What does a convertible note bridge financing term sheet look like?

April 27, 2007

CONVERTIBLE NOTE BRIDGE FINANCING

SUMMARY OF TERMS

____, 200_

Company: [___________], a [_______] corporation (the “Company”)

Amount of Financing: Up to $______________ may be issued.

Type of Security: [Secured][Subordinated] convertible notes (the “Notes”).

Purchase Price: Face value.

Interest Rate: Annual interest rate of [___], [payable at maturity][quarterly in arrears].

Convertibility: In the event the Company consummates, prior to the Maturity Date (as defined below) an equity financing pursuant to which it sells shares of its Series [ ] Preferred Stock (the “Series [__] Preferred Stock”) with an aggregate sales price of not less than $_____________, [including][excluding] any and all convertible bridge notes which are converted into preferred stock (including the Notes issued under the Note Purchase Agreement), and with the principal purpose of raising capital (a “Qualified Financing”), then the Note shall automatically convert all principal [and accrued interest] under the Note into the Series [ ] Preferred Stock at [___]% of the price paid by investors in the Qualified Financing. The Note shall convert into shares of Series [ ] Preferred Stock on the same other terms as the other investors purchasing Series [ ] Preferred Stock in the Qualified Financing.

If the Company does not consummate a Qualified Financing prior to ____, 200__, the Notes shall be convertible into common stock at a conversion price of $___ per share.

Term; Prepayment: The day that is [one year] following the date of the Note (the “Maturity Date”). All principal and accrued interest under the Note is due and payable on the Maturity Date. The Note may [be prepaid at any time without penalty upon five days prior written notice to the Holder][not be prepaid without the consent of the Holder]. [Any prepayment must be made in connection with the prepayment of all Notes issued under the Note Purchase Agreement.]

Payment on Liquidity Event: If a Liquidity Event occurs before repayment or conversion of the Note into equity, the Company will pay the holder of the Note an amount equal to _____% of the outstanding principal amount of the Note plus any accrued interest due under the Note upon the closing of such Liquidity Event. For purposes of this provision, a “Liquidity Event” shall mean (a) a merger of the Company with or into another entity (if after such merger the holders of a majority of the Company’s voting securities immediately prior to the transaction do not hold a majority of the voting securities of the successor entity), (b) a sale by the Company of all or substantially all of its assets or (c) the closing of the Company’s first firm commitment underwritten public offering of the Company’s common stock registered under the Securities Act of 1933, as amended.

Warrant Coverage: ________% coverage with warrants to purchase Series [ ] Preferred Stock at the Series [ ] Preferred Stock price per share, exercisable for [three (3) years] from the Closing of Financing. The right to exercise the Warrant shall terminate upon a Liquidity Event.

Closing: ________, 200__. A first closing will be held on or before _______, 2007 or such other date that the Company and the bridge investor(s) participating in such closing mutually decide upon. Additional closings may be held up to 90 days after the first closing at the option of the Company.

[Subordination: The Note shall be subordinated to all indebtedness of the Company to banks, commercial finance lenders, insurance companies, [leasing or equipment financing institutions] or other lending institutions regularly engaged in the business of lending money [(excluding venture capital, investment banking or similar institutions which sometimes engage in lending activities but which are primarily engaged in investments in equity securities)], which is for money borrowed, [or purchase or leasing of equipment in the case of lease or other equipment financing,] whether or not secured.]

[Security Interest: The Notes will be secured by all assets of the Company[, excluding intellectual property].

Note Purchase Agreement: The Notes will be [(i)] issued pursuant to a definitive Note Purchase Agreement containing customary covenants and representations and warranties of the Company [and (ii) secured pursuant to a Security Agreement].

Amendment: Holders of a majority in interest of the principal amount of the Notes may amend or waive any provision of the Notes and such amendment or waiver shall be binding on all holders of the Notes.

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

Comments

  • Ben

    Thank you so much – I have been looking everywhere for exactly this type of “form” term sheet, but you are the first person who has published anything remotely useful. Keep up the great work!

  • sam

    In a convertible loan, what is the most common ratio for a start-up? How do you plan your shareholding structure? Do you carve out a % for each investor? How does the dilution work?

  • http://www.startupcompanylawyer.com Yokum

    Not sure I understand the questions. You basically need to build a spreadsheet to model percentage ownership of the bridge investor depending on the valuation in the next round of financing.

  • DL

    If you are offreing a discount of 30% at the conversion of Series A price… does that get listed in the convertability section as

    … the Note shall automatically convert all principal [and accrued interest] under the Note into the Series [A ] Preferred Stock at [__70_]% of the price paid by investors in the Qualified Financing.

    Also if the discount vehicle is in the form of a Warrant… is there still an additional expectation on the part of investors for additional Warrant Coverage… or is this kind of an either / or in the above doc.

    Thanks

  • http://www.startupcompanylawyer.com Yokum

    @DL. Yes. 30% discount is written as 70% of what investors pay. Conversion discount and warrant coverage are not necessarily mutually exclusive, but serve the same economic goal. Generally you should pick one or the other.

  • DL

    Hi

    Is there much diffrence between the MOU and the actual Convertible Note Purchase Agreement. for the deal. Do you have an example of a Convertible Note Purchase Agreement handy or a link to one by chance so I know what to expect.?

    thanks

  • http://www.startupcompanylawyer.com Yokum

    @DL. The documents for a typical convertible bridge note financing include a Note Purchase Agreement and a Note. There is sometimes a Security Agreement and a Warrant depending on the terms. Your legal counsel should be able to provide you with sample forms.

  • sam

    I believe a MOU is used to set out the main terms of understanding, usually to be incorporated into an agreement. It is unlike an agreement which has details.

