Corporate & Securities Law

Convertible Note Term Sheets

By Ryan Roberts

Just like the preferred equity financing process, the convertible debt financing process can start with a term sheet, rather than a full set of financing documents.

A convertible note term sheet is beneficial because it postpones a lawyer from cranking out a full set of docs until consensus is reached regarding the convertible debt offering’s material terms. It also makes any potential back-and-forth negotiation on such terms easier to manage.

On the other hand, if you are dealing strictly with friends and family on a convertible note transaction, adding this extra step in the process could be somewhat cumbersome. Thus, it’s usually prudent to go straight to the convertible note deal docs with friends and family.

Here are terms that are typically found in a convertible note term sheet:

Amount of the Offering: How much capital can the startup raise via the convertible debt offering?

Closing: Is there a specific date that the convertible debt financing will close, or will there be an open round of seed investment?

Interest Rate: What is the rate of interest on the convertible debt? Is the interest payable upon maturity or monthly/quarterly/yearly?

Term: When is the maturity date of the convertible notes?

Prepayment: Can the startup prepay the convertible notes without the consent of the convertible note holders?

Convertibility: What amount of equity financing is required to trigger automatic conversion of the convertible notes to equity (i.e., the determination of qualified financing)? What is the discount received by the convertible note holders relative to the price paid by the qualified financing investors? Is there a convertible note discount price cap? Do the convertible notes convert to equity on the maturity date, and if so, at what pre-money valuation?

Liquidity Event Payment: How much (e.g., 2X/3X, etc.) do the convertible debt holders receive if the startup gets acquired before a qualified financing and the maturity date? What is the definition of “Liquidity Event”?

Warrant Coverage: Do the convertible debt holders receive warrants to purchase “Series A” shares, and if so, how much percent coverage?

Security Interest: Will the convertible notes be secured by any or all assets of the startup?

Amendment: What is the manner how the convertible notes can be amended? Majority of the principal amount of the notes?

Legal Fees: Does each party pay for its own legal fees?

Full post as published by The Startup Lawyer on August 24, 2010 (boomark / email).