Carlos and I recorded 6 episodes of our “Legal Hour” series last year. The episodes covered a variety of topics and issues that we’ve seen early stage founders face over the years. The goal of this series is to shed light on these topics and hopefully arm founders with the knowledge to go into any conversations with confidence and a good basis of understanding of the key points.
In case you missed them first time around, here’s what we covered in each episode and a link so you can catch-up:
Episode 1 – “Legal terms to be aware of when bringing on new investors” In this episode, we cover different golden rules on how to document and structure an investment round along with key information on how to factor in option pools. It’s also well worth also reading my previous post about down-rounds, uncovering potential concerns for startups fundraising in more challenging market conditions. We also talk about how it’s important to focus on the terms, not the structure, not letting market standard verbiage prevent you from doing your research, and how to always think comprehensively about your terms.
Episode 2 – “Legal structures to be aware of when setting up your next round“ The purpose of this episode is to arm all founders with valuable information to help them make the most knowledgeable decisions, as no founder or investor should be afraid of any legal structures – they are all trodden paths that other founders have gone through, and they are all tools from which to use. The episode covers various legal structures both founders and investors should be generally already familiar with, but going more in depth as to what the considerations should be when going for equity share purchases over convertible structures, or the importance of understanding the different national jurisdiction a company might choose to comply with, and why, discussing the advantages and disadvantages of each along the way.
Episode 3 – “What to be aware of when signing ‘standard terms’“ The term ‘standard documents’ came along not only from wanting to absorb the lessons learned, but also to introduce some level of simplicity in rather complex legal agreements. However, what is defined as ‘standard’ changes depending on various external variables that alongside others include how competitive the market is currently. So, if the standard terms aren’t static, but rather continuously shifting, what should founders look out for before placing their signature on any of them?
Episode 4– “The 6 make or break legal issues to consider when starting a company” (with guest Anthony Rose, co-founder of Seed Legals) In this episode we go over the six critical things to get sorted legally when you’re just starting a company and how data can empower founders to make better legal decisions.
Episode 5 – “Incentivising your team through Employee Share Schemes – part 1“ Episode 6 – “Incentivising your team through Employee Share Schemes – part 2″(with guest Ian Shaw, Partner at Orrick) We had so much content for this one we had to split it across two episodes! To attract and retain the right talent, startups use employee ownership as an incentive scheme. Stock options have become tech’s currency. There is a common fear among founders that dilution resulting from a sizeable stock option pool is too costly. Though, in reality, it is too costly not to incentivise your team properly. Competition for top talent is just too high to afford doing so. We firmly believe that employee ownership is an essential ingredient in advancing the European startup ecosystem. This is why, in this two part episode of Legal Hour, we dive into the nitty-gritty of employee incentive schemes. Joined by Ian Shaw, a partner at Orrick who heads the London employee share schemes and incentives practice, we discuss everything founders need to know about designing an effective option plan. In the first episode, we clarify definitions needed to understand share option schemes, commercial terms for employees, and how to walk through the elements that make up a plan with your employees. In the second episode, we dig into specifics around tax structures and option plan structures. Put the kettle on if you’re listening to these back-to-back!
A standard investor protection clause commonly found in most VC led term sheets is unfortunately likely to become more relevant than ever as we move into a challenging fundraising landscape. So now seemed a great time to dive in and unpack the ‘anti-dilution’ clause.
The anti-dilution provision is a right that usually applies to preferred shares. It’s something that is negotiated by investors to protect them from the “economic dilution” of the company raising money in the future at a lower price than they invested at (i.e. a “down round”). The impact that this provision will have on the company depends on how it is drafted. Generally, there are two main ways that an anti-dilution clause is drafted. We’ll look at them both here and work through an example scenario to show the impact.
A quick note before we start, economic dilution (which we are focused on here) in the event of a down round is very different from “percentage dilution” which happens whenever a company issues new shares at a new higher-priced round. Percentage dilution is not an issue and any investors will expect to take percentage dilution when they do not invest at a new round to protect their stake (often known as investing their “pro-rata amount”).
Example Scenario: Company X has raised the following Series A:
Pre-money: £40,000,000
Series A investment (Round size): £10,000,000
Option pool: 100,000
Fully Diluted share capital (pre the round, inclusive of options): 1,000,000
Price per Series A share: £40.00
Series A shares issued: £10,000,000/£40= 250,000
Fully diluted share capital post the round: =1,250,000
Post-money: £50,000,000
Company X then gets a term sheet for their Series B at the following terms:
Pre-money: £30,000,000
Series B investment (Round size): £15,000,000
Price per Series B share: £30,000,000/1,250,000=£24
Series B shares issued: £15,000,000/£24= 625,000
Fully diluted share capital post the round = 1,875,000
Post-money: £45,000,000
In this example scenario, Company X raised its Series A at a £40m pre-money valuation and went on to raise £10m at this valuation. For simplicity assuming one investor did the whole £10m, this investor in our scenario paid a price per share of £40. Taking into account the shares issued at the round, Company X has a post-money valuation of £50m.
