Seed stage investment deals, i.e., those in a range of approximately $100,000 on the low end and around $1.3 million on the high end, are structured either as straight equity or as convertible loans. If straight equity, the company typically issues to the investor shares of preferred stock usually designated as Series Seed which includes a package of enhanced rights but usually stripped down from those typically associated with Series A shares. Alternatively, the investor could invest in the form of a loan that converts into the security issued in the next equity round, usually at some discount to the next round’s price.
This post will focus on convertible note deal term trends based on the 2016 Venture Capital Report recently released by the helpful folks at Wilmer Hale. The convertible note data in the Report was compiled from over 100 deals handled by the firm from 2013 through 2015 for companies and investors in the U.S.
Seed investors often negotiate for a discount from the price per share in the next equity round to reward the seed investor for investing at an earlier, riskier stage. 89% of convertible loan deals covered by the Report in 2015 had discounts, a significant increase from the 66% that had them in 2013. Sometimes parties negotiate for an ascending discount in which the discount increases as the period between seed and next round increases. The Report doesn’t provide any information on time periods between seed and next round, or on the percentage of deals that had a sliding discount. The range of discounts was between 10% and 50%, with 74% of discounted deals having a discount of 20% or less and 26% having discounts of more than 20%.
A major advantage of convertible loans is that they allow the parties to defer negotiation of probably the most difficult business issue until the next round: valuation. But that advantage also poses a risk to the seed investor, namely that at the time of conversion at the next round the company’s pre-money valuation will be much higher and thus much more expensive for the seed round investor. A discount offers protection against valuation inflation, but only relative to what the next round investors are paying. An added measure of protection is a cap on the next round valuation applicable to the seed investor’s conversion rate. For example, imagine a $1 million convertible loan with no discount, no cap, and the company subsequently raises $5 million in a Series A round at a pre-money valuation of $20 million with a per share price of $1. The note would convert into one million shares ($1 million loan (leaving aside interest for simplicity) divided by $1/share). But if the note had a $5 million cap, the shares would convert at the rate of, not $1 per share, but $0.50 per share, so that the seed investor would receive two million shares ($1,000,000/$0.50) rather than one million. I’ve previously blogged here about why valuation caps are loved by angels, tolerated by VCs and hated by entrepreneurs.
Although still popular, valuation caps seem to be trending down somewhat. The Report indicates that only 55% of convertible loan deals contained caps in 2015, nearly a 20% drop from the 74% that featured them the year before.
Conversion on Maturity
The truth about seed round convertible promissory notes is that they are promises that no one intends to be kept. At least the repayment part. They are intended to be converted into equity. But what happens if a qualified next round doesn’t occur prior to the maturity date of the note? Very often, the note will provide that the outstanding principal and interest will convert on a given date, either automatically or at the option of the holder, at a set price or a price determined by a formula or procedure. According to the Report, 60% of deals in 2015 had some kind of conversion at maturity. Of those, 89% were at the investor’s option (up from 80% in 2013) and 11% were mandatory (down from 20% in 2013). In addition, 32% of the 2015 deals that converted upon maturity convert into common stock, substantially unchanged from 2013 but a dramatic decline from the 54% of the conversion-at-maturity deals in 2015 that convert into common. 68% of the 2015 convert-at-maturity deals convert into preferred, also substantially unchanged from 2013, but a sharp increase from the 46% of the 2014 deals that convert into preferred.
Sale of the Company
Upon a sale of the company prior to maturity and prior to a next-round conversion, the outstanding principal and interest may convert into common or preferred stock, either automatically or at the option of the debt holder. In 2015, 74% of the convertible deals covered in the Report had some kind of conversion on a sale of the company, up from 66% in 2014. Of those, the conversion-on-sale feature was overwhelmingly at the option of the holder (91%, up from 86% in 2014; 9% were mandatory). Of these deals, they were pretty evenly split in 2015 between those converting into common and those converting into preferred. In 2014, on the other hand, the conversion-on-sale provisions tended to favor conversions into common (60%) rather than preferred (40%).
Conversion Premiums on Sale of the Company
Seed investors sometimes negotiate for the right to be paid a multiple of principal and interest upon a sale of the company, similar to a liquidation preference associated with preferred stock. Roughly one half of the deals in the Report had company sale premiums. The premiums ranged from 1.5x (i.e., 1.5 times the outstanding principal and interest) on the low end to 4x on the upper end, an increase from the upper range of 3x in 2014, although the median multiple was steady throughout 2013-2015 at 2x.
Convertible note investors sometimes negotiate for the note to be secured by some or all of the company’s assets. If the note is not repaid or converted at maturity, the investor could look to the pledged assets to satisfy the loan. Investors in 2015 were not as successful as they were in 2013 in getting their notes secured. Only 15% of the convertible notes covered by the Report in 2015 were secured (85% unsecured), down from 25% in 2013 (75% unsecured in 2013).
The foregoing data on conversion discounts, caps, conversion at maturity, sale-of-company conversions and premiums and security suggests that the convertible note deal term pendulum may have started to swing back in favor of investors in 2015. Deal terms in the categories of conversion discounts, conversion at maturity, sale-of-company conversions and sale-of-company premiums were more favorable to investors in 2015. Terms were more favorable to companies in 2015 with respect to caps and note security. Given recent developments regarding cooling valuations and a stalled technology IPO market, it will be interesting to see whether the pendulum for convertible deal terms will move more significantly in favor of investors in 2016.