The Game-Changing Clause Every Entrepreneur Should Add to Their Convertible Notes

Part 2 - Convertible Note

Hey there, fellow entrepreneurs!

I stumbled upon a fascinating article by a Silicon Hills lawyer called "The Problem in Everyone's Capped Convertible Notes," and it really caught my attention. It delves into an issue that affects entrepreneurs far and wide: the hidden dangers of capped convertible notes. I couldn't resist sharing this valuable insight with all of you. So, let's cut to the chase and explore the essential paragraph that every entrepreneur needs to include in their convertible notes.

Before this - I hope you understand the Convertible note very well, if not please read our previous writeup - Understanding Convertible Note

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So, here's the deal. When you get into bed with a convertible note that has a cap and converts into the next funding round, there's a dirty little secret waiting to bite you in the backside. If your venture takes off and you raise funds at a higher price than the cap, those early angels can end up with "multiple liquidation preferences" on their precious dollars. Let me break it down for you:

• Let's say an angel invests $500,000 with a $5 million cap. That means they'll own at least 9% of your company if the conversion price exceeds the cap. If you raise funds at a lower price, their ownership goes up (pretty straightforward, right?).

• Now, with a regular 1x liquidation preference, they'd be entitled to $500,000 if you sell the company for less than $5 million. If you sell for more, they'd rather take their ownership percentage instead of that liquidation preference, which acts like a safety net.

• Fast forward a bit. You work your tail off for 18 months, securing a series of notes, and guess what? You're lucky enough to land $5 million at a juicy $25 million pre-money valuation. At this point, that early angel investor owns around 16.67% and probably still holds a 1x liquidation preference.

• Now here's where the trickery starts: When the initial note converts, instead of snagging a $500,000 liquidation preference, they'd cash in a mind-boggling $2.5 million liquidation preference—a whopping 5x increase!

If a venture capitalist pulled this stunt on an early-stage deal, they'd be scorched by such a bad rep that no other VC or entrepreneur would touch them with a ten-foot pole. In VC financings, this stuff is out in the open so entrepreneurs know what they're getting into. But with convertible notes, it's all implicit, and we end up scratching our heads later, wondering how we got shafted. It's the silent screwing that really stings.

But fear not, my friends! I've got a weapon to arm you against this injustice. Here's what you need to add pronto to any convertible note you're raising money on. And mark my words, if an angel refuses to agree to this, it's time to run like the wind and find someone else. Heck, I'd love to see a website that exposes these sneaky angels. I've got some big-name culprits in mind, but I won't start a public feud... yet.

Here's the magic clause to include:

"If this note converts at a price higher than the cap you're given, you agree that when it's converted into equity, your stock will be converted to entitle you to no more than a 1x non-participating liquidation preference, plus any agreed-upon interest."

Papering this when it converts is super easy if the angel has already consented to it and they are not being cheated at all. They get their full investment as a 1x liquidation preference. And please don’t let any angel try to convince you they deserve more for the early risk. The early risk is why they get a cheaper price.

Now, I'm no lawyer, so it's wise to get some legal advice to make sure this clause is airtight. But trust me, adding this baby will give you some much-needed protection and level the playing field. Don't let any angel sweet-talk you into thinking they deserve more for taking the early risk. Their sweet deal on the price already compensates.

For those seeking a more comprehensive understanding, I highly recommend checking out an exceptional post by José Ancer on the topic of the "liquidation preference overhang."

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