Company X then goes on to raise its Series B. However, market conditions have worsened and whilst Company X needs a minimum of £15m funding it’s only able to command a £30m pre-money valuation from the market. As a result, the 625,000 shares issued to the Series B investor (again, for simplicity, assuming a single investor) are issued at a price per share of £24. The £24 share price is lower than the price paid at the last round and therefore Company X has had a “down-round”. To look at it another way, this means the £10m invested by the Series A investor has gone from being worth £10m priced at the last round to now worth £6m (250,000*£24).
Once there’s a down-round this is where the anti-dilution provision kicks in. The full impact of the provision depends on if a “full-ratchet” or a “weighted average price” mechanism has been specified in the drafting.
Full-ratchet
The full-ratchet mechanism aims to fully compensate the earlier investor (in our case the Series A investor) and effectively put them in the position they would have been in had they invested at the lower price per share of the Series B round. So, if the Series A investor had acquired shares at the £24 price per share they would have received 416,666 shares (£10,000,000/£24)(rounded down to the nearest whole share). Therefore, applying the full-ratchet mechanism on the closing of the new Series B round, the Series A investor would receive 166,666 (416,666–250,0000) free shares. These 166,666 shares, assuming a £24 price per share, would represent full economic compensation for the £4m difference in value between the value of the Series A investor’s position at the Series A (£10m)and what it is now worth at the Series B (£6m).
In the VC market, this mechanism is highly unusual and definitely not founder-friendly. We’ll show the difference between applying the full-ratchet compared to weighted average price at the end of the post to show this.
Weighted average price
The weighted average price mechanism attempts to apply weighting to provide for how impactful the new round is on previous investors. Hence, it’s considered a more balanced mechanism compared to the full ratchet and a more common approach in VC financings. Even within the weighted average price mechanism, there are two different ways that this can be calculated but will get to that shortly. To start with let’s unpack the overall formula:
WAP = [(PPS(Series A) x SPM) + (PPS(Series B) x SN)] / (SPM + SN)
This looks like a scary formula but stick with me and we’ll break it down. Firstly, what do all these letters mean:
WAP = weighted average price
PPS (Series A) = price per share at the Series A
SPM = Total number of shares pre-money (i.e. before this new Series B down-round)
PPS (Series B) = price per share at the Series B
SN = New Series B shares issued at the Series B
As mentioned above, there are two different applications of the weighted average price mechanism:
the narrow-based weighted average (‘NBWA’); and
the broad-based weighted average (‘BBWA’).
The narrow version only takes into account shares actually issued at the time and the broad version also adds on any options etc. and is therefore based on the fully diluted capital of the company at the time. Applying the numbers from the example scenario we can see the difference between the two:
NBWA = [(£40.00 x 900,000)+ (£24 x 625,000)] / (900,000 + 625,000) = £33.44*
BBWA = [(£40.00 x 1,000,000)+(£24 x 625,000) / (1,000,000+625,000) = £33.85
Using the NBWA each Series A share has been economically diluted by £6.56 (£40 – £33.44) and in the BBWA by £6.15 (£40 – £33.85). Thus the BBWA mechanism is less dilutive for Ordinary shareholders and hence considered more founder-friendly.
Having obtained the weighted average prices for each we can now calculate how many shares the Series A investor would have received if they’d paid each respective price and hence calculate how many shares they would be due applying the anti-dilution mechanism.
How many shares they would have received total (NBWA): £10,000,000 / £33.44 = 299,043 shares (rounded down to nearest whole number)
How many shares they would receive applying the anti-dilution mechanism (NBWA) = 299,043 – 250,000 = 49,043
How many shares they would have received total (BBWA): £10,000,000 / £33.85 = 295,420 shares (rounded down to nearest whole number)
How many shares they would receive applying the anti-dilution mechanism (BBWA) = 295,420 – 250,000 = 45,420
The difference between Full-ratchet, NBWA and BBWA is significant as shown by this table of the amount of anti-dilution shares an investor would receive applying each different mechanism:
The vast majority of VC led rounds that I see in the market contain the BBWA approach to anti-dilution and this is definitely the market standard. It is highly unusual to see full-ratchet and if it’s included and there is a down-round then the impact can be catastrophic in terms of founder dilution (just look at those numbers in the table above!). However, in more challenging market conditionsterms that were previously considered standard can have a way of changing. Therefore, understanding how the different versions of an anti-dilution clause work can be of massive importance.
*Note: here I have rounded to two decimal places for the purposes of this post. However, an alternative approach is not to round here at all and use the raw number for the purposes of the ongoing calculations. This would lead to a different number of anti-dilution shares at the end. As with any calculation like this, it’s important to be clear on the method of rounding used and agree that between the relevant parties.
A challenge that I see founders struggle with when raising money using a convertible (note: I’ll use convertible as a term to capture advanced subscription agreements (ASAs) and/or simple agreements for future equity (SAFEs) throughout this post) is correctly understanding the dilution they are taking. This has traditionally been one of the advantages of doing an equity round (where shares are issued at the time of investment) because it allows everyone to have a clear picture when the round closes of where they stand from an ownership perspective. However, for multiple reasons (time, cost etc.) often an equity round isn’t a founder or investors preference at the earliest stage.
