On June 8, 2017, the House of Representatives passed the Financial CHOICE Act of 2017 on a vote of 233-186. Congress loves acronyms, and here “CHOICE” stands for Creating Hope and Opportunity for Investors, Consumers and Financial Choice ActEntrepreneurs. Although the thrust of the bill is focused on repeal or modification of significant portions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and addresses a number of other financial regulations, it also includes a broad range of important provisions aimed at facilitating capital formation, including:

  • Exemption of private company mergers and acquisitions intermediaries from the broker-dealer registration requirements of the Exchange Act;
  • Expansion of the private resale exemption contained in Section 4(a)(7), which codified the so-called “Section 4(a)(1½)” exemption for resales of restricted securities by persons other than the issuer, by eliminating information requirements and permitting general solicitation, so long as sales are made through a platform available only to accredited investors;
  • Exemption from the auditor attestation requirement under Section 404(b) of Sarbanes-Oxley of companies with average annual gross revenues of less than $50 million;
  • Creation of SEC-registered venture exchanges, a new class of stock exchanges that can provide enhanced liquidity and capital access to smaller issuers;
  • Exemption of small offerings that meet the following requirements: (i) investor has a pre-existing relationship with an officer, director or shareholder with 10 percent or more of the shares of the issuer; (ii) issuer reasonably believes there are no more than 35 purchasers of securities from the issuer that are sold during the 12-month period preceding the transaction; and (iii) aggregate amount of all securities sold by the issuer does not exceed $500,000 over a 12-month period;
  • Exemption from the prohibition in Regulation D against general solicitation for pitch-type events organized by angel groups, venture forums, venture capital associations and trade associations;
  • Streamlining of Form D filing requirements and procedures with the filing of a single notice of sales and prohibiting the SEC from requiring any additional materials;
  • Exemption from the Investment Company Act for any VC fund with no more than $50 million in aggregate capital contributions and uncalled committed capital and having not more than 500 investors;
  • Exempting Title III crowdfunding shareholders from the shareholder number trigger for Exchange Act registration;
  • Amendment of Section 3(b)(2) of the Securities Act (the statutory basis for Regulation A+) to raise the amount of securities that may be offered and sold within a 12-month period from $50 million to $75 million; and
  • Allowing all issuers, not just emerging growth companies, to submit confidential registration statements to the SEC for nonpublic review before an IPO, provided that the registration statement and all amendments are publicly filed not later than 15 days before the first road show.

In the coming weeks, I intend to blog in greater detail about a few of these reform efforts, including the proposed broker-dealer exemption for M&A intermediaries, venture exchanges and crowdfunding fixes.

NYSEThe fate of the Financial CHOICE Act is unclear. A variety of interest groups have expressed strong opposition to the bill, and it appears unlikely the Senate will pass it in its current form. My hunch is that the more controversial aspects of the bill relate to the Dodd-Frank repeal and other financial services reforms. I also believe that there is greater potential for general consensus building around capital markets reform, as was demonstrated in connection with the passage of the JOBS Act five years ago, so that any final version that ultimately gets passed will hopefully include much if not all of the reforms summarized above.

On March 22, the Subcommittee on Capital Markets, Securities, and Investment of the Financial Services Committee conducted a hearing entitled “The JOBS Act at Five: Examining Its Impact and Ensuring the Competitiveness of the U.S. Capital Markets”, focusing on the impact of JOBS Act at 5the JOBS Act on the U.S. capital markets and its effect on capital formation, job creation and economic growth. The archived webcast of the hearing can be found here. Most people won’t have the patience to sit through two hours and 44 minutes of testimony (although the running national debt scoreboard on the right side of the home page showing in real time the national debt increasing by $100,000 every three seconds, and by $1 million every 30 seconds, etc., is eyepopping). At the risk of being accused of having too much time on my hands, but as an act of community service, I watched the hearing (or at least most of it) and will offer some takeaways.

