Guide to Convertible Securities

Ashot Arzumanyan

Sep 12, 2017

10 min read

Early stages of startup life are usually characterized by a mismatch of valuation expectations between the investors and the entrepreneurs. While entrepreneurs think about easily acquired billion dollar markets, the investors usually look at the risks and challenges they face and, therefore, hardly share the same level of optimism. Meanwhile, there is very little data to make data driven assumptions for the valuation of a company. Convertible investment instruments are introduced to address this and other issues (ease of execution, tax risks for the founders, etc.) and make seed and early stage investing relatively seamless. In essence, the valuation exercise is kicked down the road until Series A when there is much more substantial information to value the startup.

While entrepreneurs usually have inflated expectations, the investors tend to undervalue startups at the seed stage.

In this article we discuss the widely known and applied convertible investment instruments: Safe, KISS and TechStars Convertible Note; and bring to your attention the key background knowledge and parameters you should know while dealing with those.

Some need-to-know background knowledge

When a first-time founder (especially with a tech background) initially sees an investment document it probably looks like a nightmare consisting of tricky and complicated terminology. Luckily, it is not so daunting (or at least should not be). However, there is a set of concepts one needs to know in order to digest the document easily. Below is a non-exhaustive list of those concepts - make sure you understand each of them before we move on to discussing specific standardized securities:

Investment instrument (=security): type of contract through which you receive an investment (e.g. equity, loan, loan that later can be converted to equity, others).
Convertible security: any type of financing which assumes conversion to equity if certain predefined conditions are met.
Convertible loan/debt: this is a type of convertible note - esentially a loan, which can be repaid with equity if certain predefined conditions are met.
Common and preferred stock: Equity generally is broken down into common stock and preferred stock. Preferred stockholders have greater claim to the company’s assets than common stockholders (e.g. they are first in line to collect a payout if a solvency event lower than the company’s valuation occurs). Startup investors typically hold Preferred Stock/Equity, whereas founders generally hold Common Stock/Equity. Employees often hold options that grant them the right to purchase shares of Common Stock/Equity, subject to vesting schedules.
Maturity date: Convertible notes usually contain maturity dates - the deadline on which you either convert to equity or repay the amount of the note.
Liquidation preference: if the company is sold (or liquidated some other way), then the liquidation preference allows the investor to receive something above their pro-rata share in the company. E.g. an investor who invested 100k with 2x liquidation preference will have the right to receive a minimum of $100k x 2 = $200k upon sale of the company (regardless of his or her share in the company). There are three types of liquidation preference: straight, participating and capped. Read more about each here.
Dilution: Each time you receive an investment you get diluted. Assume you hold 800 shares in the company which is 100%. Now you issue 200 new shares at the price of $1k each ($200k in total), the number of total shares in the company becomes 800+200=1000, and your shareholding percentage reduces to 800/1000 = 80%. Next if you issue another 250 shares for (say for $1m), your shareholding percentage is reduced to 800/(1000+250) = 64%. Note, however, that dilution doesn’t mean you become less wealthy. The value of your 800 shares at the first investment round was 800 x $1k = $800k, whereas at the second round the value increased to 800 x ($1m/250) = $3.2m.
Valuation discount: Let’s assume you take a $300k convertible loan and agree with your investor that when you raise your Series A at a certain valuation, your investor’s convertible note will convert at 50% discounted valuation. That means, if you raise $4m at $12m pre-money* valuation from a new investor then for the initial investor your pre-money valuation will be equal to $12m x (100% - 50%) = $6m, therefore his shareholding percentage in your company after Series A will equal $300k/($6m + $4m) = 3%.
Valuation cap: Assume you raise $300k convertible loan with $7m valuation cap. In such a case, if at Seires A you raise $4m at $12m pre-money valuation from a new investor, the pre-money valuation for the initial investor will still be $7m (that’s why it is a “cap” - it cannot exceed the amount of the cap). However, if for some reason your new pre-money valuation is $5m (below the cap), then the valuation for the initial investor will be $5m.
Interest: Some convertible notes contain interest. Assume you raise a $300k convertible loan with 10% simple interest. If after exactly 2 years you raise $4m Series A at $12m pre-money valuation, your initial investor’s $300k will now be worth $300k x (1+ 10%) x 2 years = $360k, therefore their shareholding in the company will equal $360k/($12m + $4m) = 2.25%.

Note that valuation cap, discount and interest can be (and usually are) used in combination.