I think there is a simple fix to this problem, set the cap in the convertible as a post-money valuation.In this scenario, the post-money is in relation to any money raised under such convertibles (see below for an example) but, to flag, is not inclusive of the money raised at the converting round (i.e. Seed or Series A). This is something that we have incorporated in the standard advanced subscription agreement we’ve been using for our pre-seed investments at Seedcamp. It’s also something that YC have recently incorporated in their standard deal documents.
So, how does this work in practice?
Firstly, I’ve written previously about considerations to bear in mind when setting caps. If you haven’t checked that out, I’d recommend starting here.
The difference between using a post-money and a pre-money cap is best illustrated using numbers:
Post-money
If you were to raise £100k and set a cap at £2m post money then on conversion at the cap the investor would own:
£100k / £2m * 100 = 5%
If you raised an additional £150k on the same cap that would add an additional:
£150k / £2m *10 = 7.5%
Total dilution => 5% +7.5% = 12.5%
Pre-money
Suppose you went out to raise £100k and agreed to give up 5% of your company for this. Using an ASA you, therefore, set a cap at £1.9m pre-money. On conversion at the cap the investor would own:
£100k / (£1.9m +£100k)*100 =5%
So far the same as the post-money scenario. If you then went on to raise an additional £150k on the same cap that would add the following dilution:
£150k / (£1.9m+£250k)*100= 6.97%.
This is lower than the post-money scenario because the additional amount raised has been added to the pre-money cap resulting in a new cap for the purposes of calculation.
Furthermore, as the cap has effectively increased by this additional £150k, the original £100k would now equate to the following dilution:
£100k / (£1.9m + £250k ) * 100 = 4.65%
Total dilution => 6.97% + 4.65% = 11.62%
The above is a very simplified example but you can imagine how complex this can get when using a pre-money cap to raise investment from multiple investors.
Why the concept of time is crucial
As the above illustrates, the pre-money example actually results in less founder dilution and therefore could be seen as founder favourable. This is because each incremental amount raised using a post-money cap just dilutes the current shareholders which at the pre-seed stage are usually the founders. However, I think the key concept to layer onto this analysis is time. A startup can be seen as having a value attributable to a certain period in time. The post-money method allows founders to clearly define what the valuation of their startup is for a period of time that they will raise convertibles for. Often this time period is pre a large institutional Seed or Series A. By clearly defining this time and setting the post-money cap for this period it allows founders to have a very clear picture of the dilution they are taking at each funding event documented using a convertible and therefore where they stand going into the Series A. Obviously if this time period is particularly long, a founder could determine that there are two or more distinct periods prior to the large institutional Seed or Series A and therefore there is a higher cap for the second or additional period. There are numerous ways that founders and investors can get creative to structure such financings but I think a key driver should be simplicity and speed and the post-money approach helps with this.
The exact timing of when the mechanic of conversion takes place is another area that can cause confusion. For example, often convertibles are drafted as being inclusive of an option pool that may be requested at the round in which it converts. This can add additional dilution for founders because it means that the dilution of the future option pool comes before the convertible is converted and is therefore borne by the founders and not the note holders. This is not a particularly unusual provision but it is something for founders to be aware of. For example, a pre-money cap that is inclusive of any option pool could end up resulting in a similar level of dilution as a post-money cap not inclusive of an option pool.
Overall, I think the focus should be on simplicity and speed. I do think navigating to a post-money world helps with this and provides a clearer basis for founders and investors alike.
Pre-emption rights are often talked about as one of the most important terms for early stage investors. But it’s not just important for investors, it’s also a key term for founders to understand when negotiating a financing round.
First things first, what is a pre-emption right?
A pre-emption right gives an existing shareholder the right to participate in a future financing round to the extent necessary to maintain its percentage stake in the company. It provides shareholders the right to acquire shares before they can be offered to a third party (i.e. a new investor) on either an issue of new shares or a share transfer by an existing shareholder. In this post I’m going to focus on the issue of new shares and not transfers.
Pre-emption rights are usually pro rata to a shareholder’s existing holding (so if a shareholder holds 10% of the issued share capital, broadly speaking they will be entitled to 10% of the shares being issued). However, occasionally certain investors will look for a multiple of pre-emption (also known as a “super pre-emption”) which would give them the right to invest more than their pro rata. Or, less common, an investor may look to include a right where they can take the entire round at such new financing (also known as a “right of first refusal”). Rights of first refusal on a new issue of shares can be potentially toxic for founders because they effectively reduce the options available when raising a new round (discussed more here)- definitely something to watch out for.
What does this look like in a typical termsheet?
Below is an extract of how a simple pre-emption right might look in a typical VC termsheet:
This is a fairly standard and founder friendly pre-emption clause. The right is pro rata and therefore no one investor is getting any preferential treatment such as super pro-rata or a right of first refusal (see above) on the issue of new shares.
Why do investors care?
Returns in VC are driven by the outlier big outcomes. The right of pre-emption is therefore very important for investors to be able to continue to invest in their strongest performing companies and back the winners. Hence why it’s one of the key terms that any experienced investor will fight for.
Should founders care?