Raymond Keating, Chief Economist of the Small Business & Entrepreneurship Council, testified about some disturbing trends in angel and VC investment. The value and number of angel deals is down from pre-recession levels.  VC investment showed the most life but a decline in raymond keating2016 is troubling. So what’s going on?  Keating believes it’s about reduced levels of entrepreneurship stemming in large part from regulatory burdens that limit entrepreneurs’ access to capital and investors’ freedom to make investments in entrepreneurial ventures. He also testified on the need for further reform, particularly in Regulation Crowdfunding under Title III which allows companies for the first time to raise capital from anyone, not just accredited investors, without filing a registration statement with the SEC, and identified the following reform targets:

  • Issuer Cap. Currently, issuers are capped at $1 million during any rolling twelve-month period. There’s been a push to increase that cap, perhaps to $5 million.
  • Investor Cap. Currently, investors with annual income or net worth of less than $100,000 are limited during a 12-month period to the greater of $2,000 or 5% of the lesser of annual income or net worth, and if both annual income and net worth exceed $100,000, then the limit is 10% of the lesser of income or net worth. The proposal here would be to change the application of the cap from the lower of annual income or net worth to the higher of annual income or net worth.
  • Funding Portal Liability. Currently, funding portals can be held liable for material misstatements and omissions by issuers. That poses tremendous and arguably unfair risk to funding portals and may deter funding portals from getting in the business in the first place. The proposal here would be that a funding portal should not be held liable for material misstatements and omissions by an issuer, unless the portal itself is guilty of fraud or negligence. Such a safe harbor for online platforms would be similar to the protection that traditional broker dealers have enjoyed for decades. A funding platform is just a technology-enabled way for entrepreneurs to connect with investors, and they don’t have the domain expertise of issuers and can’t verify the accuracy of all statements made by issuers.  Part of the role of the crowd in crowdfunding is to scrutinize an issuer, a role that should remain with the investors, not with the platform.
  • Syndicated Investments. Many accredited investor crowdfunding platforms like AngeList and OurCrowd operate on an investment fund model, whereby they recruit investors to invest in a special purpose vehicle whose only purpose is to invest in the operating company. Essentially, a lead investor validates a company’s valuation, strategy and investment worthiness. Traditionally, angel investors have operated in groups and often follow a lead investor, a model which puts all investors on a level playing field.
  • $25 Million Asset Registration Trigger.  Under current rules, any Regulation CF funded company that crosses a $25 million asset threshold would be required to register under the Securities Exchange Act and become an SEC reporting company. Seems inconsistent with the spirit of Regulation Crowdfunding, which for the first time allows companies to offer securities to the public without registering with the SEC.

As to the continuing challenge for companies to go and remain public, Thomas Quaadman, Vice President of the U.S. Chamber of Commerce, testified that the public markets are in worse shape today than they were five years ago and that we have fewer than half the public companies quaadmantoday than we had in 1996, a number that has decreased in 19 of the last 20 years. Mr. Quaadman blamed this in part on an antiquated disclosure regime that is increasingly used to embarrass companies rather than provide decision useful information to investors. In order to rebalance the system and reverse the negative trend, he suggested a numbere of reform measures the SEC and Congress should undertake. The disclosure effectiveness proposal should be a top priority for the SEC to bring the disclosure regime into the 21st century. We need proxy advisory firm reform that brings transparency, accountability and oversight to proxy advisory firms. Also, there should be recognition that capital formation and corporate governance are inextricably linked and there should be reform of the shareholder proposal process under Rule 14a-8.

In Part I of this two part series on model structures for seed rounds, I explained how the dramatic decline in the cost of launching an internet-based startup over the last 15 years primarily due to the disruptive effects of open source software and cloud computing has led to a surge in seed stage investing by angels and early stage VCs.  In Part I, I addressed seed rounds structured as equity, the two most common forms of which involve the issuance of modified versions of preferred stock designated as Series AA or Series Seed.

As I explained in Part I of this Series, the more complex, time consuming and expensive to negotiate deal documentation associated with Series A and later rounds can be justified when a company is raising several millions of dollars, but makes little sense for a seed round of a few hundred thousand dollars. The resulting pressure for deal document simplification has resulted over the last several years in innovative seed investment deal documents.  This Part II of the Series will address seed round structures fashioned as convertible notes or alternative instruments that functionally resemble convertible notes.

Convertible Notes

Convertible Notes advance the objective of deal document simplification and cost effectiveness even more than Series Seed and Series AA structures because they allow parties to defer negotiation of the thorniest issues to a next significant equity round.

