5 min read

Understanding Your Term Sheet: Convertible Debt, Convertible Equity and More

500’s legal expert Annie Woodworth walked us through the ins and outs of term sheets and what you need to know about convertible securities.

500 Global Team

Published

05.11.20

Part of the territory of being a founder includes wearing many hats, and while scrappiness and hustle can help you navigate your fair share of them, it doesn’t always help you decipher your term sheet. 500’s legal expert Annie Woodworth walked us through the ins and outs of term sheets and what you need to know about convertible securities.

What is a term sheet?

A term sheet is the document that outlines what your investors will get for what they put in—typically including their investment amount and investor rights. If you get a term sheet, you should get excited (and get a lawyer).

In venture financing, there are two main buckets for investments: convertible instruments and equity financings.

Companies that go through an accelerator like 500 Startups will be more familiar with convertible securities (such as KISSes, SAFEs and convertible notes), which are very common at the early stage.

Equity financings, which are also called preferred stock financings or priced rounds (such as a Serie A, B, C and so on), are more common for companies in later stages.

Convertible Debt

Convertible debt is a bit more antiquated these days, and it’s a note that has to be repaid or converted into equity. The idea is that it will convert into shares at the next equity financing, but if it doesn’t, and you reach the maturity date, then it has to be repaid (unless you extend the maturity date, which is often what happens).

When negotiating convertible debt, pay close attention to the interest rate and maturity date. If you’re dealing with venture investors, they’re not investing to make money by charging you interest—they’re trying to convert into equity. So if you see a very high interest rate, such as over 10%, it’s usually a red flag. Similarly, another red flag would be a maturity date that seems too soon— unless you’re raising a bridge round and expecting to close an equity financing within that time-frame.

 

Another point to take into consideration is how easy it is to amend the notes. If you’re doing several convertible notes at the same time with different investors, it can be easier for you to treat them like a round, and include a provision allowing a threshold percentage (often a majority) of investors to amend the terms, instead of having to go out and get everyone’s signatures to amend each one individually.

Convertible Equity

Convertible equity is more common than convertible debt in Silicon Valley these days. The two most well-known forms are the SAFE and the KISS. 

These are similar to a note in that they convert into shares at the next financing round, but there’s no maturity date or interest rate. This makes it a lot easier for everyone. For one thing, there’s less to negotiate. You don’t have to sit down and argue over the interest rate, because there isn’t one. And then if it takes longer to raise financing than you expect, you don’t have to negotiate an amended maturity date a year or two years down the line.

These carry a little bit more risk for the investor because if you don’t raise the financing or exit, then the SAFE or KISS just sits unconverted and without being repaid, but that’s a risk that investors are generally happy to take because their real interest is converting if the company does well.

These instruments are usually short, but can sometimes include added rights in the instruments or in side letters, such as:

  • Pro rata rights: Gives an investor the right to participate in a subsequent round of funding to maintain ownership in the company. This  tends to be pretty common.
  • Most favored nation: If you issue another convertible instrument to someone else, you have to go back to that investor and show them that note and let them trade out their for the new form if they think the terms are better.
  • Information rights: The right to see financials and other similar information about the company.

 

Wondering how to get a term sheet from 500 Startups? Accelerator applications are now open year round—apply today!

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500 Global Team

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