The issue with the liquidation preference of the CN is, by default, a CN converts at a lower valuation than the equity round, and therefore, receives the same liquidation preference as the equity round into which it converts. This is great for CN holders as they get 20% (typically) more money back on the liquidation preference than they would have had they invested in the equity round. This is exacerbated when a company stacks up CN’s rather than converts them. And, capitalization table math is already something akin to black magic. As such, it becomes a a challenge to manage financially, and it pays out early stage investors at a relatively higher differential rate than later stage investors and before the founders see a penny. As early stage investors, we don’t see this as a problem, but some industry critics site it as such. And, SN’s still have this issue!
As for the interest rate, it is a blunt instrument we use to force management to stay focused on exiting us because our shares effectively decrease in cost by 8% (typically) for every year they don’t repay or convert us! Again, we don’t see this as a problem.
Many have observed that a valuation cap effects the valuation of the next round of funding and are therefore problematic to the extent the investor may be shooting-himself-in-the-foot by pricing the cap too low. The original SN did not include a valuation cap, which is why we have not used them in the past. The SN’s we will consider will all contain a valuation cap, which is quickly becoming the standard. That simply means we need to set reasonable valuation caps. This is not a social welfare program for nerds. We must be compensated for the oftentimes excessive risk we take by investing in early stage investments. We absolutely want a valuation cap to compensate us for our risk (e.g. a risk premium) as an early stage investor.
The SN does not result in shares being granted at the time of the investment, but rather a warrant. Although it should be, it may not necessarily be recorded on the cap table until conversion depending on how the company views the obligation (for the record, anecdotally, we typically see 20% – 30% of the companies we go through deep diligence have errors on their cap tables, meaning these are easy mistakes to make). SN’s typically don’t come with Board of Directors participation or observer rights, which is yet more fodder for why we have panned them in the past. But, we are seeing more of these governance types of terms in the market now.
The other thing to note about a SN is it typically does not have a maturity date. So, it is essentially a zero-interest loan to the company until such time as it raises a qualified equity round. That begs the question of an early exit. In this event, the standard SN has a 1x buyout or conversion to the new stock of the acquiring company. However, a 2x liquidation preference in this event is becoming more accepted, which is what we do with our CN’s.
The SN has one other peccadillo. Since it is not a debt instrument, you can’t write down the investment as bad debt if it fails, which can typically be deducted fully in the same tax year. Equity must be offset by gains elsewhere to be deducted or taken in small doses over several years. With a CN, the holder is actually a creditor in the event of wrapping up of operations where assets remain, which is admittedly rare in this industry. The SN is lumped in with all the equity holders and enjoys no preference in distribution of assets in the event of a negative liquidation event.
Entrepreneurs love SN’s. They are cheap to execute and are essentially a passive investing vehicle with lower financial downside in the event of success or failure. This is also the reason we don’t typically use them unless they have a very compelling discount, valuation cap, a 2x liquidation preference in the event of premature exit, and some BOD oversight.
We are seeing a trend in the marketplace now whereby entrepreneurs are reluctant to price a round and thus use CN and SN to postpone the valuation issue for too long. The result is often a substantial dilution to the company when new equity invests, pricing the round. This is especially problematic when too many Notes are stacked up…and with differing valuation caps. Entrepreneurs fall prey to these traps thinking they are pushing off dilution to their favor when they are actually doing the opposite. Any sophisticated investor looking at the issue will likely pass on a new round if they believe the founders will be excessively diluted by a conversion of too many notes. So, be smart when you consider a SN (or CN for that matter) to make sure the entrepreneur has not disproportionately committed to a big conversion/dilution in the future.
When should you use a SN?
- For a bridge to a milestone/valuation changing event.
- For a very early stage investment where pricing the round is not straightforward and you expect to hold for a long time.
- When you wish to close a deal cheaply and quickly in order for some external event to precipitate that will convert your SN to equity advantageously.
- When you do not wish to create any more long-term debt on the company’s books (depending on the stage and revenue of the company, we recommend never having more than $1M in convertible debt on the books if it can be avoided).
What you should be concerned about?
- Multiple SN’s stacked up.
- Multiple valuation caps.
- An entrepreneur that is unrealistically opposed to pricing a round that will convert Notes.
- Make sure the entrepreneur has recorded all SN’s as warrants or other obligation on the cap table.
What to do when issuing a SN?
- The Discount Rate should account for the lack of an accrued interest feature.
- The Valuation Cap should roughly correspond to the expected valuation of the next round of capital.
- You should seek a 2x Liquidation Preference in the event of an early exit.
- We always advise a BOD or at least observer rights with an investment.
For more information:
- SAFE Notes Part II
- Y-Combinator docs
- Funders Club SAFE Primer
- AVC CN vs. SN
- Indinero CN vs. SN
- TechCrunch – Why Safe Notes are NOT Safe for Entrepreneurs
- Wilmderding – GREAT RESOURCE FOR UNDERSTANDING TERMS AND TERM SHEETS
This is published under the Appalachian Regional Commission POWER Grant, PW-1835-M
Copyright Appalachian Investors Alliance, Inc. 2018
@angelcapitalgr | @appalachianinvestors | www.appalachianinvestors.com | www.theangelcapitalgroup.com | www.facebook.com/angelcapitalgroup