Technically, convertible notes provide for payment of principal and interest on a maturity date of typically one to two years, but in reality these notes are not expected to be repaid.  Instead, the principal and interest is intended to get converted into the security issued in a next equity round meeting some minimum dollar amount, albeit typically at a discount to the next round’s pricing in an effort to reward the seed investors for the additional risk they’re assuming by investing at a more vulnerable juncture for the company.   In recent years, it has also become common for the valuation at which the seed investment is converted to be capped, in which case  the conversion price would be the lower of the discounted rate or the price based on the capped valuation.  Less sophisticated angels will focus on the interest rate and try to negotiate that higher; those more experienced in startup investing will understand that the conversion terms will have a far more significant impact on the value of their investment and thus focus on discount and cap.

Another way the practical reality departs from the technical is that if a qualified funding has not occurred and the note is not converted prior to maturity, the note is rarely paid at that point. Instead, a difficult conversation takes place between the company and the seed investor in which the company seeks to extend the maturity date.  The price for any such extension is usually in the form of more generous conversion terms for the investor.

Simple Agreement for Future Equity or “SAFE”

In 2013, the legendary accelerator Y Combinator introduced an alternative to theY Combinator convertible note which it called a Simple Agreement for Future Equity or “SAFE”. Although it looks like a convertible note in that it converts the investment amount into the next round’s security and typically features discounts and caps, it is not a promissory note for the simple reason that, unlike a note, there is no basic promise to repay the invested amount.  Essentially, a SAFE is a contract that provides for the type and amount of shares that will be issued in a qualified next round, if there is such a round, along with an option to receive either common stock or a return of the invested amount if the company is acquired prior to a qualified round.

The absence of a payment on maturity date feature is a major advantage to companies and a serious drawback for seed investors relative to convertible notes in that it removes an important source of leverage that the investor would otherwise have as a convertible noteholder if the company has been unable to raise a qualified next round before maturity. If that were to happen in the context of a convertible note, the note holder could demand payment and force the company into dissolution or bankruptcy.  That leverage would allow the investor to negotiate for an increase in the conversion discount or decrease in the cap.

The lack of a maturity date means that the SAFE is really only appropriate for a technology based startup that could scale quickly and achieve rapid growth. Conversely, a non-technology based startup could theoretically prosper and enrich its shareholders without the SAFE holder receiving anything for a long time, if ever.  In other words, a company may be able to grow organically without the need to do another significant raise, and may even be able to dividend out cash to its stockholders (not shared by the SAFE holders because they’re not yet stockholders), and the SAFE holders would not receive anything until the company gets acquired, if ever.

Keep it Simple Security or KISS

The Keep it Simple Security or KISS was created by another accelerator, 500 500 startupsStartups, in 2014, in reaction to resistance to SAFEs because of their lack of investor protections. KISSes more closely resemble traditional convertible notes, i.e., promise to pay on a maturity date, etc., and contain certain other important investor protections such as an option at maturity to convert into a newly created Series Seed (see my discussion of Series Seed in Part I of this two-part series), information rights and the right to participate in future funding rounds.  But inasmuch as the impetus for convertible note alternatives was a desire for simplification, cost effectiveness and time saving, it’s unclear whether the KISS, which actually contains a few more deal points to negotiate than convertible notes, will gain significant traction among seed stage companies and investors.

The cost of launching an Internet-based startup has fallen dramatically over the last 15 years. This democratization of internet-based entrepreneurship resulted primarily from two innovations: open source software and cloud computing. During the dot-com era, Internet-based startups had to build serversinfrastructure by acquiring expensive servers and software licenses and hiring IT support staff. So the first outside round of investment in an Internet-based startup was typically a Series A round of $3 million or more from one or more VCs. With the emergence of open-source software, however, startups for the most part were no longer forced to acquire software packages bundled with hardware. Another issue, though, was that startups had to acquire and maintain bandwidth to accommodate peak loads, resulting in expensive underutilization. But this all changed with the advent of cloud computing, which enabled entrepreneurs to launch an Internet startup with minimal upfront IT costs and to pay only for used bandwidth. In real dollars, the cost of starting up has declined from a few million dollars to a few hundred thousand dollars.