Yes, there are two main reasons why they should:
(1) Signalling
On a new financing round, new investors will be keen to understand if existing investors are following on at this round with respect to their pre-emptive amount (also interchangeably referred to as “pro rata”). If they’re not then this can send a negative signal to the new investor because the existing investors are expected to generally be more knowledge of the company. This is most applicable for VC funds where the expectation will be that they follow-on (less so for smaller funds).
For example, if a Seed VC has led a £1.5m seed round and post that round holds 15% then the Series A VC (considering leading the next round) will want to know whether the Seed VC is following on for their pro-rata. If they are not this could be a negative signal for the Series A VC.
(2) % available for new investors
The right to pre-emption means that on a new financing round the company will be obliged to offer the opportunity to existing investors to invest at the same terms on a pro rata basis.
For example, if following a Seed round investors hold 20% and at the Series A they are raising £5m then ~£1m (20% of this £5m) must be made available for existing investors.
Now, in practice some of the existing investors may not take up their pre-emption (e.g. Angel investors may not have liquid reserves to follow-on). However, it’s an important consideration because the amount of pre-emption taken up will effect the amount available for new investors. This could be important if the new investors have a target ownership in mind (which VCs often do). Whilst technically this is true, in oversubscribed competitive rounds there may be pressure placed on existing investors to reduce the amount they invest to provide space for new investors.
Win-win 🙌
A standard pre-emption right (like the extract above) can provide a win for both founder and investor. Investors get the crucial opportunity to follow-on in successful companies and founders get additional support, funding and a positive signal for their next financing round.
I’ve previously written about the basics and some of the key considerations when raising using a convertible note (if you haven’t read that I’d suggest starting there). In this post I wanted to dive into probably the most negotiated term, the valuation cap. It’s a topic that’s come up a lot in discussions I’ve had with founders raising using convertibles and I thought it was worth sharing some thoughts more broadly.
Some very hot companies raise money using convertibles without a valuation cap, but in todays market (and any market) that is very rare. When thinking through how best to arrive at a fair and reasonable cap, I find it useful to consider both the startup and investor perspectives. Whilst I operate on the investor side of the table, I believe that both sides fully understanding the variables at play leads to more efficient negotiations and therefore less time spent. My goal is to help founders get back to building and spend less time negotiating with investors or worse yet…lawyers (I’m allowed to say that as I used to be one 😜).
The Startup 🚀
A key consideration from the startup perspective is what any amount raised under the note will convert into at the next round. In particular founders should be mindful of the potential dilution that they will take on conversion. A very low cap could result in a toxic cap table situation and deter the next round investors — this is a situation to be avoided at all costs. I always recommend founders consider a new convertible note in the context of the next round and model this out in their cap table to understand the potential impact.
The Investor 💰
It’s logical to think that an investor would want to set the valuation cap as low as possible. The lower the cap the potentially larger % of the company their investment will convert into at the next round. However, this approach misses the point. The valuation cap is not exactly the same as a valuation. It’s primary purpose is to protect an investor against converting to a disproportionately small % if the next round valuation is very high. As such, the cap should likely be set at a premium to achieve the desired effect. As it usually works in conjunction with a discount (see my earlier post), there’s usually a range by which an investor will get comfortable by looking at proxies for valuations of similar stage startups (at the time of investment) and what is likely an achievable valuation at the next round. Add to this an investors target ownership % (on conversion) and you can see how most investors arrive at valuation caps they believe reasonable.
Time ⏲
An additional consideration from both startup and investor perspective, is the likely amount of time between the money raised under the convertible and the next financing round. The longer the convertible round represents in terms of runway the more the cap should likely be a proxy for valuation at the time of such convertible note investment. This is logical from a pure risk allocation perspective. If an investor can wait until the next round and get similar economics then they’re likely to do that (caveat if it’s a super hot deal and they’re worried about future access). Whereas if the convertible round in question is a short term bridge it may be more appropriate to use the potential imminent next round valuation as the number to more closely base the cap from.
Overall, setting a valuation cap is more art than science. Personally, I think the most crucial factor is ensuring that founders do not take a disproportionate amount of future dilution. After all, it’s the founders (and their team) who drive the most value creation in any startup so it’s in all stakeholders interest for them to be properly incentivised.
p.s. I’m yet to come across any good data on valuation cap ranges by stage of investment – if anyone has any I’d love to hear from you.
An option pool is a key tool at a high growth startups disposal to attract and retain top talent. This post sets out some of the key concepts that founders should consider when thinking about granting options to employees.
What is an option?
Options are contracts that grant the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date. In our case we’re focused on the right to buy a set number of shares at a specified price on or before a defined date. The price is often referred to as the “strike price” and refers to the price set on the date the options are granted. In successful startups, options can become very valuable as the fair value of the shares in the company increases significantly beyond the strike price.
Why do startups grant employees options?
There are a number of key reasons for startups to grant options to employees:
(1) Alignment of interests – options allow employees to share in the success of the startup (alongside its founders) and potentially provide an additional incentive for an employee.
(2) Economic/ pay – options also provide a mechanism by which startups can fill the gap between what an employee could earn in the market and what a startup is able to pay. For example, an employee may be able to earn £100k working for a large tech company with an additional very small option package (or none at all) whereas a startup may not be able to match such a salary but is able to offer a potentially more generous options package.
