Startup Bonds

The Startup Bond

Convertible notes have been used in seed stage startups for years, but they are usually used as a bridge to a preferred-stock round of funding. The idea behind the  Startup Bond is that this form of financial instrument can be used in place of the preferred stock structure--and can be used to provide all the funding a startup needs.

Notes[1], bonds, loans and debentures are all forms of debt financing. Debt is attractive to the entrepreneur in that it does not provide the lender with an equity interest and the entrepreneur does not have to give up the same degree of control as he/she would expect under the VC-Preferred model. The downside to debt from the entrepreneurs perspective is that it needs to be paid back, with interest. The investor likes debt in that it puts them in the position of creditor if the Company fails and is forced into liquidation. The problem with debt from the perspective of the investor is that they do not get to participate in the upside profits if the Company is sold or reaches a successful exit.

The interests of both investor and entrepreneur can be achieved through a Startup Bond—a convertible debt instrument that converts to stock under certain pre-defined conditions. From the investor’s perspective, the beauty of the Startup Bond is that the investor has the upside of an equity position if the Company does well, but also has the protection of being a creditor, with priority over shareholders, if the Company does not perform well and winds up in liquidation. From the founders perspective, this structure is appealing as the noteholder is not a shareholder until conversion takes place, so has no fiduciary rights to vote or control the Company.

Fiduciary duties to noteholders
Delaware and other jurisdictions have well settled law that the fiduciary duties owed to a shareholder are not extended to the holder of a convertible note until the note is indeed converted to shares. Essentially, the holders of a convertible note are treated as creditors until they convert to stock—at which time they become shareholders. The court in Simons v. Cogan[2] found that the corporation and its directors did not owe a fiduciary duty to the debenture holders because the convertible debenture did not represent an equitable interest in the issuing corporation.

If the right to conversion can take place only at the closing of a liquidity event, such as acquisition or IPO, then the investor has very little control over the Company and the founders and existing management is free to operate the Company without worrying about fiduciary duties to outside investors.

Standing to bring derivative suits
A derivative suit is a civil lawsuit filed by shareholders on behalf of a corporation asserting rights of the corporation in the absence of corporate action to protect such rights—a suit by shareholders to enforce corporate rights against directors or other insiders. The standing of shareholders to sue is derived from the rights of the corporation. Although shareholders have standing to bring a derivative suit, under Delaware law[3], creditors do not. So, the holder of a note is unable to bring a derivative suit until the note is converted to equity, at which time the holder becomes a shareholder and fiduciary duties attach.

Usary laws
Debt usually carries interest, and the level of interest that can be charged by an individual is capped by state usary laws. Consumers are often treated differently than business borrowers, with different conditions and usary law caps. In California, the legal rate of interest is 10% for consumers; the general usury limit for non-consumers is more than 5% greater than the Federal Reserve Bank of San Francisco's rate. Currently in Delaware the legal rate of interest for all borrowers is 5% over the Federal Reserve rate. When arranging a note with an individual angel investor, the usary laws may be triggered so it is important to investigate the current interest rate and statute for the state in which the transaction takes place.

Redemption
The whole purpose of investing is to inject money now in the hope that it will be returned, with interest, at some point in future. By enforcing the Securities Exchange Act of 1934, the SEC prevents unregistered securities such as shares and notes issued to closely held corporations, from being traded on the secondary markets. So, investors in non-reporting companies run the risk of having their investments locked up and unavailable for redemption if the Company fails to reach an exit.

For this reason, it is important that the convertible note carry a redemption provision such as this:

Term Redemption
The Company agrees to redeem the notes four years after the issue by returning a total of [ ] times the principal to the noteholder. So, a $100,000 note issued in 2007 will be redeemed by the Company for $200,000 in 2011.

