amendment or waiver shall be binding on all Note Holders.

This is a subject touched upon in earlier discussions of voluntary conversion upon maturity of the Notes or upon a change of control (i.e., merger or acquisition). Broadened to cover any kind of amendment or waiver that might apply to the Notes, some investors understandably object to having their own rights compromised by allowing them to be outvoted in an action that could impair the value of their investment. In practice, this sort of provision usually prevails because (1) holders of the same class of securities (convertible notes in this case) usually have aligned interests; (2) relatively small investors are accustomed to “piggybacking” on the terms negotiated by large/lead investors in venture financings generally; and (3) having this kind of provisions is important both to the Company (for reasons we’ve discussed) and to the largest or lead investor(s), who may be as reluctant as the Company to involve too many cooks in the kitchen if things get complicated and need to be renegotiated or restructured down the line.

Finally, we come to everyone’s least favorite provision:

Expenses. The Company and the Investors will each bear their own legal and other expenses with respect to the transactions contemplated herein.

In most friends-and-family or angel seed financing rounds, the parties agree to bear their own legal expenses. Many angels are comfortable enough to work without legal counsel in deals that follow the established patterns they’ve seen many times before, whether structured as convertible debt or preferred stock. By contrast, VCs usually involve legal counsel, given the larger amount of capital put at risk in any one investment, and typically ask the Company to pay or reimburse the fees of investors’ counsel out of the proceeds of the financing.

Having come to the end of our overview series, I’ll discuss some of the pros and cons of different deal structures, more recent innovations such as Series Seed documents, and other variations in future posts.  I hope you’ve enjoyed reading thus far and would love to hear from entrepreneurs or investors with any questions or comments.

This article is for general informational purposes only, not a substitute for professional legal advice. It does not result in the creation of an attorney-client relationship. All opinions expressed are those of the author, and do not necessarily represent those of Gust.

Written by Antone Johnson

user Antone Johnson Founding Principal,
Bottom Line Law Group

Antone is a business lawyer and executive advising technology and media companies, entrepreneurs and investors in corporate, commercial and intellectual property matters. Johnson is Founding Principal of Bottom Line Law Group, a business and IP law firm and was the former VP and head of worldwide legal affairs at eHarmony.

prev next

You might also be interested in

Co-founder Equity Split: A New Framework to Objectively Divide Startup Ownership and Get Back to Building a Business

We’ve just released our free Co-founder Equity Split tool. It’ll give you a fair and objective recommendation about how to divide your startup’s ownership, so you and your co-founders will have a sensible, real starting point for this notoriously hard, crucially important conversation.

Many startup founders find themselves lacking clarity and direction when it comes time to divide their

Read more >

From Accelerators to Venture Capital: What is best for your startup?

With startup growth up 61% since 2014 and more investment programs emerging, it can be overwhelming for founders to know just where to jump in. As the most startup-friendly accelerator on the planet, MassChallenge has helped 835 startup companies around the world, who have raised over $1.1 billion in funding and created over 6,500 jobs. We have seen startups at

Read more >

Valuation Part I: Peeling the Onion, or How Top Investors Value the Startups They Invest In

Update 2017: To help you understand how your startup will look to investors according to this methodology, we’ve created a fundraising feedback tool that will give you investor-level insight into your startup’s performance. In just about 15 minutes, it will tell you how much money your startup is likely to raise, where you can find that capital, and what to

Read more >

Starting a Startup as CTO / Head of Product

After less than a year, Glassbreakers is now a team of 10, we have thousands of active users on our free product, we’ve expanded into enterprises with paying customers and raised over a million in seed funding. After a few of my Glassbreaker matches inquired, I started to reflect on what it’s like to build a startup

Read more >

18 Ways to Make Your Financial Model Stand Out to Investors

The median investor looking at your proposal is in her 40s. Her eyes are going, not to mention her brain. I look at a lot of spreadsheets and analytic reports, and way too many are difficult to read and therefore hard to understand.

In an effort to make my life easier, I’ve summarized here the steps that will

Read more >


2 thoughts on “Knowledge Is Power: Convertible Note Financing Terms, Part V”

  1. Ann Greenberg says:

    Excellent series, Antone.  Thanks for taking the time to do this. 

  2. Peter Kelley says:

    Antone, thank you for sharing this series.  It is outstanding.