Top 5 Tweets

1. Your Startup’s Top 3 Priorities (via @ttunguz)  http://bit.ly/L3H6hv
2. “As CEO of Evernote, I don’t care whether there’s a bubble or not…”  -@plibin  http://on.wsj.com/JeMlyN
3. “[F]irst-time entrepreneurs often fail to realize that when you build something new, no one will care.” -@cdixon  http://bit.ly/M3aNSe
4. “The best CEOs send out short but focused weekly updates to their boards.” -@bfeld  http://bit.ly/M18S0i
5. “As the saying goes, find a job you love and you’ll never work a day in your life.” -@claychristensen  http://bit.ly/KoeKPP

Blog-Related

1. In case you missed it, I just uploaded my TechCrunch post — Convertible Note Seed Financings: Founders Beware!  http://bit.ly/J7kvVj
2. Congrats Zuck!  http://bit.ly/MB5egz

This week, in celebration of Facebook’s initial public offering tomorrow, we again present Mark Zuckerberg, an amazing, inspirational entrepreneur.  Congrats Zuck!  All the hard work and perseverance has paid-off.

http://www.youtube.com/watch?v=v32AABzvCyc

This post is the third part of a three-part primer on convertible note seed financings.  Part 1, entitled “Everything You Ever Wanted To Know About Convertible Note Seed Financings (But Were Afraid To Ask),” addressed the basics.  Part 2, entitled “Convertible Note Seed Financings: Econ 101 for Founders,” addressed the economics.  This part will address certain tricky issues.

[This post was originally published on TechCrunch.]

What Happens If a Startup is Acquired Prior to the Note’s Conversion to Shares of Preferred Stock?

As discussed in part 1, in the context of a seed financing, a convertible note is a loan that typically automatically converts into shares of preferred stock upon the closing of a Series A round of financing.  One of the tricky issues that founders must address in the note is what happens if their startup is acquired prior to the note’s conversion (and prior to the note’s maturity date, as discussed below).  There are generally three different approaches:

1)  Money Back, Plus Interest (Founder-Friendly).  The first approach is the most founder-friendly, and it is a provision that merely requires the startup to pay-off the loan, plus interest.  In other words, in the event of the startup’s “acquisition” (which is often broadly defined to include a merger, change of control or sale of substantially all its assets), the maturity date of the note would be accelerated, and the amount of the loan, plus interest, would become due at the closing of the acquisition.  Obviously, this is not very appealing to sophisticated investors because their return on a high-risk investment would only be the interest on the loan, which (as discussed in part 2) is typically 5%-7% annually.  In Fenwick & West’s 2011 Seed Financing Survey (the “Fenwick Survey”), the percentage of convertible note seed financings that utilized this approach was 17% in 2010 and 9% in 2011.

2)  Conversion Right (Investor-Friendly).  The second approach is the most investor-friendly, and it is a provision that permits the noteholders to convert the notes into equity (or otherwise grants them a certain percentage of the sale proceeds), based on an agreed-upon valuation of the startup.  There are variations and complicated language that are typically negotiated to address the conversion right; however, the bottom line is that the noteholders would be able to share in any upside if the startup were acquired.

For example, let’s assume that the noteholders invested $500,000 and were granted the right to convert into shares of common stock at a $4.5 million valuation in the event the startup were acquired prior to the Series A round (or other “qualified financing”).  If the startup were then acquired for $20 million, the noteholders would receive $2 million or 10% of the proceeds (not including accrued interest), by converting the $500,000 loan into shares of common stock representing 10% of the issued and outstanding shares, post-conversion ($500,000 divided by the sum of $4,500,000 and $500,000).

In the Fenwick Survey, the percentage of convertible note seed financings that utilized this approach and thus granted the noteholders a right to convert at an agreed-upon valuation was 33% in 2010 and 65% in 2011.

3)  Premium (Intermediate Approach).  The third approach is generally deemed an intermediate approach, and it is a provision granting the investors the right to get their money back with interest, plus a premium, which is typically drafted as a multiple of the principal amount of the loan (generally in the 0.25x to 1.50x range).  Using our example above, and assuming a 1.0x premium, the noteholders would receive $1 million, plus interest, computed as follows: $500,000 (principal amount) plus $500,000 (premium) plus interest, which is obviously $1 million less than investors with a conversion right would receive.

Notice, however, that this so-called intermediate approach can actually be the most beneficial to noteholders (and the least beneficial to the founders) if the startup were sold for a relatively low price.  Using our example above, but dropping the purchase price to $7 million, we can see that the noteholders would receive (i) $700,000 (10% of $7 million), plus interest, if they converted the note into shares of common stock; and (ii) $1 million, plus interest, if they were granted a 1x premium (an additional $300,000).  This is why many sophisticated investors will push for both a conversion right and a premium, with the right to choose the higher amount.  (Sophisticated investors will also push for a provision prohibiting the pre-payment of the loan to prevent an end-run around the second and/or third approach.)

In the Fenwick Survey, (i) the percentage of convertible note seed financings that granted the noteholders a right to receive a premium was 50% in 2010 and 61% in 2011; (ii) the median premium was 0.75x in 2010 and 1.0x in 2011; and (iii) the percentage of convertible note seed financings that granted the noteholders both a conversion right and a premium was 0% in 2010 and 35% in 2011. 

What Happens If the Maturity Date Is Reached Prior to the Note’s Conversion to Shares of Preferred Stock?