Recommended readings

Notes

* Pre-money valuation is the valuation of the company before investment. Post-money valuation = Pre-money valuation + the amount of investment.

Keep in mind!

The contract is secondary to human relations. First make sure you want to deal with the given investor in the long term (investment is a marriage! - you usually don’t marry just because someone has money 😊).
Read every single sentence of the investment document. If need be, find a friend and ask questions until the moment you realize you understand what you are signing fully. Keep in mind though, that you do this not to find any pitfall in the contract, but to make sure you have full understanding of the document.
Standardized investment instruments ease your life both at the moment of the investment as well as in later stages. Any amendment may cost you lots of money paid for legal advice both now and in the future (which is even more risky). You are lucky if your investor shares the same vision.

Safe - Simple Agreement for Future Equity

Safe is a standard form of convertible security introduced by YC in December 2013. When investors use Safe, they buy the right to convert the convertible security (i.e. Safe) to preferred stock once an equity-financing round occurs*.

Safe has the following basic features:

Safe is not a debt instrument = you don’t have any obligation to repay it.
There is no maturity date and interest in Safe. This means there is no deadline to convert to equity. YC claims that “This is particularly beneficial for startups, but also better embodies the intention of investors, who never meant to be lenders in the first place”.
Safe allows for a rolling round or so-called “high precision fundraising”. Startups can close with each investor as soon as both parties are ready - no need to close with all investors simultaneously.

There are four versions of Safe, corresponding to the four types of convertible note:

Cap, no Discount
Discount, no Cap
Cap and Discount
MFN, no Cap, no Discount

While the names of the first three are self-explanatory, the fourth requires some explanation. MFN stands for Most Favoured Nation. In this context it means that if you use Safe MFN, then you are obliged to promptly notify your investor about any subsequent convertible financing you attract. If the initial investor determines that the terms of a new convertible security issued are more attractive than those of the initial Safe, you shall amend the initial Safe to be identical to the new convertible security.

Safes are great, but they have drawbacks for the investors and therefore investors tend to avoid those (or use side letters giving them additional rights above the basic terms).

One key drawback is that there is no maturity date. Therefore, if no equity financing occurs (e.g. the company goes bootstrapping) then technically Safe cannot be converted.
Next, there is no liquidation preference allowance for the preferred stock issued upon conversion of Safe. Whereas other investors can use the benefits of the liquidation preference.
The dividend rate (if you eventually become a dividend company) will be calculated based on the price per share of the Safe Preferred Stock. If Safe contains either a cap or discount, then the price per share may be less than the one for standard equity investors, and therefore Safe Preferred Stock holders will be entitled to less dividends.

Recommended reading / materials

Notes

* Safe Preferred Stock will be a separate series of preferred stock (otherwise referred to as “shadow preferred” or “sub-series” preferred stock).

KISS - Keep It Simple Security

KISS was introduced by 500 Startups in July 2014. 500 Startups claims that those “are designed to be flexible without being overly customizable, simple while still including all of the necessary features, and balanced from both a company and investor standpoint”.

There are two types of KISS:

KISS: Debt Version (which includes an interest rate and a maturity feature);
KISS: Equity Version (without interest or maturity).

Below is the summary of the variables contained KISS.

Series (#)

You can raise multiple (series of) seed rounds - each having their number. Each series, however, shall have identical terms for all the participants.

Purchase price ($)

The amount raised from the investor

Discount (%)

Discount from next equity financing valuation

Valuation cap ($)

Pre-money valuation of the company

Interest rate (%)

Applicable for Debt Version only. Annually compounded interest rate.

500 Startups’ preferred rate is 5%.

Maturity term (months)

The number of months upon which the conversion occurs automatically. If there is no equity round before conversion, then KISS is converted at the valuation cap.

500 Startup’s default term is 18 months.

Major investor threshold ($)

Any investor who invests more than certain amount in the given series shall be considered as Major. Major Investor has additional Information (financial and other reporting) and Participation rights (see Participation multiple).

500 Startups’ threshold is $50k.

Participation multiple (x)

Applicable only to Major investors. Major investors have the right of first offer to participate in subsequent rounds on the same terms and for the same price as all other investors in such round. If the participation multiple is more than 1, then the investor can invest more than their pro-rata share in company*.

