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Term Sheet For Convertible Promissory Notes

Alex Wilmerding, Aspatore Books Staff


The number one takeaway from introductory business school finance courses is that debt is typically less expensive than equity. This is generally the case for established businesses that can comfortably service debt from cash flow and thereby access additional capital at a market rate without diluting equity holders. For companies that are not yet cash flow positive and are in early or expansion stages of growth, debt-like facilities or leverage can take on several forms, each of which will be explored in this chapter. Depending on its form and the attendant expectations of investors, debt can create a host of costs and obligations for entrepreneurs. For this reason, entrepreneurs need to assess the trade-offs involved in leveraging the capital structure of their company and the possible implications for equity holders.

The terms and obligations attendant to various forms of debt that are made available to growing private companies are as specialized as those related to equity. This chapter will explore the different types of debt or debt-like financing and the typical terms associated with them that entrepreneurs need to consider. This chapter will review the universe of issues surrounding leverage for growing, venture-backed businesses that are not yet cash flow positive and conclude with an analysis of a form of term sheet used by a venture firm to propose one of the more common forms of debt to companies - the convertible promissory note, or what is often called "bridge financing."

VC Experts has teamed up with Aspatore Books to reprint some of the more salient sections of Alex Wilmerding's book Deal Terms, The Finer Points of Venture Capital Deal Structures, Valuations, Term Sheets, Stock Options and Getting Deals Done. This excerpt features a:

Term Sheet for Convertible Promissory Notes

The following term sheet is an example of a form used by venture investors to propose a syndicated round of convertible promissory notes for a company. In each section of the term sheet, an explanation appears in italics detailing the purpose and rationale behind the language in that section.

Case Study:

Company, Inc. Summary of Terms for

Convertible Promissory Notes

Issuer: Company, Inc. ("Company").
Investors: Venture Firm One or affiliates, Venture Firm Two or affiliates and others (the "Investors")

Author's note: Most forms of term sheets include the names of the "lead" investor(s) as well as reference to "others," thereby leaving open the opportunity to other investors to participate. The term "affiliates" is included to accommodate the various funds that are associated with a firm and that may invest together the total amount a firm commits to a financing.

Type of Security: Convertible Promissory Notes ("Notes").

Author's note: Convertible promissory notes are notes that serve as debt but convert under the terms of the financing. Notes can convert to equity automatically upon a certain event or at the discretion and choice of the note holder, terms that will be stipulated in the "Conversion Rights" section of the term sheet.

Closing: It is anticipated that the Closing will occur on or about [Month] __, 2002, or as soon as possible thereafter.
Security: The Notes will be a secured senior obligation of the Company, secured by all assets (including intellectual property) of the Company.

Author's note: Notes are not always secured, but when secured can be secured broadly, as in this case, or by specific assets of the company. Should secured notes come due and the company be unable to pay them or renegotiate payment terms, note holders take ownership of the assets of the company.

Principal Amount of Notes: Up to $500,000, to be advanced from time to time as needed, to be determined by the holders of a majority in interest of the Notes following a request by the Company.

Author's note: Principal can be paid in at one time at one closing or in multiple closings. The mechanics of a financing can allow that commitments can be received for one amount, and then multiple draw-downs of capital "called" as the company requires them. While this approach is clearly more complicated than one single closing, it can provide the company with more flexibility, should the company anticipate other sources of liquidity - a large pending contract, for example - that could satisfy the company's capital needs and prevent it from having to draw any additional capital.

Term of Notes: The Notes shall be due and payable on [Month]__, 2002, subject to extension by the holders of a majority of principal amount of the Notes to [Month]__, 2003.

Author's note: Extensions set expectations both for note holders who, in purchasing a minority of notes will need to follow the lead of the majority in a decision whether to extend or to "call" notes, and for the company.

Rate of Interest: Eight percent (8%) per annum, payable at maturity.

Author's note: Whereas "Prime Plus 1%" is not uncommon as a standard for notes of this nature, it is less likely to be adhered to when Prime is below 8%.

Conversion Rights: Notes plus accrued interest to the date of conversion may be converted by an Investor at any time into Series ___ Units of the Company at a 15% discount or may, at the Investor's option, convert into shares of the Company's securities issued in the next round of financing that is greater than $1,000,000 (excluding the Notes) (the "Next Round Financing") subject to the terms and conditions of the Next Round Financing; provided, however, if holders of a majority in interest of the Notes convert their Notes, all Notes shall automatically convert at such time on the same terms and conditions as the Notes of the holders of a majority in interest of the Notes.

Author's note: The rate at which notes may convert into a subsequent round of financing will vary depending on the risk associated with the bridge financing. In this round, the notes are discounted by 15%.

Prepayment: The Notes may be prepaid in their entirety, at any time, without premium or penalty.

Author's note: The pre-payment clause gives the company the right to pay down the notes, providing it with the ability to relieve itself of the note obligation.

Use of Proceeds:

Options:

The proceeds from the sale of the Notes will be used for general corporate matters.

_______ additional options shall be created and granted at the discretion of the board to employees

Author's note: Every financing is dilutive to existing shareholders. Because the terms as outlined under the "Conversion Rights" clause typically result in additional dilution, the note holders may propose issuance of additional options to "protect" certain members of management from dilution. Whereas the dilution associated with bridge financing may "penalize" a company that has failed to perform, additional options may be appropriate particularly for those members of management who may not be directly responsible for the company missing its targets and who would otherwise be demoralized by the dilution.

Pro Rata: Each holder of Series ___ Preferred shall be entitled to purchase Notes in an amount necessary for such holder to maintain his/its percentage ownership of Series ___ Preferred (on a fully diluted basis).

Author's note: It is typical that existing preferred stockholders be offered the right to invest in proposed notes for several reasons. First, when other sources of capital are scarce, their capital is attractive. Second, the terms of a bridge financing may be significantly attractive enough to create a conflict between the note holders and the provisions of the preferred, should each member of the preferred be prevented from participating. Third, even when members of the Preferred may be unable to participate, the offering protects those who do participate from future legal action.

Existing Notes: All promissory notes issued by the Company for funds advanced to the Company previously shall be amended to provide that the terms of such notes will be the same as the Notes and shall provide for conversion in accordance with their terms in the event of conversion by the holders of a majority principal amount of notes of like tenor.

Author's note: The senior class of notes which are to be created further to the terms of this term sheet will want to be certain that any existing notes follow the lead of a new class of notes. This is stipulated so that in the event of a future financing or conversion mandated by an event considered in the best interest of new note holders, the old note holders do not serve as an obstacle to such action.

The Purchase Agreement: The purchase of the Notes will be made pursuant to a Note Purchase Agreement drafted by counsel to the Investors. Such agreement shall contain, among other things, appropriate representations and warranties of the Company, covenants of the Company reflecting the provisions set forth herein and other typical covenants, and appropriate conditions of closing. Until the Purchase Agreement is signed by both the Company and the Investors, there will not exist any binding obligation on the part of either party to consummate the transaction. This Summary of Terms does not constitute a contractual commitment of the Company or the Investors or an obligation of either party to negotiate with the other.
Expenses: The Company and the Investors shall each bear their own legal and other expenses with respect to the transaction, provided that if a sale of the Notes occurs, the Company shall pay the reasonable fees and expenses of one counsel to the Investors.

Read more of Deal Terms, The Finer Points of Venture Capital Deal Structures, Valuations, Term Sheets, Stock Options and Getting Deals Done in the Encyclopedia of Private Equity and Venture Capital.