With the precipitous drop in the cost of launching an Internet-based startup came a significant rise in interest in seed investing by angels and early stage VCs. But the typical Series A document package (amended and restated certificate of incorporation, stock purchase agreement, voting agreement, cloudinvestor rights agreement, right of first refusal and co-sale agreement) is complex, time consuming and expensive to negotiate, and contains several economic, management and exit provisions that don’t become relevant until much later (e.g., if and when the company goes public). This level of complexity can be justified when a company is raising several million dollars, but not so for a seed round of a few hundred thousand.

The resulting pressure for deal document simplification has resulted over the last several years in innovative seed investment deal documents. Seed rounds are either structured as a simplified version of a priced Series A preferred stock or as debt that converts into the security issued in a next round of equity, typically at a discount. This Part I of a two part blog series on seed round investing will focus on priced equity structures; Part II will address convertible debt.

There are currently two alternative open sourced sets of equity seed round deal documents to choose from, each with the common goals of term simplification, cost reduction, transaction time compression and document standardization. Both feature terms similar to those found in a typical Series A deal, but stripped down from the robust set of economic, voting and exit rights usually contained in a Series A. The two deal document products are:

Series AA: Created by Cooley cooleyfor accelerator Techstarstechstarsfenwick
Series Seed: Created by Fenwick & West

The main terms of Series AA and Series Seed are as follows:

1X Non-Participating Preferred: Both Series Seed and Series AA feature 1X non-participating preferred stock, meaning on a sale of the company the investor must choose between his liquidation preference of 1X (i.e., one times his investment amount) or the proceeds he would receive on an as converted basis, but not both. In other words, the investor calculates which would yield the bigger payout and choose that one. On the other hand, participating preferred would give the investor two bites of the apple: first his liquidation preference, and then his share of remaining proceeds as a common shareholder on an as converted basis.

Antidilution Protection: Series Seed provides no antidilution protection. Series AA, however, has broad based weighted average antidilution protection. Most notably, antidilution protects the investor from the economic dilution resulting from down rounds. Weighted average is the type of protection that is more fair in that it factors in the dilutive effect of the actual down round (i.e., the conversion price doesn’t adjust all the way down to the lower down round price but rather takes into consideration the number of additional shares issued at the lower price relative to the number of shares outstanding), and broad based requires inclusion in the number of shares outstanding all outstanding options and options reserved for issuance (as opposed to narrow based which would not include options).

Board Composition: Both Series AA and Series Seed provide for boards consisting of 2 common and one preferred, except that Series AA conditions the preferred board member on the Series AA shares constituting at least 5% of the outstanding equity on a fully diluted basis.

Protective Provisions: These are veto rights in favor of the preferred. Series AA gives vetos over only changes to the Series AA. Series Seed includes vetos over changes in the Series AA, but also includes vetos over mergers, increasing or decreasing authorized shares of any class or series, authorizing any new class or series senior to or on a parity with any series of preferred, stock redemption, dividends, number of directors and liquidation/dissolution.

Right of First Offer on New Financings: Both Series Seed and Series AA give investors the right to purchase their pro rata share of new issuances.

Right of First Refusal: Series Seed gives investors a right of first refusal on shares held by key holders. Series AA does not.

Drag Along Rights: Series Seed gives Series Seed holders and founders the right to require common holders to include their shares or vote for any transaction approved by the board, by a majority of the common and by a majority of the Series Seed. No drag along in the Series AA.

So what standard Series A terms are missing from Series Seed and Series AA? Missing are dividend preference (not a big deal here inasmuch as the overwhelming majority of startups will not pay out dividends), registration rights and tag-along rights (also not a big deal inasmuch as founders rarely have an opportunity to sell their shares).

Overall, Series Seed and Series AA are worthy efforts to simplify terms and reduce transaction costs. There will certainly be situations, however, where investors will resist the weaker investor protections such as the absence of participating preferred and anti-dilution protection and stripped down protective provisions. Any effort to negotiate some terms back in will undercut the objective of diversification and simplicity.

