Negotiating with an angel investor can be tricky, so at least go into the meeting feeling prepared
Most businesses will require some sort of seed investment before they can enter into the next stage of growth. However, owners need to be careful not to give up too much control over your business when raising funds.
Selling out too soon
Before entering into the negotiation process, Founders want to be fully-aware of their leverage. If they have a clear idea of what is at play in a fundraising discussion, it makes a big difference when negotiating a better deal for the company.
Fundraising via convertible note has become increasingly popular among startups today. But many people do not know how they work. Let’s get started with the basics:
What is a Convertible Note?
A convertible note is a form of short-term debt, paid back in equity. The investor puts cash in the startup and receives discounted shares upon issuing shares at a later point.
In other words, they don’t ‘own’ a part of the company just yet – this essentially means the Founder gets to retain control.
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At the same time, the investor is still considered a debtor. As such, they can set a maturity date for the loan and reclaim money later if the founding team decides not to issue shares. Raising funds via a convertible note is therefore a popular alternative to SAFE financing and equity financing.
To issue a convertible note, businesses need three documents
Convertible note term sheet: This document summarises the key terms of the agreement between a startup and investors. It is generally signed at the beginning of the transaction once preliminary terms of the financing have been agreed, before commencing detailed due diligence and drafting of definitive agreements.
Convertible note purchase agreement: This document governs the key terms of the sale and purchase of the convertible debt. It is the legally-binding contract that governs the convertible note agreement.
Convertible note certificate: A deed confirming the purchase by the registered holder of a convertible note instrument. It is a written promise to repay the debt at a specified time through equity (shares).
Here is a (simplified) example of what a convertible note agreement might look like
After negotiation, an investor agrees to provide a company with US$200,000 in seed funding. In return, the company gives the investor a convertible note that converts during Series A funding at a 20 per cent discount.
In other words, when the startup raises its Series A funding, the investor will get US$200,000 worth of stock at a 20 per cent discount.
Now, lets imagine the startup gets a US$5 million post-money valuation during the Series A funding. VCs put in $1.5 million to take a 30 per cent share of the company.
If the first seed investor were to invest in Series A, US$200,000 would get him only 4 per cent of the stock. However, because he invested early, he gets a 20 per cent discount on the stock, and thus ends up with 5 per cent of the stock instead – US$50,000 worth of extra equity.
What are the most important variables of a convertible note agreement?
The three most important variables in a Convertible Note Agreement are the investment threshold, the valuation cap, and the discount rate.
The investment threshold denotes when the convertible note executes – that is, when the investor gets his equity.
Usually, the threshold is set as a specific amount — for example, when the startup raises US$1 million or more. It could also be executed at a specific time, like when the startup raises money through Series A funding.
In most cases there is no practical difference between the two, as the note executes in Series A irrespectively.
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The discount rate outlines how much reward the investor gets for taking the risk to come on board early. In the above example, the 20 per cent discount rate meant that the investor walked away with 5 per cent of the company’s equity instead of 4 per cent.
The valuation cap protects the investor from seeing their investment get too diluted when the startup takes off.
In the example outlined above, the investor ended up getting a 5 per cent equity share. But should the company have been valued at $50 million, they would have received a far lower number of 0.5 per cent share, even if they backed it first. A valuation cap ensures the investor that they will get a respectable equity share no matter the valuation.
How does a valuation cap work?
Most companies gets a pre-money valuation during Series A funding. If the pre-money valuation exceeds the valuation cap, investors get the opportunity to execute the convertible note and are entitled to negotiate for a pre-fixed stake in the convertible note agreement.
Low VC investment means that the seed investor will benefit from the discount. By investing US$1.5 million the investor gets a 5 per cent stake.
But as the valuation grows and VCs put in more money, the seed investor’s stake dilutes. A valuation cap puts a floor to the degree of dilution.
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Founders and VCs investing in Series A benefit from a high valuation cap. The lower the valuation cap, the more likely the company will hit the “floor”, and your seed investor gets a relatively large share of the company at a very low price.
Other common terms in a convertible note agreement
Two other terms often included are the interest rate and the maturity date. As the convertible note is technically a loan, investors can charge interest, and thus receive slightly more shares when the note converts.
A maturity date is included so that the seed investors knows they will get money back should the startup delay or decide against Series A funding.
A good understanding of the Convertible Note Agreement is a great way to strengthen your hand in a negotiation with a seed investor.
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Audrey Ang has a background in Marketing and Business Development, she is currently an employee at Dragon Law – The new face of Business Law! Dragon Law is the trusted platform to manage law online. Try out their free trial today.
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