Early Redemption on Acquisition
The noteholder shall have the right to put the notes to the Company for early redemption in the case of a sale of the Company, or the sale of all, or substantially all, of the Company’s assets. So, if the Company is acquired prior to redemption of the notes, a holder of a $100,000 note putting the note to the Company shall receive the full redemption value of $200,000. However, it is anticipated that noteholders would elect to convert to common in the case of acquisition under the terms below.

As noted above, the usary laws can prevent the interest rate being set too high. The drafter of the provision can overcome this by using language referring to a “2x redemption” value in, say 4 years, instead of a “50% p.a. interest rate”.

An alternative that is more appealing to the investor is to give the investor the right to put the note to the Company for redemption after a certain period of time has passed and the Company has the funds to redeem the note with interest:

Right to Put the Note to the Company for Redemption
At any time after the [ ] year anniversary of the issuing of the note, the noteholder can put the note to the Company for redemption. Within [ ] days, the Company will redeem by returning a total of [ ] times the principal to the noteholder. So, a $[ ] note issued in 2007 could be put to Company in [ ] for a redemption value of [ ].

This would allow the investor to liquidate his/her funds if the Company is not acquired and there is no other liquidity event such as an IPO.

Conversion rights
Angel investors are accustomed to notes with conversion provisions anticipating a preferred round of funding. If there is no preferred round anticipated, then the note needs to allow for conversion at other triggering liquidity events such as the sale of company, sale of control, or sale of the Company’s assets.

Common Stock Conversion Rights
Immediately preceding a sale of the Company, or the sale of all, or substantially all, of the Company’s assets, or IPO, the noteholder shall have the right to elect to convert the note to common stock. The conversion rate shall be calculated at $[ ] per share, reflecting a pre-funding valuation of $[ ]. So a note acquired for $[ ] would convert to [ ] shares of common stock.

This allows the investor to benefit from the upside in an acquisition or exit by conversion to common stock, but by pushing the point of conversion to the time immediately preceding such event, the fiduciary duties owed by management to the investor are only triggered for a brief moment in time between the conversion and the closing of the transaction (such as the sale of the Company). This structure allows the entrepreneur to maintain control over the Company and avoid being forced to answer to the investors. Decision-making regarding dividends, exits and other significant matters are left with the entrepreneur.

Of course, the investor would like to have the option of converting to preferred stock if a VC-Preferred round were to take place, and a provision could be made in the note allowing for this:

Preferred Stock Conversion Rights
Management does not envisage the Company needing to raise significant rounds of funding and currently has no plans to raise a venture round of funding. However, if conditions change and preferred stock is issued, then the noteholder shall have the right to convert the note to such preferred stock. In such case, the redemption value of the note shall be used to calculate the number of shares of preferred stock that shall be issued to the noteholder. So, a $100,000 note with a redemption value of $200,000 could acquire preferred stock with a value of $200,000.

Exemptions from registration
Under the 1933 Securities Act and the 1934 Securities Exchange act, it is illegal to sell securities unless they are registered with the SEC, or qualify for a valid exemption from registration. Under the definitions and enumerated lists defining the scope of instruments classified as security in both the 1933 and 1934 acts, the preferred stock investment and the convertible note would fall within the scope of a ‘security’. So, the convertible note would need to be registered with the SEC or qualify for an exemption. The intra-state exemption can easily be accidentally voided by solicitation to a potential investor out of state. So, Regulation D, the private placement safe harbor provision of section 4(2) provides the most obvious source of exemption. Under Regulation D, a Form D would need to be filed with the SEC, this can be done online through the Edgars system, and either of Rules 504, 505 or 506 selected. Rounds less than $1m in value can qualify for Rule 504, rounds under $5m would seek the exemption of Rule 505, and rounds larger than that would need to be exempted under the more strenuous conditions of Rule 506.

Founders using these exemptions when raising funds for their companies need to be extremely careful that they do not solicit the offering. Each of the rules (504-506) has its own solicitation guidelines and state law also governs solicitation of securities to investors. Companies should be advised to take extreme care not to advertise the offering and to focus on face-to-face solicitations wherever possible.