This is another tricky issue.  Founders must not forget that a convertible note is a loan and, like most loans, has a fixed due date (or “maturity date”) for repayment of the total amount borrowed, plus interest.  Convertible notes are thus ticking time bombs: if the maturity date is reached, and there hasn’t been a Series A round (triggering the automatic conversion of the notes into shares of preferred stock), there is the potential for disaster.

The maturity date for convertible notes typically ranges from 12 to 24 months from the closing date, with 18 months being the most common.  In the Fenwick Survey, the median term was 18 months in both 2010 and 2011.  Accordingly, a startup that has issued convertible notes as seed financing will generally have an 18-month window in which to close a Series A round.  If the company is unable to do so during such period, it will generally be required to repay the loan, plus interest, or otherwise be in default under the note; in which case, the noteholders may force the company into bankruptcy.

As discussed below, there are two ways a startup can avoid this nightmare scenario: (i) include a provision in the note that requires an automatic conversion of the loan, plus interest, into equity on the maturity date; or (ii) negotiate an extension of the loan (i.e., a new maturity date) with the noteholders.

1)  Automatic Conversion.  Founders can often convince “friends and family” and less-sophisticated investors to agree on an automatic conversion into shares of common stock in the event that there hasn’t been a Series A round prior to the maturity date.  Sophisticated investors, however, will push back hard against such a provision.  From their perspective, requiring the loan (plus interest) to convert automatically into shares of common stock (or a new series of preferred stock) upon a default arguably rewards the founders and removes the significant leverage and rights the noteholders would have as creditors of the startup.  Indeed, in the event of the startup’s bankruptcy or an assignment for the benefit of creditors, the noteholders would have priority (i.e., be ahead of the stockholders) with respect to any payments or distribution of assets.  Moreover, the noteholders would likely have the leverage to negotiate a conversion into equity on terms satisfactory to them regardless of the terms of the note.

The Fenwick Survey does not address the percentage of convertible note seed financings that required the notes to convert automatically into equity at the maturity date.  It is interesting to point out, however, that the convertible notes issued by Y Combinator companies to the Start Fund include an optional conversion upon maturity into Series AA Preferred Stock based on a $5 million valuation (see post here).

2)  Loan Extension.  The second approach — negotiating an extension — is more common and obviously depends on a number of different factors, including the startup’s financial condition and prospects, the market conditions, the relationship between the founders and the investors, etc.  Moreover, for an extension to work from a practical standpoint, it is often necessary that the note include a provision permitting its amendment or a waiver of its terms upon the written consent of a majority of the holders (based on the principal amount outstanding).  Founders and company counsel sometimes miss this issue, and it later comes back to haunt them – when one minor noteholder ends-up holding the negotiations hostage.

Does a Startup Have to Comply with Any Securities Laws in Connection with the Issuance of Convertible Notes?

Yes, a convertible note is a “security” under federal and state securities laws.  Accordingly, founders must understand that, even though a convertible note is debt upon issuance, it is no different than issuing shares of common or preferred stock for purposes of securities-law compliance.  Needless to say, a comprehensive discussion of applicable securities laws is beyond the scope of this post; however, here are two key takeaways for founders: (i) make sure all the noteholders are “accredited investors”; and (ii) don’t compensate anyone for helping you raise funds unless they’re a registered “broker-dealer.”

1)  Accredited Investors.  The rule of thumb in connection with private placements (like a convertible note seed financing) is to issue securities only to accredited investors in reliance on Rule 506 of Regulation D of the Securities Act of 1933.  There are two significant reasons for this:  First, Rule 506 preempts (or overrides) state securities laws – which means that a startup doesn’t have to spend a lot of time and money dealing with applicable state securities commissions (other than preparing and filing a Form D).  Second, there is no written disclosure requirement, like a private placement memorandum, if the investors are accredited.

There are eight categories of investors under the current definition of “accredited investor,” the most significant of which for seed financings is an individual who has (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase, not including the value of their primary place of residence; or (ii) income exceeding $200,000 in each of the two most recent years (or joint income with a spouse exceeding $300,000 for those years) and a reasonable expectation of such income level in the current year.

2)  Broker-Dealers.  There are lots of companies, individuals, websites and other so-called “finders” offering to help startups raise funds.  Founders must understand, however, that if a finder is receiving some form of commission or other transaction-based compensation (which is often the case), the finder will generally be deemed a broker-dealer and thus will be required to be registered with the SEC and applicable state commissions. If the finder is not registered as so required and sells securities on behalf of a startup, the private placement will be invalid and the startup will be in violation of applicable securities laws.

For example, in August 2011, the California Department of Corporations issued a formal consent order against Profounder (a crowdfunding site that recently shut down) to “desist and refrain” from engaging in securities transactions without registering as a broker-dealer.  Accordingly, any startup that raised funds via Profounder runs the risk of having violated applicable federal and state securities laws by utilizing an unregistered broker-dealer.  (Note: Pursuant to the recently-enacted Jumpstart Our Business Startups Act, certain sites will be permitted to register with the SEC as a “funding portal” in lieu of a broker-dealer, provided that certain other requirements are met.)

The bottom line is that founders must be very careful any time they are taking other people’s money.  Non-compliance with applicable securities laws could result in severe consequences, including a right of rescission for the investors (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution.

