Burkland Associates Convertible Note Presentation

Convertible NotesConvertible Notes

Jeff Burkland

© 2014 Burkland Associates. Proprietary and Confidential

About the Speaker – Jeff Burkland

• Relevant Background– Part-time CFO for multiple startups– Part-time CFO consulting company– Invest in startups

• Other Background– Started and sold a company– Harvard MBA

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Objectives

• Audience– Who is out there?

• Stage of company– What do you want to get out of this discussion?

• Speaker Style

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Convertible Notes - Overview

• A Fundraising Tool• Example Using Numbers• Other Key Terms• Pros and Cons vs Priced (equity) Round• Priced Round Datapoints• Convertible Equity

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A Fundraising Tool

• Increasing in popularity• Convertible Note vs Priced Equity• Typical convertible note is used to raise between $200k and $1m

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Let’s understand the details so we can see the big picture….

Example

$500,000 in convertible notes paying 5% interest with a $4 million pre-money cap and a 20% discount.

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Example


Amount to be raised in the Note

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Example


“Notes” are a loan, or “debt.” Not quite equity...

…although they will be allowed to “convert” into equity in some circumstances, typically next equity round or sale of firm.

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Example


Same as interest on a loan, but usually accrued rather than paid in cash because startups are low on cash. Typically paid on acquisition or used in value of conversion.

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Example


• In this case, the founder might think the company is worth $4-5M while the investor thinks it’s worth $2-3M. So rather than argue over the value of equity they negotiate debt with a $4M cap.

• In this example, the cap is expressed as a cap on the pre-money valuation before the cash from the investment which causes the conversion.

• Be careful not to call a cap a “valuation.” It’s something different (that avoids a valuation).

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Example


The “and” you usually see is a bit misleading grammatically. Typically it means the investor can exercise his/her cap OR discount, whichever leads to the best results. We’ll walk through two examples…

The note investors can convert into equity at 20% less than the price of the next equity round or a sale of the firm.

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If the pre-money valuation in the next equity round is $4.5M and $1M of new money is raised, the noteinvestors get (ignoring interest):

Example


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( )

• Discount,= Fixed $ value. % ownership dependent on pre-money and new $ amount

= 11.4%or 11.4%x$5.5M post = $625K

Note Value100%-Discount

$500K100%-20%

( )=

Post-Money=

$4.5M+$1M

= Note ValueCap

x (100% – New Investor Ownership) = $500K$4M

x (100% - )$1M$4.5M+$1M

• Cap,= Amount purchased via cap reduced by new investor dilution

= 10.2%or 10.2%x$5.5M post = $563K

In this scenario, the investor would use the discount to get the most value.

NOTE: This is a common method. There are other methods that lead to different results - remember this is a contract.

If the pre-money valuation in the next equity round is $6M and $1M of new money is raised, the noteinvestors get (ignoring interest):

Example


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• Cap,= Amount purchased via cap reduced by new investor dilution

= 10.7%or 10.7%x$7M post = $750K

= Note ValueCap

x (100% – New Investor Ownership) = $500K$4M

x (100% - )$1M$6M+$1M

• Discount,= Fixed $ value. % ownership dependent on pre-money and new $ amount

= 8.9% or 8.9%x$7M post = $625K.

( )Note Value100%-Discount 100%-20%

( )=

Post-Money=

$500K

$6M+$1M

In this scenario, the investor would use the cap to get the most value.

NOTE: This is a common methods. There are other methods that lead to different results - remember this is a contract.

Other Key Terms• Term - 1 yr or up to Series A closing. • What occurs at term

– Silent– Convert at “cap” valuation– Due in full

• Security – In a default, debt gets paid before equity• Conversion

– Automatic– Optional

• Warrant coverage (optional)– Warrants are essentially long-dated options– Used instead of discount (very rarely in addition to discount)– Becoming much less common in Convertible Notes– “15% warrant coverage” means for every $100 in notes you buy, you get an option to

purchase $15 worth of equity. Usually, the strike price is at the valuation of the next priced round. It gets complicated. Simplest approach is to think of it in much the same way as a discount.

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Convertible Note - Pros and Cons• Pros

– Some say cheaper because of simpler contracts– No equity rights (ex voting, Board, and fiduciary duty) before conversion

• Cons– Downsides of debt before conversion

• Paid before equity• Can force bankruptcy if can’t be paid when required and holders won’t negotiate• Does not decline in value in a down round

– Next round equity investors might require a renegotiation of the note’s terms– There is a case where a cap on a round with a participating preference can

cause a substantial windfall to note-holders• Confusion of “cap” and “valuation”. Can be good or bad.• Not always better or worse than equity. Depends on the risks, terms, and

company factors.

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Recommendation for most Friends & Family and Seed Rounds: Lead with a Convertible Note. Let a whale lead a priced round if they want. Consider excluding a cap.

