After years of increasing acceptance of and reliance on convertible note financings as a mechanism for funding early-stage companies, we have noted a clear emerging trend away from such transactions (and others like them, including SAFEs (Simple Agreements for Future Equity) and KISSes (Keep it Simple Securities)) that defer determination of valuation at the time of the financing in favor of a return to priced equity rounds.
Why Convertible Notes and Other Securities That Defer Valuation Determination?
Over the past decade, convertible notes have become a “go to” alternative method of raising capital for early-stage companies, in place of the more traditional priced equity round. A convertible note is simply a loan that converts to equity upon a company’s future priced equity financing. The theory has been that early-stage companies simply are not appropriate subjects for a meaningful valuation determination given the absence of observable performance metrics. At the same time, priced equity rounds often involve more complex documentation, especially provisions relating to the rights, preferences, privileges and designations of preferred equity instruments, and, therefore, a longer time period to closing and higher transactional costs. Cash-starved startups eagerly embraced convertible notes as an easy fix: kick the can down the road on valuation until the company has achieved some performance metrics and is raising enough capital to support and justify the valuation analysis; rely on simpler documentation; and enjoy a shorter time period to closing and lower transaction costs.
These benefits seem obvious enough, but investors are smart and their demands have evolved. The perceived benefits of kicking the can down the road on valuation have been diminished somewhat by investors’ appropriate demand for capped conversion prices. The much-sought-after minimal negotiation and simplified documentation started to become illusory as investors next sought increased protections above and beyond the capped conversion price, including a board seat or an observer’s right; information rights; participation rights; and liquidation premiums, among others. Convertible note deals began to more closely resemble priced preferred equity rounds, with increasing complexity, time and cost.
In the ongoing search for easier and lower-cost access to capital, innovative entrepreneurs, investors and advisors next looked to SAFEs and KISSes as alternatives to the convertible note, but discounts and caps remain common requirements. As with the evolution of convertible notes, SAFEs and KISSes on steroids emerged (with additional provisions and investor protections akin to those increasingly found in convertible note deals).
Why the Return to Priced Equity?
Unlike a convertible note, a priced equity round establishes a valuation as of the date of the investment. Investors provide the company with capital in exchange for an ownership stake in the company. Investors generally prefer a priced equity round rather than a convertible note, as the former provides greater rights, privileges and protections (as well as certainty) than does a convertible note, or a SAFE or a KISS transaction, including a liquidation preference, antidilution protection, etc. Founders, too, often recognize that a priced equity round establishes the dilutive effect of the financing, while convertible notes with caps involve substantial uncertainty, often with negative surprises for founders when the priced equity deal finally is consummated. Also, a far-too-often overlooked benefit of ownership of equity interests for founders and investors alike may be found in “qualified small business stock” (QSBS) and the very favorable tax treatment associated with QSBS, which can dramatically increase return on investment.
What Are Entrepreneurs and Investors to Do?
Whatever the instrument – preferred stock, common stock, convertible note, SAFE or KISS – the goal remains the same, however elusive it may be: ample access to low-cost capital. In our representation of early-stage and emerging growth companies, we have noticed an emerging but clear trend away from convertible notes and a return to priced equity financings. The trend seems to be driven by a combination of (i) the increasing complexity of, and, therefore, the rising transaction costs associated with, convertible note financings (as noted above, the historical simplicity of such transactions was a major driver in their adoption); (ii) institutional investors having a clear preference for priced equity rounds; (iii) the presumed “certainty” of the dilutive effect of the priced equity round over the uncertainty associated with deferring that analysis and determination to subsequent investors, impacting founders and investors; and (iv) the increased willingness of investors and entrepreneurs to accept relatively standardized term sheets and definitive transaction documents. This standardization is a critical point – transaction costs must be appropriate relative to the amount of capital being raised. By standardizing terms, we can reduce the cost of early priced/preferred stock rounds, thus allowing for the return to priced equity rounds and a decline in the reliance on convertible notes.
Given the foregoing, the market is pushing for standardization of documents and terms, which can be used to simplify the negotiation and drafting of priced equity rounds. First it was Series Seed Preferred Stock. In our practice, while handling series seed preferred stock financings, we noted that the rights, preferences and privileges of the series seed preferred stock can vary widely, with some transactions closely resembling traditional Series A financings (with the full range of definitive documents, rights, preferences and privileges), while others are much simpler (requiring only the purchase agreement and restated certificate, with far less complexity and, with that, reduced transaction costs). We, and others, have attempted to create a highly standardized set of deal documents, so as to be consistent with the rationales for the trend identified above. Enter “pre-seed” preferred stock financings, with a simple term sheet, fewer but important protections, and a menu of provisions that may be included or excluded depending on the term sheet and results of negotiations. If investors and companies can come to an understanding and agreement with respect to the terms of a financing at the various financing stages, the costs of such transactions can be dramatically reduced, allowing for and accelerating the shift away from convertible notes and back to priced equity rounds.
Convertible notes were never truly intended to replace the priced equity round, but given the costs associated with such transactions, they were born of necessity. If we can reduce the costs of the priced equity round, we can better match form and substance, providing a happy medium for companies and the investors who support them. Of course, there is no “one size fits all” in the world of financing for early-stage tech and tech-enabled companies. Trends come and go, but the constant is the never-ending desire to provide mechanisms for entrepreneurs and investors to achieve their goals with securities and capital-raising tools that offer broader and easier access to much-needed capital resources at costs that are appropriate relative to the size of the capital raise. The search continues.
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