Just recently the issue of Convertible Notes vs. Preferred Equity came up with an entrepreneur. It was an interesting discussion and caused me to think deeply about both types of financing methods and why entrepreneurs and investors may or may not like either one.
In this Part I post, I describe what I’ve learned about Notes and Preferred Equity. This is by no means exhaustive or even showing that I’m an expert in this, but I choose to state what interesting information I did dig up over the many months I’ve been doing this angel investing stuff.
Characteristics of Notes:
1. They are cheap. I just heard a quote from a law firm that, after terms were set, you could close a Note at about $1000 in legal fees.
2. They are quick. You can close a Note in about 2 days, assuming everybody gets their cash transferred in. If you need cash in a hurry and the other larger financing round is going to take more time to close, then the Note can give you cash in the short term very quickly.
3. The paperwork is minimal. Only one document is required, which is expanded from the term sheet and spells out the terms of the Note in exhaustive detail. Investors sign that, the money is transferred, and you’ve got cash.
4. At early stage, many companies have little assets. Generally, for early stage startups, Notes are unsecured, meaning they are not backed by the assets of the company. So if you go under, you are really under no obligation to pay investors back.
5. It keeps options open for the next equity financing. Valuations may change and the Note doesn’t cause any potential issues with Preferred Equity ownership prior to the next round of financing.
6. Negotiation on terms is possible, increasing time and cost to close.
7. Notes, or convertible notes, are basically loans to the company. The investor doesn’t own any part of the company, and there is a promise to pay back the loan with interest. The convertible aspect means that at some point, generally when the next financing occurs, the money you invest would convert to the terms of the next financing. Sometimes it’s spelled out as to which financing it is, and sometimes it is not.
Characteristics of Preferred Equity:
1. Preferred equity holders gain actual ownership in the company.
2. It locks in a valuation for the company at time of closing.
3. They are more expensive than Notes to close. A recent quote, after terms were set, would cost about $10,000 to $20,000 in legal fees to close a Preferred round (versus the $1000 of a Note closing).
4. Preferred Equity rounds take longer to close. They may take up to 3 weeks to finalize everything (versus as little as two days for a Note).
5. There is more paperwork involved. A Note involves only the expanded Note document. A Preferred Equity round involves a Stock Purchase Agreement, Investor Rights Agreement, filing of changes in the Articles or Certificate of Incorporation, potentially a Voting Agreement, and other supporting documents and changes. After all the paperwork is signed, a Preferred Stock certificate is sent to each shareholder.
6. It will require an official board meeting resolution to approve, and recording of minutes.
7. Negotiation in terms is possible, increasing time and cost to close.
8. Preferred Equity may cause issues in further financing rounds as follow-on round investors may desire more ownership and/or control in a company and may be deterred from investing by the fact that there already are Preferred Equity owners present.
9. Preferred Equity holders get preferential treatment as defined by terms. These can be things like, in case of company liquidation, they get paid back first, or anti-dilution provisions, or special voting privileges, or the ability to select a board member to represent their interests.
In Part II, I look at Notes versus Preferred Equity from the entrepreneur point of view. Part III will look at Notes versus Preferred Equity from an investor point of view.