(3) Retention – most option packages are on a vesting schedule and/or be subject to leaver provisions (all Seedcamp and other VC backed companies will include vesting in their ESOPs). Therefore, employees who receive options will be additionally incentivised (in positive situations) to stick around to gain the maximum benefit.
(4) Tax and governance – when considered in comparison to issuing shares to employees rather than options, options have the benefit of potentially being more favourable from a tax perspective (see below). Also if shares are issued the employee would become a shareholder in the startup and inherit certain rights (i.e. dividend, information, voting) that may not be appropriate.
How many options should the first employees get?
This is a common question that comes up regularly with the companies that I work with. There’s no magic formula and often the answer is the incredibly frustrating “it depends”. The process is often described as more art than science and it’s very difficult to point to an exact way of answering the question.
There’s some great posts out there going into more detail on the topic so I’m not going to dwell on this here but I’d recommend reading these to get an overview of methods to arrive at amounts for individual grants broken down by roles:
A key point to note, that my colleague Carlos flags in his post, is the importance of being clear with what % the grant is in relation to. It’s important to highlight that the % is in relation to the current fully diluted cap table (at the date of the grant).
eShares have a great example of how they explain employee equity to new hires in their offer letter – in this, they clearly set out the scenarios and what such a grant could be worth to the employee. Buffer famously also include a full transparent breakdown of how they calculate option grants and the factors and variables they take into account — more on that here.
How do startups grant options?
Once the total pool size and breakdown has been determined the process needs to be properly documented. Getting the paperwork right is crucial to avoid complications down the line.
For UK companies, generally, the first thing required is to get an Employee Share Option Plan (ESOP) written up and approved by the startup and its board. Such a plan requires careful drafting and advice from a specialist tax adviser and/or lawyer. Most UK startups go down qualifying their ESOP under the Enterprise Management Incentive (EMI) route. The major benefit of this approach is that it potentially means there is no income tax payable by employees when exercising their options — only on the gains on an exit (where Capital Gains Tax (CGT) will be payable). This is a significant potential tax benefit for employees. Before any option grants are made it’s necessary to get a valuation of the startup done. Such a valuation for an EMI qualifying ESOP is different from that referred to at a funding round (where it’s set by third party investors (VCs, Angels etc.)) and in this case actually requires an application to be made to HMRC. Care needs to be taken with the application and advice should be sought from a specialist accountant to assist. Obtaining a low valuation for the purposes of pricing the options (strike price) is generally seen as preferable because it will maximise the potential gains and therefore the impact of the grant for the employee (as such it’s helpful for hiring purposes). The valuation will only be valid for a set period of time (~60 days or so) so it’s important to make the option grant shortly thereafter. It’s worth noting also that options granted under the EMI route only qualify if made to employees. Once all the paperwork has been approved, finalised and signed by startup and employees the option grants need to be filed with HMRC (within 3 months) to qualify for the tax advantage.
The market for options in Europe
Overall I don’t think there’s enough value given to startup options in Europe. Perhaps this is down to the risk tolerance of us Europeans and our tendency to favour a certain salary over equity. I’d like to see European startups be more aggressive with their option grants and spend more time educating employees as to the potential value that such option grants could present. It feels like there’s value being left on the table there. The US market appears to be ahead in this regard probably buoyed by the fact founders there can point to more success stories of startups scaling to exit. For any startup, one thing is for certain, talent is absolutely critical and therefore spending time devising a strategy around how options can be used to attract and retain world class talent is time well spent!
— — —
It goes without saying that ESOPs are a complex area and advice should be sought from a qualified account and/or lawyer to ensure all the proper steps are taken. Also to note, the above is meant only as a quick summary and there are some other points to consider such as: eligibility criteria and a maximum amount that can be granted (the full criteria can be found here).
Convertible notes are one of the most common ways of raising financing for a startup. Particularly the first round of financing. We currently use a form of convertible for all of our pre-seed deals at Seedcamp. Having reviewed and issued many convertible notes over the past few years, I wanted to distill this knowledge down into some key questions for founders to consider and why I think they’re important.
Before we get to the questions, some background..
What is a convertible note?
Broadly speaking, a convertible note is a financing instrument that can be used to provide funds to companies in advance of issuing shares. It is often used on early stage financings because it avoids the need to establish an explicit valuation. Convertible notes can provide a faster and simpler way to document a funding round than a priced equity round.
I’m using the term “convertible note” in this post but many of the below points will also apply to other convertible financing agreements such as: Simple Agreement for Future Equity (SAFE), Advanced Subscription Agreement (ASA) etc. The reason for choosing one variant over the other is often driven by potential tax preferences for investors (i.e. ASA for EIS / SEIS investors) or familiarity (i.e. SAFE for US investors).
For an example of a convertible note and advanced subscription agreement and some of the main differences between the two check out the Seedsummit site here.
8 questions to consider when reviewing a convertible note
(1) What constitutes a Qualifying Financing?