Top 5 Tweets

1.  The Education of Mark Zuckerberg (NYTimes) – “He has a higher ask-to-talk ratio than anyone I know.”  http://nyti.ms/KBObbH
2. “We gave up too early.” -@choxi  http://bit.ly/JkjEwD
3. As Dewey Collapses, Partners and Retirees Face Big Financial Losses – “How could this have happened?”  http://nyti.ms/J0q1Jl
4. “WE HAVE MET THE ENEMY… AND HE IS US” – searing report via the Kauffman Foundation on the VC industry  http://bit.ly/IUzdNl
5. Facebook IPO Jackpot: What Everyone is Worth on Paper  http://on.wsj.com/L6wnXN

Blog-Related

1. In case you missed it, here’s part 3 of my TechCrunch series on convertible note seed financings:  http://tcrn.ch/JbGRj5
2. I just uploaded this interesting vid interview of Matt Cohler, a very impressive entrepreneur and investor:  http://bit.ly/JiyGEa
3. I just uploaded my new Forbes post — Fundraising 101: Checklist for Entrepreneurs  http://bit.ly/KMZ33x
4. New motivational vid post: “It Is My Duty”  http://bit.ly/J5DQSj

This week, in tribute to Mother’s Day, I am sharing this special video.  I too lost my mother a few years back, and I too am deeply grateful to her for all she taught me.  My mother was indeed an amazing woman and touched so many lives as a kindergarten and first-grade teacher for 30 years.  I’ll always remember her favorite words of advice to my brother and me: “Be kind and caring to others, and you’ll realize how rewarding life is.”  I miss you, Mom.

To Our Clients & Friends:  Welcome to our weekly series “Helping Entrepreneurs Succeed.”  Each week, we share a favorite video of a successful entrepreneur, investor or business leader on a variety of topics.  This week, we present Matt Cohler, a General Partner at Benchmark Capital and an impressive entrepreneur and investor.   Matt previously served as the VP of Product Management at Facebook (where he was the seventh employee) and Vice President and General Manager at LinkedIn (where he was a member of the founding team).

In this interesting, 20-minute interview via TechCrunch, Matt provides some solid advice and insight, including the following:

1)  With respect to funding, entrepreneurs need to ask themselves two very important questions: (i) whose money is the investor investing — his or someone else’s? and (ii) what has the investor done in the past (what role has he played) to build really great companies?

2)  Think of funding as a “continuum” – i.e., think of your funding today in terms of the funding you’re going to take in the future and how they interrelate.

3)  We don’t have an “innovation” problem in Silicon Valley, we have an “aspirational” problem.

4)  Great entrepreneurs think big and don’t focus on minimizing downside risks; instead, they focus on maximizing upside potential.

I hope you enjoy it.  Many thanks, Scott

I’ve been a corporate lawyer for 18+ years, and there are certain fundamental mistakes that I’ve seen entrepreneurs repeatedly make in connection with fundraising.  Accordingly, I thought it would be helpful to provide a simple checklist tailored to first-time entrepreneurs.  I’ve also included links to prior posts for a detailed discussion.

1.  Do your homework and determine which investors are the right fit for your startup (see post here).

2.  Hustle and build relationships in order to get warm introductions to those investors (see post here).

3.  Optimize for people, not valuation (see post here).

4.  Only raise money from friends and family as a last resort (see #1 in post here).

5.  Get references and speak with other entrepreneurs and founders who have done deals with your prospective investors (see post here).

6.  Limit your pitch deck to 10 slides or less, tell a story and demo your product (see post here).

7.  If it’s a seed round, issue convertible notes (see post here).

8.  Don’t solicit investors via Facebook, LinkedIn or Twitter (see posts here and here).

9.  Only raise funds from “accredited investors” (see post here) and make sure your lawyers file a Form D with the SEC and applicable state commissions (see post here).

10.  Don’t pay anyone a commission for raising funds for you unless they are a registered broker-dealer (see post here).

To Our Clients & Friends: Welcome to our weekly series “Helping Entrepreneurs Succeed.”  Each week, we share a favorite video of a successful entrepreneur, investor or business leader on a variety of topics.  This week, we again present Phil Libin, co-founder and CEO of Evernote, and a bright and engaging entrepreneur.

In this interesting keynote address at the recent TNW conference, Phil discusses, among other things:

• the wrong reasons to start a company – i.e., (i) money, (ii) power, (iii) boredom and (iv) flex time;
• the only “legitimate” reason to start a company – i.e., to change the world;
• the definition of “entrepreneurship”; and
• the five factors that make this the best time in history to start a company.

I hope you enjoy it.  Many thanks, Scott

Top 5 Tweets

1. “One of our Seed…investors decided to not participate pro-rata in the A Round because of our 4-day week.” @ryancarson  http://bit.ly/IQGs6Y
2. Why one company is making all its employees learn how to code   http://bit.ly/JLC6Tt
3. “HTML 5 is going to change everything…every pixel can be an app.” -@Moonalice  http://bit.ly/JhGEds (at 1:25)
4. “There are now far more capable lawyers and law firms than there is work for them to do.” -Michael Trotter  http://nyti.ms/Ke3J1q
5. “The VC industry is contracting and consolidating swiftly…” -@greels1   http://bit.ly/Izpw5Q

Walker Blog-Related

1. In case you missed it, I uploaded my Saturday TechCrunch post on the economics of convertible notes to my blog:  http://bit.ly/I6d0fQ
2. New motivational vid post: “I Would Just Stay Up All Night and Read the Manuals” (via Mark Cuban)  http://bit.ly/IFlnPs