SEC 2August 6, 2015 was a productive day for the Staff of the Securities and Exchange Commission’s Division of Corporation Finance on the issue of the prohibition on general solicitation in the context of online private offerings under Rule 506(b). My last blog post, entitled “It’s Complicated”: Establishing “Preexisting Relationships” with Prospective Investors, analyzed the Citizen VC no-action letter delivered that day dealing with establishing pre-existing relationships with investors online to demonstrate the absence of general solicitation in a Rule 506 offering. On the same day, the Staff provided additional guidance on the issue of general solicitation in the form of new Compliance and Disclosure Interpretations (“CDIs”).

Background

Rule 502(c) promulgated under the Securities Act of 1933, as amended, prohibits an issuer from offering or selling securities by any form of general solicitation or general advertising when conducting certain offerings intended to be exempt from registration under Regulation D. The prohibition on general solicitation has been perceived as perhaps the single biggest obstacle to raising capital in the private general solicitationmarkets. In September 2013, the SEC released final rules for a new offering exemption contained in Rule 506(c) that permits general solicitation efforts, provided securities are sold only to accredited investors and the issuer uses reasonable methods to verify that each purchaser is an accredited investor. What constitutes reasonable verification methods will depend on the facts and circumstances of each case, but generally involves a more intrusive inquiry than an offering under traditional Rule 506(b), which is why most private offerings are still being conducted under Rule 506(b) despite the prohibition on general solicitation.

New Guidance

The new CDIs come in the form of Q&As, some of which provide official confirmation of existing practice while others provide new flexibility in online offering activities. Here’s an outline of the new CDIs:

Factual Business Information

Factual business information that does not condition the public mind or arouse public interest in a securities offering is not deemed an offer and may be disseminated widely. In the new guidance, the Staff stated that factual business information is a facts and circumstances concept, but is typically limited to information about the issuer’s business, financial condition, products or services, and generally does not include predictions, projections, forecasts or opinions with respect to valuation of a security, nor for a continuously offered fund would it include information about past performance of the fund.

Angel Investors

angelThe Staff confirmed that it is possible for angel investors who have a relationship with an issuer to make introductions to other prospective investors in their personal network and share information about a securities offering without such issuer being deemed to engage in a general solicitation. Whether or not a general solicitation has occurred requires a facts and circumstances analysis, but an issuer could rely on such network to establish a reasonable belief that other offerees in the network have the necessary financial experience and sophistication.

Establishing “Pre-Existing” and “Substantive” Relationships

A relationship with an offeree is “pre-existing” for purposes of demonstrating the absence of general solicitation under Rule 502(c) when the relationship was formed prior to the commencement of the securities offering or, alternatively, when it was established through either a registered broker-dealer or investment adviser prior to the registered broker-dealer or investment adviser participating in the offering. Similarly, a relationship is “substantive” for purposes of demonstrating the absence of general solicitation under Rule 502(c) when the issuer (or a person acting on its behalf) has sufficient information to evaluate, and does in fact evaluate, a prospective offeree’s financial circumstances and sophistication, in determining his status as an accredited or sophisticated investor. Self-certification alone (by checking a box) without any other knowledge of a person’s financial circumstances or sophistication is not sufficient to form a “substantive” relationship.

Demo Days

Whether or not “demo days” or “pitch days” constitute general solicitation is also – you guessed it – a factsimages12NM2J0D and circumstances question. If the presentation does not discuss the securities being offered, the securities laws are not implicated. Where the presentation does discuss the securities being offered, however, attendance at the demo day or pitch day should be limited to persons with whom the issuer or the organizer of the event has a pre-existing, substantive relationship or who have been contacted through an informal, personal network as described above under “Angel Investors”. For more on this issue involving demo days, see my previous blog post “Will Your Demo Day Presentation Violate the Securities Laws?”.

In my last post, I blogged about online funding platforms. In that post, I described the typical model of indirect investing through a special purpose vehicle (“SPV”) with the platform sponsor taking a carried interest in the SPV’s profits from the portfolio company and no ourcrowdtransaction fee, as a means of avoiding broker-dealer regulation. I also discussed the concept of a pre-screened password protected member-only website as a means of establishing a preexisting fundablerelationship with prospective investors and thus avoiding the use of any act of “general solicitation,” which would otherwise violate the rules of the registration exemption under Rule 506(b).