Choosing Conv. Note or Equity – Back to the Example

• $4.5m pre-money next rounda) Investors end up with 11.5% (early noteholders) + 18% (next round priced money) = 29.5%. Original equity holders

end up at 70.5%b) Investors at 16.5% (first round, diluted by second round) + 18% (next round) = 34.5%. Original equity at 65.5%5.0% advantage to Original Equity (Founders) using Convertible

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This is why company factors are so important – what is the backup to little to no valuation increase or a down round? Can a cap be excluded?

Compare 2 seed scenarios…a) $500,000 Convertible, 5%, $4 million pre-money cap, and 20% discount

vsb)$500,000 Priced at $2m pre-money

… after raising $1m next round:

• Break-even point: ~3M pre-money next round valuation

• $2.5m pre-money next rounda) Investors end up with 18% (early noteholders) + 28.5% (next round priced money) = 46.5%. Original equity

holders end up at 53.5%b) Investors at 14.5% (first round, diluted by second round) + 28.5% (next round) = 43%. Original equity at 57%3.5% advantage to Priced Round

Convertible Notes at the Extremes

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• Down round and Large Notes– Equity*- Founders & previous investors absorb the value decline proportionally.

– Convertible Note - Founders absorb the decline.

* We assume no anti-dilution clause. Some anti-dilution clauses can behave like a convertible note on down rounds.

Priced Round?

• What if you want to go with a priced round?• Subject of another seminar to fully explore• That said, next are some datapoints

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Stages of Development and Funding

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Round Company Stage

Data Risk Value Return

Friends & Family

IncorporationEarly development

Soft data; value proposition; projections

Sky High $500k-$2M

20X +*

Seed Development Tech Validation, time to market, beta rev/traction

Extremely high

$2M-$4M 10X +

Series A Shipping product

Early Revenue/ Traction

Very High $4M-$10M 10X

Series B Shipping product

Predictive RevPath to CF+ or Significant Traction

High $10M+ 5X – 10X

Later-Stages Shipping product, profitable

Hard data, EBITDA, net income

Lower - Moderate

$20M+ < 5X

* Friends and Family are not always motivated only for the financial returns, though.

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A Real World Example: Which Option Would You Choose?

Managing to near term valuation is not always the right answer; raising more money sooner bought more runway which led to overall higher valuation. Additional dilution outweighed by greater economic value.

Option A Option BSeries A Pre $3.5 $4.5

$ Raised $4.0 $2.0

Post $7.5 $6.5

Original Owners’ Ownership % 47% 69%

Series B Pre $20.0

$ Raised $15.0

Post $35.0

Original Owners’ Ownership % 40%

Original Owners’ Ownership $ $13.85

Series B Pre $60.0 $20.0

$ Raised $15.0 $15.0

Post $75.0 $35.0

Original Owners’ Ownership % 37% 40%

Original Owners’ Ownership $ $28.0 $13.85

Convertible Equity

• Like Convertible Note, without the debt• Fairly new• Appears to be growing in use• No bankruptcy downside• Might allow investors to start the capital gains clock at issuance of convertible equity• Probably more appropriately aligned with intent of friends and family• Subject of another seminar

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Recommended, IF your fundraising approach can handle something fairly new

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Parting Thoughts

• More cash is preferred to less cash

• Cash sooner is preferred to cash later

• Less risky cash is preferred to more risky cash

• Don’t run out of cash

Principles of Financing StrategyPrinciples of Financing Strategy**

* William Sahlman, Harvard Business School, January 2007

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Thank you for your participation today

Jeff BurklandFounder and PrincipalBurkland Associates645 Harrison St., #200San Francisco, CA 94107

(415) 944-8215 [email protected]

Please direct questions and feedback to:Please direct questions and feedback to:

Extra SlidesExtra Slides

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Control – I need 50% ownership to control, right?

Not that simple…•Fiduciary Duty typically applies as soon as you sell the first share, even if you keep 99%.

– You are obligated to optimize value or face shareholder lawsuits– Called “Minority Shareholder Rights.” Generally stronger in the U.S. Ask anyone who’s

invested in Russia. Even Western Europe more casual vs U.S.– Keep you from buying 51% of company then selling assets to yourself for $1. Taking

boondoggles with company funds. Etc.– Therefore, operational control means only that you get greater latitude in determining

what is optimal. You can’t do whatever you want, that requires 100.0%.•Mechanisms to maintain operational control.

– Preferred shares typically don’t have the same voting rights as common, so founders might not face as much pressure from them. In big corporations, preferred shares often have no voting rights, but most startup investors insist on some.

– Other classes of shares can separate economic rights from voting rights. Facebook did this but most tech firms don’t have the sway to pull off. Especially at the VC level, they want the right to fire you.

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Small Business & Entrepreneurship

Burkland Associates Convertible Note Presentation