Welcome to our weekly series “Motivational Clips for Entrepreneurs.”  Each week, we post a favorite video clip to inspire and motivate entrepreneurs.  Why?  Because we know how tough it is being an entrepreneur; and whether you’re launching a venture, trying to execute your business model or raising funds, you need a little juice to help you push the ball forward.  Indeed, I hope this video about Mark Cuban (an amazing entrepreneur) is a little juice.  Cheers, Scott

http://www.youtube.com/watch?v=x6Xt1lcKPgs

Top 5 Tweets

1. Peter Theil: “To understand…startups in 2012, you have to do the truly contrarian thing: you have to think for yourself.”  http://bit.ly/HLra1Z
2. I’m proud of the team that I’ve built at my firm:  http://bit.ly/IRdsjY
3. “I don’t think these big VC seed programs benefit anyone.” -@cdixon   http://bit.ly/Jk6CRo
4. “[A] number of the startups who took VC money in their seed stage are now running into signaling issues…” -@eladgil  http://bit.ly/J08ywu
5. JOBS Act – Frequently Asked Questions via the SEC  http://1.usa.gov/ISt5Wb

Walker Blog-Related

1. Here’s my new TechCrunch post — Convertible Note Seed Financings: Econ 101 for Founders  http://tcrn.ch/I0nhIG
2. New motivational vid post for entrepreneurs: “This Kid is a Genius”  http://bit.ly/I972u8
3. I just uploaded this brief vid of VC David Hornik discussing what makes a great pitch:  http://bit.ly/HR6plE

This post is the second part of a three-part primer on convertible note seed financings.  Part 1, entitled “Everything You Ever Wanted To Know About Convertible Note Seed Financings (But Were Afraid To Ask),” addressed certain basic questions, such as (i) what is a convertible note? (ii) why are convertible notes issued instead of shares of common or preferred stock? and (iii) what are the advantages of issuing convertible notes?

This part 2 will address the economics of a convertible note seed financing and the three key economic terms: (i) the conversion discount, (ii) the conversion valuation cap and (iii) the interest rate.

Part 3 will cover certain special issues, such as (i) what happens if the startup is acquired prior to the note’s conversion to equity? and (ii) what happens if the maturity date is reached prior to the note’s conversion to equity?

[Note: This post was originally published on TechCrunch.]

What Is a Conversion Discount?

As discussed in part 1, in the context of a seed financing, a convertible note is a loan that typically automatically converts into shares of preferred stock upon the closing of a Series A round of financing.  A conversion discount (or “discount”) is a mechanism to reward the noteholders for their investment risk by granting to them the right to convert the amount of the loan, plus interest, at a reduced price (in percentage terms) to the purchase price paid by the Series A investors.

In other words, the founders are saying to the investors, in effect, if you take this risk and give us money today, we’ll reward you by giving you “20% off” at our Series A round down the road (20% being the usual discount, as discussed below).  For example, if the investors in a $500,000 convertible note seed financing were granted a discount of 20%, and the price per share of the Series A Preferred Stock were $1.00, the noteholders would convert the loan at an effective price (referred to as the “conversion price”) of $0.80 per share and thus receive 625,000 shares ($500,000 divided by $0.80), which is 125,000 shares more than a Series A investor would receive for its $500,000 investment and a 1.25x return on paper ($625,000 divided by $500,000).  (The foregoing example does not include accrued interest on the loan, which is typically about 5%-7% annually, as discussed below.)

Discounts generally range from 10% (on the low side) to 35% (on the high side), with the most common being 20%.  In Fenwick & West’s 2011 Seed Financing Survey (the “Fenwick Survey”), the percentage of convertible note seed financings that granted a discount to investors was 67% in 2010 and 83% in 2011; and the median discount was 20% in both 2010 and 2011.

As discussed in part 1 of this series, one of the significant advantages of issuing convertible notes, as opposed to shares of preferred stock, is the extraordinary flexibility they offer in connection with “herding” prospective investors and raising the round.  Clearly, a greater discount can be offered to early investors who are assuming more risk, particularly where the startup is closing its financing on a rolling basis over an extended period of time (as is the trend).

Moreover, a note can include a discount that increases over time – e.g., (i) 1.5% per month up to 25%; or (ii) 10% if the Series A round closes within 6 months, 15% if it closes between 6 and 12 months, and 20% if it closes after 12 months.  In the Fenwick Survey, the percentage of convertible note seed financings that included a discount which increased over time was 25% in 2010 and 5% in 2011.

Finally, founders should be aware that investors will sometimes push for the issuance of warrants in lieu of a discount.  In a seed round, this makes no sense and only creates more paperwork and, accordingly, higher legal fees.  In the Fenwick Survey, the percentage of convertible note seed financings that included the issuance of warrants was 0% in both 2010 and 2011.

What is a Conversion Valuation Cap?

A conversion valuation cap (or “cap”) is another mechanism to reward the noteholders for their investment risk (and for their efforts in increasing the value of the startup as a result of introductions, advice, etc.).  Specifically, a cap is a ceiling on the value of the startup (i.e., a maximum dollar amount) for purposes of determining the conversion price of the note — which (like a discount) thereby permits investors to convert their loan, plus interest, at a lower price than the purchase price paid by the Series A investors.