  • sam

    There may be samples of a note purchase agreement on the internet.

  • Amit

    First–Thank you for the great insight.

    I am starting an LLC medical implant company with a low starting investment to get on the market ($50-60k). The interested investor (a surgeon) would be my first customer and can make my business cash positive on his business alone. I really do not think that a subsequent round of funding will be required and my exit strategy is to be acquired. I am brainstorming on equity and debt structure as it is too early in the startup to rely on the embryonic growth a 3 or 5 year financial plan would involve. Thus I've been thinking about convertible debt financing for this reason.

    1. In your experience, what interest rate should I include in a convertible note? I saw a post that recommended 7-10% but that seems low to me.

    2. Is convertible debt appropriate for an LLC?

    3. How do you set up someting equivalent to a “maximum conversion valuation” if you aren't planning another financing round? I want to minimize the conflict of interest that convertible debt can raise.

  • http://www.startupcompanylawyer.com Yokum

    @Amit,

    1. Investors investing in technology companies don't invest for the interest. They invest for the equity upside. Exact amount of interest doesn't matter to most investors. I never get concerned about the exact interest rate.

    2. I don't like dealing with LLCs for startup companies. Because of the flexibility, there is no “off the rack” method for converting debt into a membership interest in a LLC. This leads to “reinventing the wheel” and higher legal fees.

    3. Set a backstop conversion mechanism where the note converts into equity at a pre-set valuation at the option of the holder.

  • Kevin

    Do you need to deal with reg rights (with respect to the underlying preferred shares) at the time of issuance of the convertible notes, or do the convertible note investors simply get (upon conversion) whatever reg rights are granted at the time of the issuance of the preferred?

    Also, do you need to build into the notes, the note purchase agreement, or elsewhere, a provision whereby the note holders agree to enter into a shareholder agreement (with, e.g., transfer restrictions) at the time of conversion into preferred (or possibly common) shares?

  • http://www.startupcompanylawyer.com Yokum

    @Kevin – Convertible note investors get whatever registration rights the investors in the preferred round get. Yes, the note holders need to agree to sign the same documents as other investors in the preferred round.

  • http://twitter.com/zacksteven Zack Steven

    Thanks so much for posting this. Very helpful!

  • charliehatfield

    I have a LLC company and want to do a friends and family round of investing. Do you usually use a convertible note for Friends & Family if not what method do you recommend. Second, does the convertible note need to be filed with the state or some governing body?

  • http://www.startupcompanylawyer.com Yokum

    @charlie,

    1. In my practice, we typically do not do financings of LLCs. The concept of a convertible note doesn't map over well into an LLC. Generally speaking, convertible notes are the preferred mechanism from the company's perspective for an early stage angel financing.

    2. The convertible note does not need to be filed anywhere. There may need to be securities law filings, however.

  • Zack

    Yokum — Thank you so much for the amazing website. There is so much great information here.

    I have a follow up question about the interest rate on the convertible note. I understand that for an early stage non-cash flowing business the interest would usually not actually be paid and would simply accrue. My question is, does the accrued interest get included in the amount that gets converted?

    That is, if there is a $100k convertible note with a 10% interest rate and a 20% discount on conversion. If the conversion happens after 1 year at $1/share. I understand that the 20% discount means the convertible noteholder would get to convert at $0.80/share. My question is, does s/he get to buy $100k worth of shares or $110k worth of shares (e.g. the note amount + accrued interest) at $0.80/share? Or is the accrued interest only payable if the note reaches maturity and does not convert ?

    It seems to me that, if the convertible noteholder converts the amount including the accrued interest that the interest rate would still be very relevant. Am I missing something ?

    Thanks again. This is the first time I've had the guts to write you a question/comment but I love your site! =)

  • http://www.startupcompanylawyer.com Yokum

    @Zack – Whether the interest is converted or not is a negotiable point. Typically, the interest is also converted, but occasionally, some investors prefer to have the interest paid in cash at conversion.

  • kittygiusio

    so if i want to isue a convertible note to an investor, i need this document as well as a note Purchase Agreement? So I need two (2) documents to accomplish this? ie secure this financing?
    Thanks!
    Kitty

  • http://www.startupcompanylawyer.com Yokum

    @Kitty – you need to engage an attorney to deal with your questions.

  • http://www.startupcompanylawyer.com Yokum

    @Kitty – you need to engage an attorney to deal with your questions.

  • Castor66

    Yokum,

    My situation is similar to Charliehatfield's as described above – I'd like to do seed financing from family and friends, and want to structure it as convertible debt.

    Prior to considering convertible debt though for the friends/family financing, I've been leaning towards the LLC as the company's legal structure. Can you help me understand why you don't typically do financings of LLCs?

    It seems to me that if I'm dealing with friends and family, and am not going to do a 2nd round of financing, it'd be nice to stay with the LLC structure and therefore still have liability protection, while avoiding corporate income tax.

    If I need to be talked out of doing this as an LLC, I'd just like to understand the reasons why – as the best of both worlds scenario I envision is keeping the LLC and doing convertible debt financing.

    Thanks,

    Josh

  • CuriousEntrepreneur

    Yokum – great site! quick question on conversion discount & warrant coverage: can you elaborate on the reason(s) why one should pick one or the other but not both. Thanks.

  • allison447

    Yokum,
    Thanks a lot. Can we write a tentative agreement using such documentation with referral investors? My chosen numbers using terminology such as automatic conversion at 75%, $1.00 par price conversion, 150% liquidity event, and 70% warrant coverage. Is this going to make a non financial entrepreneur like a versatile manager (goal), or a vacuous goof (potential)?