Rethinking the Convertible Note: Seed Financing and Restructurings with Variable Price Notes
Capital raising through some type of convertible note instrument has become a common occurrence. It has also become common practice to use one of many publicly available convertible note templates without contemplating the nuances specific to the startup. While there are obvious efficiency gains to the spread of templates, these are of uneven quality. Some older forms of convertible notes (that I call legacy type of notes) are now, in my opinion, inadequate, whereas others such as the KISS documents by 500 Startups, substantially improve on prior practice. My objective is to highlight two areas in most note templates that can be substantially improved and I propose three changes to the open source KISS (debt) documents to illustrate how these changes could be implemented (see the attached modified form of KISS). 
These changes arise from the same personal observation that startups often go through multiple “rounds” of convertible note financing and issue notes at different valuation caps before their Series A round. However, all convertible note templates are drafted in one or two ways: either they are meant for discrete, individual investors or, if the notes are to be issued to a plurality of investors, these are drafted as if the capital raising could be finalized in a single seed round of limited duration with uniform pricing. This has two unintended effects: (i) it limits the startup’s flexibility in restructuring the notes through the noteholders’ collective action, and (ii) it causes additional founder’s dilution that was unforeseen at the time the note was drafted. The following changes are meant to resolve these issues, and the final product is an open-ended note of fixed maturity but variable pricing (the “Variable Price Note”).
- Easy Note Restructurings with Variable Price Notes
- The Holdouts Issue
Often new financing is conditional on a restructuring of a startup’s outstanding convertible promissory notes. The restructuring can be more or less extensive, and in any event will require amendments to the notes’ conversion terms or definitional provisions. However, holdouts can make a voluntary debt restructuring very difficult. For this reason, it is often advisable to insert collective action language in the notes to allow for majority action of the noteholders.
Holdouts are well-known figures in the public bond and sovereign debt markets. A holdout is a bondholder (or noteholder) who refuses to accept an offer of conversion from the company in the hope of profiting if the offer succeeds without his participation. The holdout’s “decision rests on the hope that very few others will behave as he does, and that reorganization will improve the firm’s financial condition. If so, he will receive the full face value of his bonds rather than the lower exchange price paid to those who tendered their bonds. When enough bondholders use this reasoning, the offer fails”.
 This article was originally published on UpCounsel’s blog: Rethinking the Convertible Note.
 In preferred stock offerings the holdout issue arises in connection with down rounds. The certificate of incorporation normally allows for the mandatory conversion of preferred stock into common upon a majority class vote of the preferred. This provision is used to cram down preferred stockholders who refuse to participate in the new round.
 Lewis S. Peterson, Who’s Being Greedy: A Theoretical and Empirical Examination of Holdouts and Coercion in Debt Tender and Exchange Offers, 103 Yale L.J. 505, 506 (1993-1994).
 Lewis S. Peterson, Who’s Being Greedy, 514. See also David Skeel, Why the Class Action Strategy is Worth a Second Look, 22 Int’l Fin. L. Rev. 23 (2003): “Sovereign debt restructuring has repeatedly been stymied by the holdouts of bondholders who hope their peers will agree to take a haircut while they get paid in full… The most exciting development in sovereign debt practice in the past year has been the dramatic increase in the use of so-called collective action or majority voting provisions. These provisions permit a bond to be restructured if a specified majority of the bondholders sign on, and so bind dissenting bondholders to the will of the majority.”
Collective action language is designed to address the holdout issue by binding all members of a predefined group of noteholders to any amendments approved by a voting majority. It will consist at a minimum of two parts: (i) language defining the composition of the relevant group of noteholders and (ii) the amendment section. As explained below, most convertible note templates will restrict the composition of the relevant group of noteholders in one or two ways, thus reducing the ability of the startup to avail itself of collective action.
- Legacy Notes
I call “Legacy Notes” those convertible note instruments that organize a round of funding around a closing period of limited duration. One could say about Legacy Notes what Paul Graham (one of the founders of Y Combinator) once wrote about fixed-size, multi-investor angel rounds: “I think angels (and their lawyers) organized rounds this way in unthinking imitation of VC series A rounds.” Legacy notes are typically issued as a schedule to a note purchase agreement and define the group of noteholders as the persons that are listed on the schedule of purchasers attached to it. Then the purchase agreement generally requires that any additional sales of notes occur within 90 to 180 days of the initial closing of the sale.