Using the example above, let’s assume the cap were $5 million and the pre-money valuation in the Series A round were $10 million.  If the noteholders invested $500,000 and the price per share of the Series A Preferred Stock were $1.00, the noteholders would convert the loan at an effective price of $0.50 per share ($5,000,000 divided by $10,000,000) and thus receive 1,000,000 shares ($500,000 divided by $0.50), which is 500,000 shares more than a Series A investor would receive for its $500,000 investment and a 2x return on paper ($1,000,000 divided by $500,000), not including any accrued interest on the loan.  Notice that if there were a 20% discount and no cap, the noteholders would only receive 625,000 shares or a 1.25x return, as noted above.

If we bump-up the pre-money valuation to $20 million and the cap remains at $5 million, you can see how the noteholders are rewarded (and protected): their $500,000 loan now converts at an effective price of $0.25 per share ($5,000,000 divided by $20,000,000) and they would thus receive 2,000,000 shares ($500,000 divided by $0.25), which is 1,500,000 shares more than a Series A investor would receive for its $500,000 investment and a 4x return on paper ($2,000,000 divided by $500,000), not including any accrued interest on the loan.  Again, if there were a 20% discount and no cap, the noteholders would only receive 625,000 shares or a 1.25x return.

As you can see, noteholders with a 20% discount and no cap would receive 625,000 shares whether the pre-money valuation in the Series A round were $10 million, $20 million or $50 million.  This is why sophisticated investors vehemently argue that a note without a cap (i) misaligns the interests of the founders and the investors; and (ii) penalizes investors for their efforts in helping the startup increase its value.  The math can be tricky, but the bottom line is that noteholders without a cap do not share in any increase in the value of the startup prior to the Series A round.

Accordingly, as discussed in detail in part 1, a cap is akin to a valuation in a priced round (i.e., if the startup were issuing shares of common or preferred stock); however, the beauty of a cap is that it is not a valuation for tax purposes — which facilitates the financing by allowing the founders to grant different caps to different investors.

In the Fenwick Survey, the percentage of convertible note seed financings that included a cap was 83% in 2010 and 82% in 2011; and the median valuation cap was $4 million in 2010 and $7.5 million in 2011.

How Do the Discount and the Cap Interrelate?

If the convertible note includes both a discount and a cap, the applicable language will typically provide that the conversion price will be the lower of (i) the price per share determined by applying the discount to the Series A price per share; and (ii) the price per share determined by dividing the cap by the Series A pre-money valuation.  As reflected in the examples above, the reason the conversion price is the “lower of” (not the “higher of”) is because the lower the conversion price, the more shares the noteholders are issued upon conversion.

In the first example above where the discount was 20%, the cap was $5 million and the pre-money valuation was $10 million, we saw that the conversion price was (i) $.80 when we applied the discount to the Series A price and (ii) $.50 when we divided the cap by the pre-money valuation.  Accordingly, the conversion price would be $.50 (the lower of) for purposes of computing the number of shares issued to the noteholders upon conversion.

Now watch what happens if we drop the pre-money valuation to $6 million:  Applying the discount, the conversion price, of course, stays the same at $.80; but when we divide $5 million (the cap) by $6 million (the pre-money valuation), we get $.83, which is obviously higher than $.80 — and thus the discount applies, not the cap.  This is a bit counter-intuitive because the pre-money valuation exceeds the cap by $1 million.  Notice, however, that unless the pre-money valuation were greater than $6,250,000, the cap would not be triggered ($5,000,000 divided by $6,250,000 equals $.80).

If this weren’t confusing enough, there is one other complex issue that founders need to be aware of with respect to discounts and caps: the additional liquidation preference that is created.  Indeed, this is a particular problem, and could result in a substantial windfall to investors, in a large convertible note financing with a low conversion price.

For example, in a $2 million convertible note financing with a 50% discount (or a 50% conversion cap ratio), the noteholders would receive $4 million worth of shares of Series A Preferred Stock upon conversion (not including accrued interest), which would include whatever liquidation preference is attached to the shares (typically 1x).  Accordingly, the noteholders would receive an extra $2 million of liquidation preference.

There are several different approaches to solving this issue, the most elegant of which is to convert the notes into a different series of preferred stock (e.g., Series A-1), with a liquidation preference per share equal to the conversion price; however, for purposes of this post, it’s enough for founders simply to be aware of this issue and how it relates to discounts and caps.

What is the Typical Interest Rate and How Do the Investors Get Paid?

The third and final piece of the economics puzzle is the interest rate component.  Again, a convertible note is a loan and typically requires the startup to pay simple (not compounded) interest on the amount of the loan.  Interest rates on convertible notes have historically been in the range of 7%-10% annually, but recently have dropped to the 5%-7% range.  In the Fenwick Survey, the median annual interest rate in convertible note seed financings was 6% in 2010 and 5.5% in 2011.

As alluded to in the examples above, the interest is not paid in cash on a periodic basis like a typical loan, but instead accrues (or accumulates), and then the total amount of interest due is added to the loan amount and converted into shares of preferred stock upon the closing of the Series A round.  For example, if the interest rate were 5% in a $500,000 convertible note seed financing and the Series A closing occurred on the one-year anniversary of the convertible note closing, the investors would convert an additional $25,000 ($500,000 x .05).

Each state has its own laws (called “usury” laws) that limit the maximum interest rate that may be charged on a loan.  In California, for example, unless an exemption applies, the maximum annual interest rate for a non-consumer loan is the higher of (i) 10% or (ii) 5%, plus the rate charged by the Federal Reserve Bank of San Francisco on advances to member banks on the 25th day of the month prior to the date of the loan (or, if earlier, the date of the written loan commitment).