Disclosure
The securities regulations and SEC enforcement activities focus on disclosure. Issuers of securities (in this case startup companies raising funding) are required to provide accurate disclosure of material information to investors. Information is considered material if a reasonable investors would consider the information when making a decision to buy or sell the security, or to cast a shareholder vote. A lawsuit based on fraud can be brought by a shareholder or investor as the result of a mis-statement or omission of a material fact under the 10b-5 section of the 1933 Act. Section 11 also allows for a claim of fraud in the prospectus, but this only applies to situations of IPO or issues of new securities by post-IPO reporting issuers.

So, what does the entrepreneur need to disclose to the investor to avoid an action based on 10b-5 fraud? There are no bright-line rules but form SB-1 or SB-2 could be used as guideline of the type of information that should be provided to investors. Although it sets a higher bar in terms of what needs to be disclosed, SB-2 may be the safer option for issuers to select as it incorporates a requirement to disclose the risk factors. By failing to disclose such risk factors, founders may find themselves less-than perfectly prepared to defend a 10b-5 suit from disgruntled investors later on.

New convertible note offerings from VCs
Charles River Ventures[4] (CRV), a Silicon Valley VC recently launched an interesting new form of investment structure for companies raising smaller rounds of funding. The CRV program works as follows:
CRV has created an innovative program to eliminate these issues and help entrepreneurs get up and running quickly - the CRV QuickStart Seed Funding Program. CRV QuickStart provides select entrepreneurs with a loan to fund the work needed to build out your idea, enabling you to explore its potential in its earliest stage before you raise a round of formal equity financing. By offering up to $250,000 in the form of a loan (also referred to as a “convertible note”), we’re providing the capital to fuel ideas without that painful seed-stage dilution.

Here is how the loan works:
A standard interest bearing loan will be made to a corporation, which we will help you establish if you do not already have one in place. CRV will not seek a personal guarantee and will not hold you personally responsible for repaying the loan.
The loan converts into equity only if and when your company closes its next round of funding (typically a Series A round). If the Company successfully raises its next round, in exchange for sharing the risk with the entrepreneur, CRV receives a discount on the conversion price when the loan is rolled into that next round. the discount will be a maximum of 25% (determined ratably at five percent per month, depending on how long it takes to close the financing, up to the maximum) off of the per share price.
A simple example: if CRV loans your company $100,000 with a six percent interest rate, and six months later the Company closed a Series A round, at that point the loan balance (with interest) would convert at a 25% discount (value = loan dollar amount plus interest / .75) into $137,333.33 worth of Series A stock. Given that seed funding amounts are typically very small compared to the amounts one might expect to raise in a Series A round, as the example illustrates, the aggregate discount amount, in this case $37K, is a tiny fraction of what tends to be a multimillion dollar Series A financing.

In addition, CRV would like the opportunity to support the Series A financing and will have an option to invest equally with other new investors in the Series A equity funding. For example, if you raise a $3M Series A round, and the entrepreneur wanted 2 venture firms or investors, CRV would be allowed to contribute up to $1.5M of the round (e.g. $3M divided by 2). If the entrepreneur wanted 4 firms or investors, CRV would be allowed to contribute up to $750K of the round (e.g. $3M divided by 4). Whatever number of investors the entrepreneur wants, we will happily support the ability to split the investment equally among the investors.

This type of structure bridges the gap between angel funding and VC, and it is important in that it provides new options and alternatives to entrepreneurs.

[1] A note is usually less than 5 years in duration, a bond is longer than 5 years and a debenture is unsecured.
[2] 549 A 2d 300. Delaware. 1988.
[3] Kusner v. First Pennsylvania Corp., 531 F.2d 1234.
[4] http://www.crv.com/AboutCRV/QuickStart.html

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