As mentioned above, the primary intention of convertible notes is for them to convert into shares (the clue’s in the name) and the majority of such conversions happens at the next financing round of the company that constitutes a “Qualifying Financing”.
The Qualifying Financing is usually the trigger for an automatic conversion of the note which is then calculated using either the valuation cap (see below), discount (also, see below) or price per share paid at the round -whichever results in the greatest number of shares to the note holder.
The amount (i.e. size of the next financing round) that constitutes a Qualifying Financing can vary depending on the stage of the company and how much the company is raising in total under the convertible note. A reason behind having a qualifying amount is that it protects the investor from having their investment converted to equity in a company that is under funded. Before it is converted the convertible note will technically class as debt and therefore rank higher in the event the company becomes insolvent. This can also ensure that the Qualifying Financing is a true financing for a meaningful amount. However, this lower bound amount should not be set too high so that the Company risks having the money not convert at a true financing round.
(2) Is there a Valuation Cap?
This is often one of the most negotiated elements of a convertible note. The level the Valuation Cap is set at can have a major impact on the number of conversion shares issued. Understanding how it works is of crucial importance. Simply put, it is the maximum value at which the convertible note would convert in a Qualifying Financing (see above), regardless of the price set at such Qualifying Financing. This mechanic prevents the shareholding on conversion from being reduced to a very small % in the event that the company raises at a high valuation for its next round. To illustrate how this would play out in practice let’s look at an example..
Valuation Cap — Example scenario:
Company X is raising a £1m priced equity round (i.e. they are issuing £1m worth of shares to the new investors investing at this round) at a £3m pre-money valuation (for the purposes of the two examples in this post, we’ll call this the “Seed Round”).
Previous to the Seed Round, Company X had raised £50,000 on a convertible note with a valuation cap of £1m (this is the only note they have raised to date).
Assuming that the £1m round is a Qualifying Financing (see above), the convertible note would automatically convert at the valuation cap of £1m because this will result in a greater number of shares than if the convertible note converted at the terms of the round (i.e. £3m pre > £1m cap). Broadly speaking, the convertible note investor would get an effective~3x lower price per share than that paid by the new investors investing at the round by taking the Valuation Cap as the basis for calculation rather than the pre-money of the round.
I always recommend founders model the impact that the notes they enter into will likely have on their cap table when they convert. As the above example shows, the Valuation Cap can have a significant impact on the dilution incurred by the company. However, it’s worth bearing in mind that the convertible note investor has likely invested at an earlier point in time and therefore should probably be entitled to better economics to reflect the increased risk they took.
(3) Has a Discount been specified?
Like the Valuation Cap, the Discount placed on a note is another variable that can have a significant impact when calculating the number of shares that the note converts into. Hence, it is also usually front and centre in any negotiation. Generally, where included, the discount it is drafted as a % of the price paid by investors investing at the round often ranging from 0–30%. Again, taking an example scenario to help illustrate..
Discount — Example scenario:
Using the Seed Round metrics from above (£1m at a £3m pre).
In this example, assume that Company X had raised £50,000 on a convertible note with no valuation cap but a discount of 20% (this is the only note they have raised to date).
Assuming that the £1m round is a Qualifying Financing (see above), the convertible note would automatically convert by taking the price paid per share and discounting by 20% because this will result in a greater number of shares than if the convertible note converted at the terms of the round (i.e. Seed Round price per share> 0.80*Seed Round price per share). Broadly speaking, the convertible note investor would get an effective 20% lower price per share than that paid by the new investors investing at the round.
Note:Convertible notes can also be drafted to include a Valuation Cap and a Discount (and, in rare cases, they could include neither). If they include both, the convertible note holder would choose to either convert into shares using the Valuation Cap or the Discount (whichever would result in them receiving the most shares).
Overall, both the Valuation Cap and Discount are very important terms and care should be taken in particular when determining the effect they can have on the ownership position following conversion.
(4) Is there an Interest Rate?
To flag, not every convertible note will carry an Interest Rate (i.e. the note we use as the basis for our pre-seed investments at Seedcamp does not carry an interest rate). If it is included, the Interest Rate will usually start accruing from the day the convertible note is signed and issued until the day the note becomes due and payable or converts. The interest rate is important to consider because, on a conversion, the accrued interest can be thought of as acting like an additional discount. Overall, the Interest Rate is an additional factor that impacts the investor’s return and therefore can form part of a negotiation.
(5) What happens if the next round is not a Qualifying Round?
Usually the convertible note holder would have the option of whether to convert or not if the next round does not constitute a Qualifying Round. The Valuation Cap or Discount may be set at different levels compared with how the note would convert on a Qualifying Financing (if different it would be common for the valuation cap and/or discount to be more favourable for the investor). This provision may also give the convertible note holder the option to convert the note to shares in the event there is no financing round prior to the maturity date (see below) based on an agreed pre-money valuation. This clause can have an impact in the event things don’t go to plan and the company has to raise a smaller than planned round (i.e. a bridge financing or similar).
(6) What happens if the company is acquired before conversion?