Welcome to our weekly series “Motivational Clips for Entrepreneurs.” Each week, we post a favorite video clip to inspire and motivate entrepreneurs. Why? Because we know how tough it is being an entrepreneur; and whether you’re launching a venture, trying to execute your business model or raising funds, you need a little juice to help you push the ball forward. I hope these videos are a little juice. Cheers, Scott

Caine’s Arcade from Nirvan Mullick on Vimeo.

To Our Clients & Friends: Welcome to our weekly series “Helping Entrepreneurs Succeed.”  Each week, we share a favorite video of a successful entrepreneur, investor or business leader on a variety of topics.  This week, we present David Hornik, a partner at August Capital and indeed a very smart investor.  (Incidentally, David’s portfolio company, Splunk, just went public today.)

In this interesting brief clip, David discusses what makes a great pitch to investors, including the importance of (i) “selling a vision” (both the person and the project); and (ii) “capturing my imagination.”  I hope you enjoy it.  Thanks, Scott

Top 5 Tweets

1. In case you missed it, here’s my TechCrunch post on convertible note seed financings:  http://tcrn.ch/HpRUZv
2. I love partnering with This Week in Startups.  Here’s why:  http://bit.ly/IjlIEm
3. Solid advice for founders via @englishpaulm: “As hard as you think you work in recruiting, work much harder.”  http://tcrn.ch/HD9rN2  (at 8:30)
4. How To Raise Your First Round of Capital – solid deck via @bussgang   http://slidesha.re/HA5o6g
5. “What baffles me is the lack of questions that come from entrepreneurs at the table.” -@tonysphere  http://tcrn.ch/I8l5kh

Walker Blog-Related

1. New motivational vid for entrepreneurs: “Get Up You Son of a Bitch”  http://bit.ly/IiO5AH
2. I just uploaded this short vid of Jack Dorsey – a few solid nuggets for entrepreneurs:  http://bit.ly/Ik8p6X
3. New motivational vid post: “You Gotta Lay Your Heart On The Line”  http://bit.ly/I3aELG
4. In case you missed it, here’s the Walker Corporate Law Q1 newsletter:  http://bit.ly/I6IKg9

To Our Clients & Friends: Welcome to our weekly series entitled “Helping Entrepreneurs Succeed.”  Each week, we share a favorite video of a successful entrepreneur, investor or business leader on a variety of topics.  This week, we again present Jack Dorsey, Co-founder and Executive Chairman of Twitter and Co-founder and CEO of Square, and indeed an extraordinary entrepreneur.

In this interesting presentation, Jack shares the following three pieces of golden advice for entrepreneurs:

1)  Start “drawing” your idea and “getting it out of your head” (and seeing it from a “completely different perspective”), and then share it with others;

2)  Recognize when “luck” is around you – i.e., recognize the conditions and situations around you that encourage the execution of your idea; and

3)  Iterate – i.e., get user feedback and be “an editor” – and take all the input and refine your idea.

I hope you enjoy it.  Many thanks, Scott

Introduction

We are in the golden age of seed financing.  Venture capital funds, seed funds, super angels, angel groups, incubators, and “friends and family” are all playing the seed financing game and investing early in startups in an attempt to land the next Facebook.

As a result, the pendulum has swung dramatically in the founders’ favor, and the issuance of convertible notes for seed financing has never been more prolific.  Indeed, as a corporate lawyer for 18+ years, I have seen this development first-hand.

This post is the first part of a three-part primer on convertible note seed financings.  Part 1 will address basic questions, such as (i) what is a convertible note? (ii) why are convertible notes issued instead of shares of common or preferred stock? and (iii) what are the advantages of issuing convertible notes?

Part 2 will discuss the two most significant issues for founders in connection with the issuance of convertible notes: (i) the valuation cap and (ii) the discount (and how they interrelate).

Part 3 will cover certain special issues, such as (i) what happens if the startup is acquired prior to the note’s conversion to equity? (ii) what happens if the maturity date is reached prior to the note’s conversion to equity? and (iii) what securities laws do founders need to worry about in connection with the issuance of convertible notes?

[This post was originally published on TechCrunch.]

What is a Convertible Note? 

A convertible note is short-term debt that converts into equity.  In the context of a seed financing, the debt typically automatically converts into shares of preferred stock upon the closing of a Series A round of financing.  In other words, investors loan money to a startup as its first round of funding; and then rather than get their money back with interest, the investors receive shares of preferred stock as part of the startup’s initial preferred stock financing, based on the terms of the note.

Why Can’t a Startup Issue Shares of Common Stock to Investors?

It can.  In fact, many incubators like Y Combinator and TechStars are issued shares of common stock for their initial investment (usually about $20,000).  Friends and family are also often issued shares of common stock.  Most sophisticated investors, however, will not accept shares of common stock for their investment and will push hard for shares of preferred stock, with special rights (as discussed below).

In addition, the issuance of shares of common stock creates three potential problems.  First, the founders risk substantial dilution because it is often difficult for the founders and the investors to agree on a valuation for the startup and, accordingly, to agree on the percentage ownership the investor will receive.  For example, if a startup is merely two guys and an idea, how much equity should an investor receive for a $100,000 investment? 10%?  25%?  50%?

Second, there may be tricky tax issues depending upon the timing of the investment.  For example, if two co-founders are issued shares of common stock for a nominal purchase price upon incorporation, and investors pay substantially more for their shares of common stock at the same time or shortly thereafter, the IRS may impute a much higher value on the shares issued to the founders and deem the excess amount over the purchase price a form of compensation — and therefore taxable to the founders as ordinary income.