SEC logoIn a no-action letter dated August 6, 2015 entitled Citizen VC, Inc., the SEC has provided important guidance on the procedures needed for an online funding platform to establish the kind of preexisting relationship needed to avoid being deemed to be engaged in general solicitation. As an aside, the concern over general solicitation and preexisting relationships is relevant to offerings under new Rule 506(b), but not under Rule 506(c).   Despite the creation in 2013 of an exemption under new Rule 506(c) pursuant to the JOBS Act for general solicitation offerings in which sales are made only to accredited investors, most online funding platforms continue to prefer to conduct portfolio company offerings indirectly through SPVs under Rule 506(b), despite the prohibition on general solicitation, primarily because of the additional requirement under Rule 506(c) that issuers use reasonable methods to verify accredited investor status.

In its request for a no-action letter, Citizen VC described itself as an citizen vconline venture capital firm that facilitates indirect investment in portfolio companies (through SPVs) by pre-qualified, accredited and sophisticated “members” in its site. It asserted to have qualification procedures intended to establish substantive relationships with, and to confirm the suitability of, prospective investors that visit the website. Anyone wishing to investigate the password protected sections of the site accessible only to members must first register and be accepted for membership. To apply for membership, prospective investors are required to complete an “accredited investor” questionnaire, followed by a relationship building process in which Citizen VC collects information to evaluate the prospective investor’s sophistication, financial circumstances and ability to understand the nature and risks related to an investment. It does so by contacting the prospective investor by phone to discuss the prospective investor’s investing experience and sophistication, investment goals and strategies, financial suitability, risk awareness, and other topics designed to assist Citizen VC in understanding the investor’s sophistication, utilizing third party credit reporting services to gather additional financial information and credit history information and other methods to foster online and offline interactions with the prospective investor. In the request letter, Citizen VC asserted that the relationship establishment period is not limited by a specific time period, but rather is a process based on specific written policies and procedures created to ensure that the offering is suitable for each prospective investor.

Citizen VC stated in its request letter that prospective investors only become “members” and are given access to offering information in the password protected section of the site after Citizen VC is satisfied that the prospective investor has sufficient knowledge and experience and that it has taken reasonable steps necessary to create a substantive relationship with the prospective investor. Once a sufficient number of qualified members have expressed interest in a particular portfolio company, those members are provided subscription materials for investment in the SPV formed by Citizen VC to aggregate such members’ investments, the sale of interests of such SPV is consummated and the SPV then invests the funds, and becomes a shareholder of, the portfolio company.

In its request letter, after providing the foregoing background, Citizen VC asked the SEC staff to opine that the policies and procedures described in the letter are sufficient to create a substantive, pre-existing relationship with prospective investors such that the offering and sale on the site of interests in an SPV that will invest in a particular portfolio company will not constitute general solicitation.

sec no-actionIn its no-action letter, the SEC staff concluded that Citizen VC’s procedures were sufficient to establish a preexisting relationship and do not constitute general solicitation. It stated that the quality of the relationship between an issuer and an investor is the most important factor in determining whether a “substantive” relationship exists and noted Citizen VC’s representation that its policies and procedures are designed to evaluate the prospective investor’s sophistication, financial circumstances and ability to understand the nature and risks of the securities to be offered. The staff went on to say that there is no specific duration of time or particular short form accreditation questionnaire that can be relied upon solely to create such a relationship, and that whether an issuer has sufficient information to evaluate a prospective offeree’s financial circumstances and sophistication will depend on the facts and circumstances of each case. The staff also based its conclusion on Citizen VC’s representation that an investment opportunity is only presented after the prospective investor becomes a “member” in the site.

An argument could be made that SPV-based online funding platforms represent the future of VC investing. The Citizen VC no-action letter provides valuable guidance relating to the establishment of the kind of substantive relationship with prospective investors needed to enable the online funding platform to conduct Rule 506(b) offerings without being deemed to engage in general solicitation.

I’ve noticed a recent trend of angel investors demanding valuation caps on their convertible bridge loans, and I’ve received questions lately from startup and VC clients about them.  So I thought this would be an opportune time to explain what all the fuss is about.

