One Simple Paragraph Every Entrepreneur Should Add To Their Convertible Notes

I’m so tired of seeing young entrepreneurs get screwed by their angel investors on convertible notes and I know I can’t convince you not to do it so I’d like to offer one simple bit of advice to help you avoid getting screwed (at least on one part of your note).

When you do a convertible note with a cap that converts into the next round of funding one of the unintended consequences is that if you’re successful and raise at a larger price than your cap the early angels often get “multiple liquidation preferences” on their dollars in.

Here’s How It Works

• Angel gives you $500,000 at a $5 million cap (thus they will own at least 9% of your company if it converts at a price higher than the cap). If you raise at a lower price they will own more than 9%. [This is called a “full ratchet,” which is also historically a term that VCs would be crucified for trying to get away with but I’ll avoid talking about that in this post.]
• With a normal 1x liquidation preference this investor would be entitled to $500,000 if you sell your company one day for less than $5 million (if you sell for more they would rather take their % ownership than the liquidation preference, which is basically downside protection).
• You raise a series of notes over 18 months and eventually are fortunate enough to raise $5 million at a $25 million pre-money valuation (this investor owns 16.67% and will likely have a 1x liquidation preference).
• When that initial note converts instead of $500,000 liquidation preference they would get $2.5 million liquidation preference instead of a $500,000 or a whopping 5x liquidation preference.

If a VC tried to do this to you on an early-stage deal they would get such a bad reputation that no other VCs or entrepreneurs would work with them. On VC financings this term is explicit so entrepreneurs understand they’re getting screwed. On a convertible note, it happens implicitly so entrepreneurs don’t understand it. It’s the silent screwing that stings.

So here’s what every entrepreneur should add immediately to any convertible note they are trying to raising money against and run from any angel who won’t agree to this. In fact, I’d love it if somebody would start a website that outs angels who intentionally use this hidden trick. I know a few very high profile names that would quickly go on that list but I’m not going to bother picking a fight publicly.

“If this note converts at a price higher than the cap that you have been given you agree that in the conversion of the note into equity you agree to allow your stock to be converted such that you will receive no more than a 1x non-participating liquidation preference plus any agreed interest.”

Papering this when it converts is super easy if the angel has already consented to it and they are not being cheated at all. They get their full investment as a 1x liquidation preference. And please don’t let any angel try to convince you they deserve more for the early risk. The early risk is why they get a cheaper price.

I feel certain a lawyer could draft this more elegantly than I could and I would be grateful if any lawyer reading this would draft actual language in the comments section below. If you do I will amend this blog post. But the text I have above will be effective, will work and will end the practice of angel investors preying on entrepreneurs that don’t know any better until after you’ve screwed them.

If you want an excellent further primer please see this excellent post on the “liquidation preference overhang” by José Ancer in which he gives even more math and the solution options.

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Also note that he’s provided good legal language you can insert into your note:

“Financing Conversion Securities” means securities with identical rights, privileges, preferences and restrictions as the Qualified Financing Securities issued to new investors in a Qualified Financing, other than (A) the per share liquidation preference, which will be equal to (i) the Note Conversion Price at which this Note is converted, multiplied by (ii) any liquidation preference multiple granted to the Qualified Financing Securities (i.e., 1X, 2X, etc. of the purchase price), (B) the conversion price for purposes of price-based anti-dilution protection, which will equal the Note Conversion Price, and (C) the basis for any dividend rights, which will be based on the Note Conversion Price.

[This post by Mark Suster first appeared here and has been reproduced with permission.]

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