Third, the issuance of shares of common stock may cause potential problems with respect to stock option grants because the underlying value of the shares of common stock (i.e., the “strike” or “exercise” price) will have been established.  The goal, of course, regarding option grants is to price the options as low as possible so that the option recipients are incentivized and are able to adequately share in the increased value of the company that they help create.  A high strike price undermines that goal.

How Does the Issuance of Convertible Notes Address These Problems?

One of the key advantages of issuing convertible notes is that the valuation issue is kicked down the road until the Series A round of financing – when there are a lot more data points and thus it’s much easier to value the startup (i.e., price the round).  Accordingly, the issuance of convertible notes disposes of the foregoing three problems.  Again, a convertible note is a loan (debt, not equity).  A valuation of the startup is thus unnecessary; and, if there is no valuation, there are no problems of dilution, taxes and option pricing.

What are Some of the Other Advantages of Issuing Convertible Notes?  

Speed, simplicity and cost.  Indeed, a startup could close a convertible note round in a day or two by merely issuing a 2-3 page promissory note, which could cost as little as $1,500-$2,000 in legal fees (or a little more if a note purchase agreement is also executed, which is customary).  On the other hand, the issuance of shares of preferred stock is complex, and it can take weeks to negotiate all the terms and documents — with legal fees in the neighborhood of $10,000 – $30,000 or more (depending upon whether the investors insist on full-blown Series A-type documentation, as opposed to stripped-down documentation like the “Series Seed,” discussed below).

Another significant advantage of issuing convertible notes is to avoid giving the investors any control.  When investors receive shares of preferred stock, they are typically granted certain significant control rights, including a Board seat and veto rights with respect to certain corporate actions (such as the sale of the company) pursuant to so-called “protective provisions.”  They also have certain key rights as minority stockholders under applicable State law (usually Delaware).

Convertible noteholders are rarely granted control rights (and have no minority stockholder rights).  For example, in Fenwick & West’s 2011 Seed Financing Survey (the “Fenwick Survey”), convertible noteholders were granted a Board seat in only 4% of the seed financings; while preferred stockholders were granted a Board seat in 70% of such financings.

Finally, another advantage of issuing convertible notes (and probably the least understood and most important) is the extraordinary flexibility they offer in connection with “herding” prospective investors and raising the round.  As Naval Ravikant, a co-founder of AngelList, aptly noted in a recent interview on This Week in Startups with Jason Calacanis (at the 17:55 mark): “Convertible notes have made variable pricing possible.”

Paul Graham reached the same conclusion in his post, “High Resolution Fundraising”:

The reason startups have been using more convertible notes in angel rounds is that they make deals close faster. By making it easier for startups to give different prices to different investors, they help them break the sort of deadlock that happens when investors all wait to see who else is going to invest.

Naval and Paul are referring to the conversion valuation cap (or the “cap”), which I will discuss in detail in part 2 of this series; however, suffice it to say that the cap is designed to protect the investors by putting a ceiling on the conversion price of the note and thereby permitting investors to share in any significant increase in the value of the startup subsequent to their investment.  If, for example, the cap were $5 million and the pre-money valuation in the Series A round were $10 million, the amount of the note (plus accrued interest) would convert into shares of preferred stock at an effective price of $5 million or one-half of the price paid by the Series A investors.

Accordingly, the cap is akin to a valuation in a priced round (i.e., if the startup were issuing shares of common or preferred stock).  But the beauty of the cap is that it is not a valuation for tax purposes, which is why different investors may get different caps, unlike in a priced round (unless there were subsequent closings sufficiently far enough apart to justify different valuations).  As Paul provides in his post above:

The reason convertible notes allow more flexibility in price is that valuation caps aren’t actual valuations, and notes are cheap and easy to do. So you can do high-resolution fundraising: if you wanted you could have a separate note with a different cap for each investor.

Why Do Sophisticated Investors Push for Shares of Preferred Stock Instead of Convertible Notes?

We’ve already covered one of the principal reasons: preferred stockholders are typically granted control rights, including a Board seat and certain veto rights.  They are also typically granted certain additional economic rights (like Series A investors), such as pro-rata rights and a liquidation preference.  In fact, in the Fenwick Survey, 9% of the preferred stock seed financings included a participating preferred liquidation preference (which is not founder friendly).

Other reasons have been articulated by a number of high-profile investors (including Fred Wilson, Mark Suster, Manu Kumar and Seth Levine), the most significant of which can be summarized as follows:

1)  There are now stripped-down, preferred stock financing documents (like “Series Seed” and other standardized forms) that make a priced round just as fast and cheap as issuing convertible notes.

2)  The interests of the founders and the investors are “misaligned” if the investors are issued convertible notes that are not capped.  This is because it’s in the founders’ interest to maximize the company’s valuation in the Series A round, and it’s in the noteholders’ interest to minimize it.  Investors are thus “penalized” for helping a startup get a higher valuation as a result of their introductions, domain expertise, etc.

3)  Obtaining a fair valuation may be tricky for unsophisticated investors, but not for sophisticated ones.  As Fred Wilson argues: “I can negotiate a fair price with an entrepreneur in five minutes…”

4)  Noteholders must wait for the date of conversion to start the clock running for long term capital gains treatment; with shares of preferred stock, the clock starts running immediately.

Are the Series Seed and Other Standardized Forms Really as Fast and Cheap as Convertible Notes?

