We have seen an increased number of term sheets for convertible note financings lately and thought it might be helpful to discuss some of the terms and conditions of these notes. In an earlier issue of Insights, we discussed angel investing and the risks (and rewards) of that strategy. Convertible note financings are used for seed financing and are a very economical and efficient way for start-up companies to obtain seed capital without losing control of the early-stage company.

CONVERTIBLE NOTE

A convertible note financing is short-term debt that automatically converts into shares of preferred stock upon the closing of a Series A financing round. This method of financing is favored by company founders because it can be completed very quickly, is somewhat simple, and is relatively inexpensive in terms of legal costs. A convertible note purchase agreement and note can be a few pages long and prepared and closed in a few days.

While start-up companies can issue common stock to early investors, there are a variety of reasons why the founders may be reluctant to do so. These include the difficultly in putting a value on an early stage company and potential tax issues for founders issued stock at nominal values. Because convertible notes are debt not equity, their issuance puts off the valuation matter until the later round of financing – by which time the company may have developed to an extent where more and better information is available on which to base a valuation.

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Bette Davis once said that growing old is not for sissies. If she were she alive today, she would no doubt be an accredited investor and may well add angel investing to the potentially long list of activities not for sissies.

Typically, angel investors provide seed capital to start-up companies or entrepreneurs. When an individual or newly formed closely-held entity seeks financing for a new venture, the most common sources of financing are individuals who have a preexisting relationship with the founders of the venture. With every IPO of a former start-up and the corresponding stories of amazing returns on investment for the few initial investors, angel investing activity, as a whole, and the number of people seeking out such investments has steadily increased over the last decade. The Center for Venture Research at the University of New Hampshire found that the number of active angel investors in 2012 was 268,160. A decade earlier, that number had been approximately 200,000. The dollar amount invested over the same period grew to $22.9 billion from $15.7 billion. There is potential for the numbers to grow further: The Angel Capital Association estimates that there are approximately 4 million potential accredited investors (persons with an individual or joint net worth with a spouse that exceeds $1 million - not counting the primary residence) in the United States who might be interested in start-up and early stage companies.

This increase is despite the fact that approximately 80% of start-ups fail. Many investments made by angel investors end up worthless or sit for long periods in inert companies that buyers have little interest in.