 Paul Graham, High Resolution Fundraising, last accessed December 2, 2017.
In a priced round, the closed offering period has a twofold objective: (i) to comfort early investors that later investors will not benefit from the same pricing terms, thereby providing an incentive to invest in the current round rather than in a later round; and (ii) combined with preferred stock protective provisions, to discipline management’s capital raising endeavors. Applied to convertible notes, the first argument is not without reason – one might object that pricing concerns do not apply to convertible notes, but notes often convert at the valuation cap. However, the second is not reflective of the needs and practice of seed stage startups. It’s not just a matter of capital needs being often unforeseeable and marked by urgency. Capital raising is for early stage startups a largely “do it yourself” endeavor that is often completed without the help of a lead investor or financial intermediary. In these circumstances, to require that the company corral all of its investors within a 90 to 180-day period and raise enough cash to last until a priced round can often be unrealistic.
 I will not elaborate on the obvious: convertible notes do not traditionally contain protective provisions; the restrictions imposed by a closed offering period does not allow noteholders to exercise control over additional funding rounds.
Legacy Notes are also drafted with the assumption that once a funding round is complete, the startup will move on to a Series A round. This does not accurately reflect the reality of startup financing, because in practice and for entirely legitimate reasons, startups often opt to issue notes for extended periods of time before settling on a priced round. Finally, the practical effect of defining the group of noteholders so restrictively (those that purchase notes within 90 to 180 days of the initial closing) is to compel the startup to issue notes in multiple separate rounds to small groups of investors or even to individual investors, and therefore to entirely forego the benefits of collective action.
- Fixed Price Notes
Some of the newer forms of notes are issued in series and define the group of noteholders as anyone that holds a note in the series. Because these notes do not rely on a limited closing period, they could be termed “open ended.” However most of these notes require or assume that pricing terms (maturity period, discount, valuation cap and interest rate) remain unchanged within the same series, which intrinsically limits the usability over time of the note and the size of the noteholders’ group. I call these notes “Fixed Price Notes.”
In a convertible note with discount and valuation cap, the discount rate will decrease as the maturity period shortens, while the valuation cap will increase along with the founders’ and investors’ expectations for the startup. In practice, if a startup is able to articulate or provide evidence of increasingly optimistic expectations about the future, it will propose a larger valuation cap to its new investors. However, the Fixed Price Note reflecting the increased valuation cap will have to be part of a new series. The following table exemplifies how different combinations of valuation caps and discounts, within the same fixed 2-year maturity, compel the issuance of multiple Fixed Price Notes series.
|Time 1||+ 6 months||+ 12 months||+ 18 months|
|Note Series||Series 1 Note||Series 2 Note||Series 3 Note||Series 4 Note|
|Maturity Date||Time 1 +24 months||Time 1 +24 months||Time 1 +24 months||Time 1 +24 months|
|Valuation Cap||$5 million||$7.5 million||$9 million||$12 million|
Each of these series will correspond to a discrete group of noteholders for voting purposes.
Most startups have an interest in maximizing their ability to use collective action. Issuing Fixed Price Notes in series seems preferable in this regard than issuing Legacy Notes. However, compared to hypothetical variable price notes or single series financings, Fixed Price Notes expose the startup to a much greater risk that majority noteholders in one or more series might holdout, thereby hindering a restructuring.
- Variable Price Notes
While there is an intrinsic reason for issuing preferred stock in series, there is no intrinsic reason for issuing notes in separate series. In fact, the nexus between note pricing and note series comes rather indirectly out of the convenience of minimizing the number of series of preferred stock that must be authorized in the startup’s certificate of incorporation. This is because, upon conversion, a note’s effective conversion price will equal the per share liquidation preference and the conversion price for purposes of price-based anti-dilution protection of the applicable series of preferred stock. Ultimately, the certificate of incorporation will authorize as many different series of preferred stock as there are preferred stock conversion prices and effective note conversion prices. So, the thinking goes, if the notes are issued in series with uniform pricing, this will reduce the range of effective conversion prices and consequently the number of different series of preferred stock.