The Series Seed and other standardized forms have solved a huge problem: how to get shares of preferred stock into the hands of investors in a seed investment without having to draft and negotiate a full-blown set of Series A documents, with all the bells and whistles (and associated legal fees of $50,000+).

However, to say that using these forms makes a preferred stock financing as fast and cheap as a convertible note financing is a bit misleading because we are talking about non-negotiable, fill-in-the-blank forms.  Obviously, any transaction will be fast and cheap if the parties utilize fill-in-the-blank forms, without any back-and-forth negotiation.

Indeed, as I have previously discussed, the fundamental problem with these standardized forms is this one-size-fits-all approach.  Every financing is different, and the structure and terms are based on a number of different factors, including (i) the size of the investment; (ii) whether the startup is “hot” (and there’s a competitive environment); (iii) who the investors are; (iv) current market conditions, etc.

Simply put, it may not be in the founders’ interest to utilize these forms and issue shares of preferred stock for a relatively small investment or if the founders have strong negotiating leverage (as recently demonstrated by the $2.35 million convertible note seed financing by HealthTap) — particularly because these forms require the founders to grant certain control rights (and additional economic rights) to the investors, as discussed above.  Nor does the issuance of preferred stock allow for the extraordinary flexibility that the issuance of convertible notes permits (also discussed above).

As Naval Ravikant profoundly pointed out in his recent interview with Jason Calacanis (at the 19:19 mark):

Venture capital used to be the bundling of advice, control and money. And now people have come along, like Y Combinator and TechStars and AngelPad and so on, to say ‘we’re the advice’; and then people have come in, like Yuri Milner at Start Fund, and say “we’re money – we just want to give you money” and the control provision has gone away.  So you’re starting to see the whole ecosystem become unbundled. 

Welcome to our weekly series “Motivational Clips for Entrepreneurs.”  Each week, we post a favorite video clip to inspire and motivate entrepreneurs.  Why?  Because we know how tough it is being an entrepreneur; and whether you’re launching a venture, trying to execute your business model or raising funds, you need a little juice to help you push the ball forward.  I hope these videos are a little juice.  Cheers, Scott

Top 5 Tweets

1. “I had $1,700 in my bank account yesterday, and now I have a whole lot more.” -@charlesforman (OMGPOP founder)  http://nyti.ms/H6nBns
2. A Pinterest spammer tells all – “First week of doing this I made around $2,000 which was Feb. 20-29.”  http://bit.ly/GUmmrS
3. Start-Ups Good At Y Combinator Demo Day, But Is Price Right? “Everything you see here is of high quality”  -@chudson  http://on.wsj.com/H1hjrh
4. A New Dawn for Consumer Internet Acquisitions – interesting post (and chart) via @davidbeisel  http://bit.ly/GTMy56
5. I love this quote: “I couldn’t care less who is mad at me as long as the entrepreneur comes out ahead.” -Ron Conway  http://bit.ly/HjsyI7

Walker Blog-Related

1. New motivational clip for entrepreneurs: “Are You Not Entertained?”  http://bit.ly/HutmPJ
2. I just uploaded this interesting two-minute vid clip of Steve Ballmer discussing company culture:  http://bit.ly/H5rGH0

Welcome to our weekly series “Motivational Clips for Entrepreneurs.”  Each week, we post a favorite video clip to inspire and motivate entrepreneurs.  Why?  Because we know how tough it is being an entrepreneur; and whether you’re launching a venture, trying to execute your business model or raising funds, you need a little juice to help you push the ball forward.  I hope these videos are a little juice.  Cheers, Scott

http://www.youtube.com/watch?v=FI1ylg4GKv8

To Our Clients & Friends: Welcome to our weekly series “Helping Entrepreneurs Succeed.”  Each week, we share a favorite video of a successful entrepreneur, investor or business leader on a variety of topics.  This week, we present Steve Balmer, the CEO of Microsoft and an impressive, energetic leader.

In this insighful, two-minute clip (courtesy of Stanford University’s Entrepreneurship Corner), Steve discusses company culture and the tension (i.e., the “ying and yang”) between (i) patience vs. short-term results, (ii) passion for technology vs. passion for customers and (iii) great individuals vs. great teamwork.  I hope you enjoy it.  Many thanks, Scott

Top 5 Tweets

1. Solid, detailed summary of the JOBS Act via Debevoise:  http://bit.ly/GLz8Js
2. “Tesla seems to have a business model that’s going to work…If Apple made a car, this could be it.”  http://nyti.ms/GXoCjj
3. “The idea that law school is an easy ticket to financial security is finally breaking down.”  http://nyti.ms/GCRgmi
4. Should Equity-Based Crowd Funding Be Legal? – interesting debate via the Wall Street Journal  http://on.wsj.com/xFS3q9
5. Large law firms face an uncertain environment amid sluggish overall performance & mounting pressure on profitability”  http://nyti.ms/GXcCwk

Walker Blog-Related

1. New motivational vid post: “Think When You Were a Kid”  http://bit.ly/GSAg1P
2. I just uploaded this video interview of Jeff Clavier – some solid nuggets for entrepreneurs:  http://bit.ly/GIwbbC

Welcome to our weekly series “Motivational Clips for Entrepreneurs.”  Each week, we post a favorite video clip to inspire and motivate entrepreneurs.  Why?  Because we know how tough it is being an entrepreneur; and whether you’re launching a venture, trying to execute your business model or raising funds, you need a little juice to help you push the ball forward.  I hope these videos are a little juice.  Cheers, Scott