Raising Capital: The Legal Basics

- August 28, 2013 3 MIN READ

Most start-ups will never raise an institutional investment round. This isn’t necessarily a bad thing. If you can reach profitability and maintain great growth rates without raising capital, do it! Why dilute yourself unnecessarily?

Unfortunately for most tech, high growth start-ups, this approach won’t work. You need capital to build out and market your product and pay your staff. If you don’t grow quickly your business is likely to fail. If you do get to the stage where you’re successful in raising capital it’s important that you have a good understanding of the types of legal documents and structures that will be used as part of the financing process.

Over the coming weeks we’ll be providing a brief run-down of the legal basics related to raising capital. We’ll kick off this week with an explanation of Convertible Notes. Before you read any further, remember that if you do get to the stage where you’ve got a term sheet in front of you, you need to find a lawyer! Furthermore, you need a lawyer who has experience in, and understands, start-ups.  Most lawyers will have no idea how a convertible note works; make sure you hire a specialist.

Convertible Note

Issuing a convertible note is one of the most popular ways for a start-up to raise a seed round. By using a convertible note, the start-up is issuing a promissory note to the investor. The note converts into equity upon a trigger event, which is usually either (i) the start-up raising their Series A round (a “qualified financing”) or (ii) the note reaching maturity. Both investors and founders like convertible notes as they’re relatively simple to negotiate (and I mean relatively!), and crucially they don’t require a valuation of the company at the time of investment.

Conversion Events

As mentioned above, the note will convert into equity if certain events occur. The first of these is that the start-up raises a Series A round in which investors receive equity, not debt, for their investment. If this occurs, the note will convert into equity at a discount to the price per share paid by the Series A investors.

Most convertible notes also have a second conversion event, which is time based. If the start-up hasn’t raised a Series A round by a certain date (this could be 1-4 years from the issuance of the convertible note), then the note will automatically convert in to equity, usually based in a multiple of the start-up’s revenues, or another similar metric.

Discount Rate (or Conversion Discount Rate)

Obviously your seed investors need to be rewarded for taking on the risk of investing in your start-up at an early stage. The start-up rewards the convertible note holders by agreeing to a conversion discount. This means that when the conversion event occurs the note holders will receive more shares per dollar invested than the Series A investors. If, for instance, the conversion discount rate is 30% and the Series A investors are investing at $1 per share, the note holders will actually receive one share for every $0.70 invested.

Valuation Cap/ Price Cap

The next issue to keep an eye out for is the valuation cap. Convertible notes work well, but they do occasionally lead to the incentives of the note holders and founders not being aligned. This is best demonstrated by an example of a start-up that raises a small seed round of $100,000 and is hugely successful over the next year, and raises $50m at a $100m pre-money valuation. The note holders will end up owning a tiny sliver of equity; they won’t have benefited from the vast up spike in the company valuation.

For this reason, most convertible notes will include a valuation cap. You’ll end up with a clause which ensures that conversion will happen at a rate which is the lower of a percentage of the series A share price, or the share price if the pre money valuation was set at the valuation cap.

To Conclude

There are a whole range of other issues you need to decide on when entering into a convertible note, including the interest rate (usually 3-10%), whether you want the seed round to be “open” with a decreasing conversion rate and many more.

Next week we’ll discuss the differences between issuing common stock and preference shares. And if I can leave you with one thought: Make sure you hire a good lawyer. Get in touch with us if you’ve got any questions.

By Lachlan McKnight, CEO of LegalVision. LegalVision provides online legal services, including fixed-fee lawyers and customised legal documents. All of the lawyers in the LegalVision network work online, are highly experienced, and offer quick, high quality advice.