In reality, contrary to belief, drafting a certificate of incorporation with multiple series of preferred stock is not particularly burdensome, so long as each series of preferred stock has identical rights and differs from other series only on pricing. This, of course, reflects ordinary convertible note practice: if the note conversion price is lower than the Series A price, the note will customarily convert into a shadow series of preferred stock with identical rights and privileges as the Series A but different pricing (see for example the definition of “Shadow Series” in the KISS). In addition, now that startups can conveniently automate their cap table management on online platforms, it is possible to issue shares, track all types of equity and model new financing rounds with relative ease. Startups should be able to issue convertible notes with a dozen different combinations of valuation caps and discounts at no significant additional cost. Hence, it is entirely feasible and not cost prohibitive to issue convertible notes with differential pricing, but otherwise identical terms within the same series, and then to convert these notes in correspondingly multiple series of preferred stock. I will call these notes “Variable Price Notes.”
- Maturity of Variable Price Notes
The original KISS instrument defines the maturity date as eighteen (18) months following the Date of Issuance and allows the latter term to differ in each KISS. Hence a KISS could be issued with multiple maturity dates within the same series and, at least in theory, KISSES of the same series could be issued indefinitely. In practice, KISS instruments rely on the fixed valuation cap to limit the round’s duration, while the fixed discount provides an incentive to group all notes within the same few months’ period. At any time on or after the “maturity date”, a majority in interest of noteholders can elect to either call the note or convert it to stock based on the conversion cap. Because the noteholders are likely to have notes with different maturity dates, “maturity” for the purpose of repayment or conversion can only occur on or after the date that all of the notes held by a majority in interest have reached their respective maturity date.
In Variable Price Notes, the round’s duration is unconstrained by the valuation cap and no incentive to temporally group the notes arises from a fixed discount. This could make the notions of majority in interest and maturity, essentially, moving targets that the startup could alter each time it issues more notes. This is why Variable Price Notes should have a fixed maturity date, which based on my experience could realistically occur anytime between 18 months and 3 years from the date of issuance of the first note in the series.
Back in 2010, Paul Graham argued convincingly that giving startups the flexibility to set different pricing terms for different investors can facilitate their capital raising. See Paul Graham, High Resolution Fundraising. I have now added a substantial argument in favor of higher resolution fundraising from the other end of the pipeline. Startups should be free to issue notes of a same series until the Series A round with multiple different combinations of valuation caps and discounts as a means to maximize collective action, reduce the risk of holdouts, and facilitate note restructurings.
- Avoid Unintended Dilutive Language in Legacy Notes
Consider the formula for converting a note under a conversion cap:
Conversion Price = Valuation Cap / Fully-Diluted Capitalization
Any increase in the denominator, will result in a proportional decrease of the conversion price and a proportional increase in the number of conversion shares issued to the investor. Any arbitrary increase in the denominator will result in an unexpected dilution of the founders.
Now compare this language taken from the definition of “Company Capitalization” in the Y Combinator’s SAFE (hereafter, “Clause 1”):
“Company Capitalization” means the sum, as of immediately prior to the Equity Financing, of: (1) all shares of Capital Stock (on an as-converted basis) issued and outstanding, assuming exercise or conversion of all outstanding vested and unvested options, warrants and other convertible securities, but excluding (A) this instrument, (B) all other Safes, and (C) convertible promissory notes; and (2) all shares of Common Stock reserved and available for future grant under any equity incentive or similar plan of the Company, and/or any equity incentive or similar plan to be created or increased in connection with the Equity Financing.
to this clause, taken from a Legacy Note (hereafter, “Clause 2”)
The Note Conversion Price, however, shall not be greater than the quotient obtained by dividing (x) $6,000,000 by (y) the sum of (1) the total number of shares of Common Stock outstanding (assuming full conversion and exercise of all convertible or exercisable securities other than the Notes) and (2) shares of Common Stock issuable to employees, consultants or directors pursuant to a stock option plan, restricted stock plan, or other stock plan approved by the Board of Directors.
from the perspective of determining the fully-diluted capitalization of the company prior to conversion under the conversion cap.
