Angel Investing – A Note on Notes

Business Concept: Close-up the Funding button on the keyboard and have Lime, Green color button isolate black keyboardThere are a variety of funding options for entrepreneurs to consider as they explore taking in external capital. For investors, understanding the pros and cons of these various funding options and how they fit into a company’s overall funding plan is critical. One option, a Convertible Note, is a hybrid structure that is used as a bridge to a future equity round. In addition to a stated interest rate and maturity date, Convertible Notes will have conversion terms that outline how the notes will be repaid or converted into equity. The amount of equity that a company needs to raise to trigger the conversion of the notes is referred to as the qualified equity financing. Historically, I have seen this form of funding used primarily in pre-seed rounds where the company needs to raise a small amount of capital to get to proof of concept as well as a bridge financing between a Series A and B round in order to provide the company with a bit more runway to get to the metrics required by a Series B investor.

The rationale for the use of Convertible Notes has been that they are faster, cheaper, easier to consummate than a typical preferred stock offering when a small amount of capital is being raised. In addition, many notes are structured on a rolling close basis so that the company has access to the funds as soon as the checks are written, without a requirement to meet a minimum funding level. It is a bit like needing a full tank of gas to reach your destination, but only being able to fill the tank half way. Not only do you not reach the destination you had in mind, you end up in the middle of nowhere.

Recently I have seen more $1 million plus convertible note seed offerings. In many cases the company has been raising funds for well over a year or is quickly approaching a maturity date with no qualified equity financing in sight. As a note holder, I may be faced with either extending the term of the note or being converted into common stock at a cap that may well exceed the true value of the company. With the availability of standardized Seed Preferred documents such as those used by New York Angels, an active angel group of which I am a member, the faster, cheaper, easier argument goes away. In addition, as a Preferred Shareholder in a company I have protective provisions that require my consent on issues that can adversely affect the Preferred Shareholders. As an investor, I think that Convertible Notes make sense for a small pre-seed round of funding or as a bridge from a Series A-B round ( or Seed to A…). For larger offerings, I prefer (no pun intended) to invest in Preferred Stock. From the founder’s perspective, some issues that need to be considered when employing Convertible Notes are outlined in a recent article by Ed Zimmerman, the Chair of the Tech Group @ Lowenstein Sandler LLP and an awesome supporter of women entrepreneurs.

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