There will usually be a specific clause that addresses the situation in which the company is acquired before the convertible note has had a chance to convert into equity in the company. This situation is common in “acquihires,” or the acquisition of a company at a very early stage, and in which the amount being paid for the company is based on the recruitment of its employees rather than the company’s intrinsic value (i.e., the company’s intellectual property, revenue, etc.). The three most common possible scenarios for the treatment of the note are: (1) the convertible note converts into ordinary shares of the company, and then proceeds from the acquisition are distributed to the common stockholders on a pro rata basis; (2) the convertible note converts into preferred shares, which provides protection of liquidation preference, among others; (3) the convertible note holder is entitled to a return of a certain amount, based on then balance of the note (i.e. the amount they invested under the convertible note). In (3), the return entitlement can be 1x, 2x or higher. This clause is important for founders to consider particularly if aquihires are common in their industry or they believe the company may be acquired prior to a conversion.
(7) What’s the Maturity Date and what does it mean?
The Maturity Date is the date that the convertible note technically would need to be repaid if it is still outstanding (i.e. it has not converted or been repaid in some way). In practice, if the Maturity Date comes to pass it is often agreed by the convertible note holder that it can be extended (particularly common for VC investors, experienced Angels etc.). Look out for wording explicitly stating that the Maturity Date can be extended. However, investors may enforce the repayment which could have dire consequences for the company (i.e. if they have insufficient funds or if such a call on funds would lead to insolvency). Most sophisticated investors would appreciate that extending is likely the best route because, in practice, it is very unlikely that the company would have sufficient disposable funds to repay the note. However, the same may not be true of all investors. Be careful in picking your investors – particularly if they have not invested using a convertible note before and don’t fully understand the risks and what the situation would likely be in the event the company does not succeed.
(8) What type of shares will the note convert into?
Generally, this will be either ordinary shares or the same class of shares that are issued to other investors at the round. It’s favourable for the investor to receive the same class of shares as those issued at the round because they will generally be preferred shares and carry such rights (i.e. protection of liquidation preference etc.). It’s important for founders to understand this clause because they are potentially increasing the size of any liquidation preference (see this post) they create on a future round.
The above points are by no means exhaustive but hopefully they provide a useful primer. I’d recommend founders run any detailed points past a lawyer and get legal advice before entering into any agreements.
It goes without saying that the valuation placed on a company is a key variable forming part of any negotiation at a financing round. However, I’d argue that terms can matter more. This is never more true than when considering a VC favourite, the “liquidation preference”.
What is a liquidation preference?
A liquidation preference is a right that can be required by investors in respect of their capital contribution (i.e. their investment amount). It is a common right given to preference shareholders. It effectively provides a mechanism by which they can receive a certain amount before other shareholders on some form of liquidation event (this often also covers winding up, merger and acquisition). The amount they will receive could be equal to the amount they invested (typically referred to as 1x), or some multiple thereof, depending on the terms negotiated.
What’s the impact?
This largely depends on the drafting of the liquidation preference. In particular, whether the liquidation preference is “participating” or “non-participating”.
To explain let’s consider two simplified scenarios:
Company X has received an offer for an investment of £5m from “VC Fund” for its Series A at a £15m pre-money valuation. This will be its first outside investment (good going Company X!). The £5m will be invested in return for preferred shares that, amongst other things, benefit from the right to a 1x non-participating liquidation preference.
In Scenario 1, post investment the equity split amongst investors and founders is as follows:
VC Fund = 25%
Founders = 75%
In Scenario 1, assume the company struggles to achieve traction and fails to raise again and with limited options decides to pursue an exit for £10m.
From a £10m acquisition offer the proceeds would be split as follows:
VC Fund = £5m = 50%
Founders = £5m = 50%
Even though the equity split is 25:75 in favour of the founders, in this scenario, the 1 x non-participating liquidation preference results in a 50:50 split of the acquisition proceeds. This is because VC Fund would choose to get its preferred amount in order to recover their investment rather than participating pro rata with other investors.
Scenario 2— Participating liquidation preference
Assume the same economics as scenario 1 (£5m at a £15m pre) but this time the VC Fund has negotiated a 1 x participating liquidation preference.
The same post investment equity split amongst founders would apply:
VC Fund = 25%
Founders = 75%
Again, assuming a situation transpires whereby a £10m acquisition offer is to be pursued.
In scenario 2, for a £10m acquisition offer the proceeds would be split as follows:
VC Fund = £6.25m = 62.5%
Founders = £3.75m = 37.5%
Again, the VC Fund would elect to maintain its preferred share rights rather than convert into ordinary shares. This results in a significant swing in favour of the VC Fund in terms of returns received.
Participating vs. Non-participating
The two scenarios highlight the difference between participating and non-participating liquidation preferences. The non-participating variant can be thought of as an “either or” clause whereby the investor can receive the amount they invested or their pro rata share of the proceeds. In the above scenario 1 they would choose to receive their preference amount because this is the greater (£5m vs. £2.5m). However, if the acquisition price exceeded £20m the VC Fund would elect to convert its preferred shares to ordinary shares in order to participate pro rata because this would result in a greater return than £5m. This is why non-participating liquidation preferences are often classified as “down-side protection” provisions because they help investors potentially limit their loss on a liquidity event.