Clause 1 assumes full conversion and exercise of all convertible securities excluding (1) the very SAFE where the language appears, (2) all other SAFE instruments and (3) all convertible promissory notes regardless of whether they belong to different series or are issued individually. Hence all notes are treated as being part of the same transaction, whether or not they have in fact been issued under the same note purchase agreement or belong in the same series. Clause 2 however assumes full conversion and exercise of all convertible securities other than the Notes, and this term is usually defined in the note purchase agreement as the notes issued pursuant to that agreement. This means that according to Clause 2 we have to include in the fully-diluted capitalization any notes issued outside of a limited closing period, notes of any other series or, if the notes have been issued individually, any note other than a specific note.
Similar to Clause 2, the original KISS instrument excludes from Fully-Diluted Capitalization the conversion contemplated by the applicable provision of Section 2, which I interpret as the KISS instruments of a same series. As seen above, the KISS series are limited in time by fixed pricing, which favors the issuance of KISS instruments in multiple series.
The (probably) unintended effect of adopting Clause 2, rather than Clause 1, is a significant increase in dilution. To quantify the dilutive effect of Clause 2, consider the simplified pre-money cap table below of a fictitious tech startup, StartUp Inc.:
|CAP TABLE BEFORE INVESTMENT|
|Unallocated Option Pool||125,000||125,000||5.26%|
Let us assume further that during the course of the last year StartUp Inc. has issued $1,000,000 worth of convertible notes to two groups of investors (the Series 1 Notes and Series 2 Notes) at different valuation caps and 20% discount from Series A price:
|Convertible Notes||Series 1 Notes||Series 2 Notes|
|Discount from Series A share price||20.0%||20.0%|
|Date of the Convertible Note funding||1/1/2016||4/1/2016|
|Hypothetical Conversion Date (Series A funding)||1/1/2017||1/1/2017|
On January 1, 2017, StartUp Inc. raises $2 million from a group of Series A investors at $8 million pre-money valuation. For the sake of simplicity, I will ignore the customary option pool increase.
Applying Clause 1, you would calculate the denominator without assuming that any convertible notes have converted beforehand. The noteholders from the Series 1 and Series 2 groups will receive respectively 251,987 and 206,987 shares of preferred stock upon conversion. The fully diluted cap table would look like this:
On the other hand, if the Series 1 Notes and the Series 2 Notes had been issued pursuant to an instrument containing Clause 2, you would need to assume the prior conversion of either the Series 1 Notes or the Series 2 Notes to calculate the conversion valuation cap price of, respectively, the Series 2 Notes and the Series 1 Notes. In this scenario, the Series 1 Notes and the Series 2 Notes would each convert into 21,961 and 21,962 additional shares of stock respectively. This would result in additional dilution to the founders (approximately 74 basis points), and an additional $147,951 worth of stock issued to investors.
Of course, the dilution would have been much greater had all the notes been issued individually.
The “valuation cap” is a hypothetical pre-money valuation at a future date; it denotes a price per share prior to giving effect to the conversion of the notes. It makes little sense to convert a note based on the cap and yet assume the conversion of all outstanding notes other than the one particular note where the language appears. Strangely enough the drafting differences between Clause 1 and Clause 2 may not in fact reflect philosophical differences. As noted above, Clause 2 belongs to a Legacy Note and it may simply erroneously assume that all notes would be issued prior to a qualifying transaction under the same purchase agreement (during the same closing period). In reality, as noted above, startups often go through multiple “rounds” of note issuing before settling on a priced round.
The Variable Price Note modifies the basic KISS instrument to exclude (i) KISSes of the same series, (ii) KISSes of other series and (iii) any convertible securities issued for capital raising purposes, from an accounting of Fully-Diluted Capitalization. I have adopted this last language (“convertible securities issued for capital raising purposes”) from the Series Seed Convertible Note Financing Documents Generator given that there are a few non-debt convertible instruments out there such as the equity type of KISS and the SAFE.
The take away for forward-thinking founders is to never issue notes to discrete individual investors, but always in series; when the latter, to issue the notes in a limited number of series and to define the participating group of noteholders to be as inclusive as possible. Ideally, prior to the Series A round, startups should issue only one series of open-ended notes with variable pricing (the Variable Price Notes).