First, the basics.

Convertible Notes

A convertible note evidences a loan that typically converts automatically into equity upon the closing of a “qualified financing”, i.e., a funding round of some agreed upon minimum amount.  The conversion is often “next round priced”, namely it converts into the security issued in the next round at the same pre-money valuation or, more likely, at a 10%-25% discount to the pre-money valuation of the next round.1  Next-round pricing makes sense when the company is at a very early stage and neither the company nor the angel investor has a clue as to what the company is really worth at that time.  So they decide to punt to the next round when two things might happen: the company will hopefully have generated revenues or hit some other objective milestone that justifies a particular valuation, and the investors in the next round might be institutional (VC’s) who are more adept at valuing a company objectively.  The discount represents the angel’s reward for the additional risk associated with investing at an earlier, more precarious point in time.  Convertible notes are attractive to both sides relative to equity because they’re easier to negotiate and document (no economic, management or exit rights and no haggling over valuation).

Risk and Incentive Distortion

Next-round pricing, despite the typical conversion discount, may pose certain risks and distortions in incentives to the angel investor.  Although the angel would generally like to see the company’s post-investment valuation increase, a higher valuation also means a more expensive conversion and a smaller percentage of the equity to be issued to the angel for the investment he made in the angel round.  For example, if the angel invested $200,000, he would own 20% of the equity if the next round is at a $1 million post-money valuation ($200,000/$1,000,000), but only 5% of the equity if the next round is priced at $4 million ($200,000/$4,000,000).  Accordingly, some believe the angel is incentivized to minimize valuation until he converts, creating an unhealthy diversion of incentives between the angel and founder.  But a higher valuation also lowers the percentage of the overall equity to be issued to the VCs in the next round.  So it’s difficult to generalize as to the impact of a next-round priced funding on investors and thus any incentive distortion that it poses.  Each deal is affected by its own set of circumstances and the devil is really in the details.

Valuation Cap

A cap on next-round valuation for pricing the angel’s conversion is a common mechanism to minimize risk to the angel and align incentives with the entrepreneur.  It basically provides that, solely for the purpose of pricing the conversion of the angel’s loan into equity and determining the number of shares to be issued to the angel, the price per share will be the lesser of the next-round’s price (or discount thereto) or the cap.  This arguably aligns the interests of angel and founder:  both will seek to make the company as valuable as possible and to raise future money at a price that is significantly higher than that of the last round of funding.

Unintended Consequences

Valuation caps can potentially impact the valuation of the next round, and in extreme cases can prevent a next round from happening altogether.  I’ve seen some VCs view the cap on existing bridge notes as a ceiling on the next round’s price on the theory that it was the high point negotiated between the angel and entrepreneur.  This might make it difficult to persuade a VC to agree on a valuation much higher than the cap.  For this reason, entrepreneurs often hope to avoid disclosing the angel round terms to prospective VCs until a price has been agreed to with them.  But if the cap is disproportionately low relative to the next round’s valuation, and the per share price is not carefully calculated to include the convertible note shares in the fully-diluted outstanding capitalization, the VCs will be in for a rude awakening when a large portion of the equity they thought they were getting percentage-wise ends up going instead to the angel note holder.  Conversely, if the conversion shares are included in the pre-money fully-diluted shares, which is more often the case, it’s the founders who suffer disproportionate dilution from the conversion.

Conclusion

My preferred way of handling next round priced convertible notes is through variable discounts that increase as the next round gets further away in time  from the note investment or occurs after milestones have been hit.  Valuation caps on convertible notes can work, but the parties need to structure them carefully with an eye toward the next funding round.  From the company’s perspective, the cap should be set sufficiently high so as to avoid a perceived benchmark.  Well counseled VCs will insist that the shares issuable to the angel on conversion are included in the pre-money fully-diluted shares, resulting in the founders suffering all the dilution.  Finally, the conversion terms should be disclosed as early as possible to the VCs to avoid a serious loss of confidence in the entrepreneur on the part of the VCs and possibly even cratering the deal.


1 Pre-money valuation with respect to a particular round of funding is the valuation of the company measured before the new money comes in; post-money valuation is calculated as the pre-money valuation plus the amount invested in that round.