The participating variant gives the investor the right to receive their preference amount and their pro rata share of the remaining proceeds. In scenario 2 this results in £5m (1 x their investment amount) plus £1.25m (25% of the remaining £5m). A participating liquidation preference provides down-side protection whilst also giving the investor the right to participate in the upside, hence the “double-dip”.
In addition to non-participating and participating, other terms to look out for in relation to liquidation preferences are:
senior liquidation preferences that stack on top of liquidation preferences that were provided to investors on previous rounds.
multiple liquidation preferences in the above two scenarios we have assumed a 1 x liquidation preference but this could be higher (i.e. 1.5x, 2x etc.)
For a useful maths cheat sheet on the implications of participating, non-participating, senior and multiple liquidation preferences on exit proceeds check out this post.
How is this fair?
Whilst providing any form of preference may seem disproportionately favourable to an investor, let’s consider this for a moment from the investor perspective. Again using my £5m round and £15m pre example from above, a £10m exit is a very poor outcome for an investor and especially so for an institutional VC investor. When you take VC money you’re setting on a course to pursue outsized returns, a £10m exit likely does nothing for a VC with regards to them returning their fund. So although the inclusion of a liquidation preference does provide downside risk protection for an investor it also serves a secondary important purpose – aligning incentives. Without a liquidation preference a £10m exit would be an OK outcome for founders in the event there’s two of them and they each walk with £3.75m (£7.5m / 2) — that’s a pretty nice payday. But with the preference their potential proceeds are reduced significantly. Therefore the inclusion of a liquidation preference also further incentivises the founders to shoot for higher growth and a larger exit outcome and provides an additional mechanism for aligning their interests with that of their investors.
What’s market here?
I don’t like solely looking at “what’s market” and would always rather encourage founders to discuss with their investors why they are looking for certain terms and get a sense for how important they are for them. However, for early stage financings where the company is issuing preference shares, 1 x non-participating is standard. If you’re a founder negotiating an early stage financing round and your investor is looking for participating or a multiple you should ask them to explain why they require this. If what they are asking feels inequitable this may be an area to push back because it could set a nasty precedent for future rounds.
Fenwick and West’s “The Terms behind Unicorn Valuations” analysed the terms of financings undertaken by US based unicorns during the 9 month period ended December 31 2015. The following is interesting to note with regards how liquidation preferences were structured in the surveyed companies documents:
Non-participating liquidation preference over common (ordinary) shares was included in 98% of the equity documents
Participating liquidation preference was in 6%
Senior liquidation (preference over common and other series of preferred stock) was in 21%
Multiple liquidation preference was in 6%
Hopefully the above illustrates why I think terms matter more than (or at least as much as) valuations and why it’s so important for founders to appreciate this and go into financing discussions armed with this knowledge.
Startups rarely (if ever) go perfectly to plan; things often go wrong and life throws up all sorts of scenarios that can have an impact. Sometimes things get so bad that founding teams split up. The chances of this are often increased where you have large founding teams formed in a short period of time (i.e. when the team haven’t really worked together before). Regardless of the size of your team and the likelihood of a founder fallout, how big an impact such a split has on your startup can make or break it. This is where vesting comes in.
One of the primary drivers behind the idea of vesting is to help reduce the impact of a co-founder leaving by ensuring they don’t leave with a disproportionate amount of equity. How this often works is that founder shares vest over time. So, as a founder you are 100% vested when you “own” 100% of the shares that have been allocated to you. For example (very simplified):
if you have a straight-line (meaning you vest daily a proportion of shares) vesting schedule in place over 4 years and you started vesting 2 years ago you will have vested 50% of the shares allocated to you.
Vesting is important to ensure that, should a co-founder leave during the vesting period, there is enough equity left in the company to adequately incentivise the remaining founders and team. This is even more important when you think that the company will likely have to hire someone to replace the departing co-founder and they will likely want a chunk of equity. Often vesting is thought of as solely an investor protection provision requested at the time of a fundraising round. I always advise founders not to think of it purely this way because, as described above, it helps protect against a potentially catastrophic impact of a founder fallout situation for all stakeholders (founders and investors).
Personally, I’m always impressed with founders who think about vesting early on and appreciate the theory behind it. It’s not necessary to worry about the detailed mechanics, your lawyer will incorporate this into the long-form legals when it is required (usually at a fundraising round). Often vesting schedules are set over 3–4 years with some form of a cliff after one year. This means that an amount (often 25%) is deemed to be vested only after one year of continued work (the “cliff”), with the remainder vesting incrementally on a straight line basis over the following 2–3 years. For example (assuming 4 years):
0–12 months = 0% vested
12 months = 25% vested
12–48 months = straight line vesting (i.e. you vest a small amount each day)
48 months = 100% vested
All sophisticated investors will request some form of vesting schedule should you raise a round of financing from them so it’s worth giving some thought to this when you are staring out.
I haven’t really dived into the nitty gritty of specific terms in this post (in particular I haven’t looked at the circumstances around founders leaving (i.e. Good Leaver, Bad Leaver, Acceleration on Exit etc.)). It goes without saying how important it is to fully understand any legal documents and the implication of the terms contained therein.
Tom Wilson 