500 Startups uses 1x by default.

Corporate transaction payment (x)

Corporate transaction means either of the following:

• the sale, transfer or other disposition of substantial part of the Company’s assets,

• merger or consolidation of the Company with or into another entity,

• liquidation, dissolution or winding up of the Company.

Corporate transaction Payment is equal to X times the Purchase Price plus all accrued and unpaid interest (if Debt Version).

500 Startups uses 2x multiple by default.

Qualified financing threshold ($)

Not each equity financing qualifies. You usually agree some minimum threshold amount. Any amount raised below that will not trigger a conversion event.

Why this threshold? Remember the purpose of convertible note - postponing valuation to a later stage when the company is mature. Hence, if you raise another small round, it is reasonable to assume that you have not reached sufficient maturity to price your company.

500 Startups’ default threshold is $1m.

In addition, KISS provides with MFN protection by default.

Obviously, the KISS is a bit more complicated but much more balanced and investor friendly (compared to Safe).

Further reading

500 Startups Announces ‘KISS’: Free legal docs for startup founders and investor
What are the key differences between the Y Combinator SAFE and 500 Startups KISS?
KISS and SAFE vs TATS (Tradeable Automated Term Sheet) - Quora question response by Jared Brubaker, managing partner of Brubaker Law and author of TATS

Notes

* Assume you have 10% in the company and 2x participation right. When the company raises $500k, you have pro-rata participation right to invest $500k x 10% = $50k. However, because of the 2x participation right, you can invest $50k x 2 = $100k in that round.

Techstars Convertible Promissory Note (Bridge) Financing

Techstars Promissory Note is a publicly available form introduced by Techstars in 2011. The notes are framed around two basic documents:

Convertible Promissory Note Purchase Agreement (“Agreement”)
Convertible Promissory Note (“Note”)

The first one governs the general terms of the financing round (applicable to all investors of the round), whereas the second one contains the terms of investment of the particular investor. The Agreement usually contains an appendix with a list of all the Notes issued under that Agreement.

The main differences with KISS are the following:

The Agreement defines Requisite Holders = holders of the Notes representing a majority of the aggregate principal amount of all Notes then outstanding.
In certain conditions (e.g. no qualified equity financing round) Requisite Holders may require repayment of the Notes together with accrued interest - a term that is not favorable to the entrepreneur.

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Applicability in ArmeniaTechnically you can attract investment to a company incorporated in Armenia through KISS, Safe or any other instrument governed by foreign jurisdiction. However, in such case it is recommended to add an arbitration clause to resolve the disputes through a specified arbitration process. Note that Armenian legislation is very pro arbitration, and additionally Armenia is party to Convention on the Recognition and Enforcement of Foreign Arbitral Awards and foreign arbitration is enforceable in Armenia.

Keep in mind, though, most of the countries foresee denomination of the stock in national currency. In Armenia the shares need to be denominated in Armenian drams (the national currency of Armenia), so the issue of currency conversion needs to be discussed at the note issuance and subscription stage.

On a separate note, it is better to start seeking any form of investment after incorporating in a jurisdiction that is preferable to your follow-on investors. In the tech startup world Delaware is one of the expected jurisdictions unless your investors are bound to certain geographic, regulatory or other restrictions. Depending on the specificity of the process, clients, investors etc., it sometimes might be advisable to establish a company somewhere else (e.g. if the market is Iran or Russia, or if the investor is from Europe, then Luxembourg, the Netherlands or the Ireland could be expected incorporation jurisdiction).

Our recommendation is that you consult with a lawyer in Armenia before entering into any such agreement.

Closing remarksWhile the deal is very important, let’s keep first things first. At the end of the day, what matters most is not the details of deal terms but the capability of the team and winning the game. People are not saying "He got a 4x liquidation preference." They're saying "He invested in Google." (Paul Graham). Hence, above all, both entrepreneurs and investors should seek mutual understanding and trust.

We at SmartGateVC are always happy to help entrepreneurs within our orbit and are open to give advice. We also seek to level up our ecosystem through sharing our knowledge and experience.

Acknowledgments: Big thank you goes to Aram Orbelyan of Concern Dialog Law Firm for comments and reviewing the section of applicability in Armenia.

Disclaimer: This is not a legal or financial advice, and for more specific issues, we suggest to consider consulting the specialist. The purpose of this guide is to explain in general terms different models used in the startup world, and it is to be understood as a general introduction, rather than advice. We do not bear any responsibility for any harm or damage which may raise from use, non-use or wrong use of the information described in this post.

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