You may understand how term sheets form, but what about the underlying deals they describe? What are the key issues and tradeoffs involved? The topic of equity deal terms is vast, and starting to tackle it first requires an understanding of a key threshold question. And the question happens to be one of the most contentious and controversial topics in early stage investing today: whether you should do a priced equity round or use convertible debt instead.
A priced round is an offering and sale of newly-created stock in your company at an agreed-upon per share price. Once stock is sold, investors are part owners of your company. Convertible debt is a loan from those investors that is never meant to be paid back. It is intended to convert into stock at a future date, based on some yet-to-be-determined price.
Why the Controversy?
Convertible notes are popular, simple and familiar, despite having important drawbacks. Reasonable people differ on how to weigh the pros and cons. Some note detractors cannot get past the downsides, while note fans prefer not to let perfect be the enemy of good enough. Many who use notes choose to ignore or don't fully appreciate the issues involved, and this can cause defensiveness when the practice is called into question.
The Problems With Notes
The fundamental challenge is the misalignment of pricing incentives notes create between the investor and entrepreneur. With a note, the price of the stock is not set at the time you commit. It is set at a future time in connection with a future priced round. If the price on that future round is set high, the entrepreneur wins and gives less stock to the note holders. If the price is set low, the investors win and get more stock for their original investment. Your investors win if you lose - not a well-aligned set of incentives.
This misalignment can be partially addressed by setting a cap or maximum price at which note holders will convert, and/or by promising an automatic discount on the price of the round, or even by providing warrants instead of a discount. However, these mechanisms don't really solve the problem, and also introduce their own set of issues.
The cap has the effect of sending a strong but totally inexact pricing signal in the eyes of the market. If the entrepreneur sets the cap high, they are fenced into a high implied valuation that they may not be ready for when the day comes. Setting a low cap can telegraph weakness and lead to a lot of dilution if the next round prices a lot higher than the cap.
Keep in mind that all of this is happening at a time when investing in the company is really risky and its theoretical value is changing rapidly with each small milestone achieved. Many investors feel that equity upside is a perfectly-calibrated form of compensation for assuming the early risk, because these investments can catapult the company up the steep part of the valuation curve. However, in the majority of cases, notes are done with a relatively a high cap which creates a situation where the discount to the cap is all investors receive. This means they are basically taking equity risk for debt returns.
Caps don't work any better for founders. As a pricing tool they are about as blunt as a sledgehammer. Because of how they work, if a cap is set wrong, founders risk unlimited founder dilution on the upside and give away the equivalent of unlimited anti-dilution protection for investors on the downside. No founder would willingly sign up for multiple liquidation preferences or full ratchet anti-dilution protection, but an out of whack cap set by an inexperienced founder or investor can operate similarly.
Note holders also assume risk that their contractual protections can be renegotiated at any time (as contrasted with the harder-to-alter rights provided to holders of equity). Undisciplined founders who don't have a lead investor can issue multiple notes with different caps and conflicting terms which can pile up, creating a mess that can be nearly impossible to reconcile.
Perhaps most importantly, investors doing a simple convertible note lack other investor protections typically included in priced rounds such as board seats, protective provisions, a minimum needed for the round to close, pro-rata rights, drag along rights, registration rights, etc. Although mechanisms exist to address this, including note-holders' agreements, investor rights agreements, voting agreements and side letters, adding all these terms back in on top of a capped note with a discount destroys the greatest virtue of notes - their cheap simplicity. And the Frankenstein you've created is still an awkward bargain--both founders and investors are giving up key projections and assuming fundamental misalignments. (Side note: some people recommend a device called a SAFE (Simple Agreement for Future Equity) as a better alternative to convertible notes. SAFEs are basically warrants, so while they do address some of the pricing alignment issues with converts, they do not address these weak positioning issues and are not a complete or even useful solution to the problem.)
Why Notes Are Popular
Unlike stock transactions, convertible debt deals at their core are nothing more than short promissory notes (here's an overview of the key documents.) Notes are cheap and easy. Convertible debt defers the issue of pricing, involves fewer simpler documents, and allows founders to bring in one investor at a time without a coordinated closing. By comparison, priced equity rounds permanently alter the capitalization of the company by adding new stockholders. Given this permanence and the inherent complexity of these transactions, a great number of different types of deal documents are required for stock transactions.
However, there are two places where the virtues of notes might outweigh their drawbacks: very small initial seed rounds and supplemental bridges between priced rounds. In very early stages when the amount of money is small, founders and investors tend to know each other or at least share affinities for the market, the technology or the customer. In these deals, transaction costs need to be kept really low to avoid becoming a huge percentage of the round. Simplicity tradeoffs make sense because being exact is an unaffordable luxury. In the context of a supplemental bridge, notes can make sense for different reasons: because of the reduced pricing risk. The company has already been priced in an earlier round and milestones and growth are better understood, making it harder for the cap to be wildly off.
Although my bias is that if you can possibly price your round, you should, I do believe in being creative. For example, if it is a smaller round, and transaction costs are a concern, they can be cut in half by setting up a plan to use the exact same documents on your next round of financing. If that approach doesn't work, consider a very simple sale of common stock. Although investors will pay less because they have fewer protections, alignment is created, transaction costs are low, and any pricing signals are mitigated because it is a common stock share price and later rounds will be preferred stock.
If you choose a note because neither of those ideas appeal or the round is so small that it doesn't matter, I highly recommend at least using a thoughtfully derived cap, a reasonable discount (check your market norms and avoid both the high and low ends of the prevailing range) and a note-holders agreement to address key issues like voting and governance.
No doubt the debate over priced rounds vs. convertible notes will continue. Hopefully you're now more aware of the issues and trade-offs before you venture down the path.