In a convertible note financing (or an increasingly popular SAFE financing), the change of control premium—the benefit given to a lender if the company has an exit before the notes convert—is an easily overlooked term. This is because it is rarely applicable, especially when the financing is a seed-type investment. The typical expectation from a lender is that either the company will secure additional financing (i.e., the note will convert into preferred stock) or the note will never be repaid because the company was a complete flop. Only in cornerstone cases will a company sell itself prior to its next equity round. In these cases, lenders want to (and arguably should) be rewarded for being the only economic backers in the company. The most common form of reward is a fixed multiple of the principal amount of the note. But it can benefit both founders and investors to avoid a fixed-multiple change of control premium and instead include an optional conversion into equity on a change of control.
The main problem with a fixed-multiple premium is that it can overcompensate lenders in very small exits and undercompensate them in very large exits. To illustrate, let’s say NewCo (a pre-Series A company) completes a $1.5 million note financing with more or less market terms:
- the notes convert at the next preferred stock financing at the better of a 20% discount or a $6 million pre-money valuation cap; and
- if there is a change of control before the financing, the lenders get their principal and interest repaid plus a premium payment of 1.5X the original investment.
As a side note, this scenario would be even more awkward if NewCo also had a series of preferred stock outstanding. In this case, the lenders would get their entire investment and premium, while the preferred holders would probably receive nothing. From the preferred holders’ perspective, it is inequitable that they should take a bath on their investment while the lenders get their full premium. With these results, NewCo might even have trouble convincing a majority of the preferred holders to approve the sale without changing the economic terms of the notes.Next, imagine that six months down the line, NewCo is DOA: it has not completed its next round of financing, it is out of cash, it can’t find any new investors, and the lenders have no interest in investing more money in NewCo. After shopping around for a potential buyer, the best offer NewCo can find is $4 million. Based on the terms of the notes, the lenders would receive $3.75 million (plus the accrued interest) of this purchase price. After paying back the lenders and taking into account transaction costs, the equity holders (who primarily consist of the founders) would likely be left with next to nothing. By comparison, if the investment was structured as a traditional Series A preferred stock round at a $6 million pre-money valuation and a 1X liquidation preference, the investors would receive only their preference ($1.5 million), and even after accounting for transaction costs, there would be proceeds remaining to be divided among the common equity holders. While the lenders should be able to protect their investment, the comparisons above show how the premium payment can be ham-fisted. If NewCo has a fire-sale exit, the lenders should be willing to forgo a beneficial return. The pain should be equally spread among both the lenders and the founders.
To illustrate the other end of the spectrum, let’s change one fact: six months after the note financing, NewCo receives an unsolicited offer to sell itself for $40 million. In this scenario the lenders would receive their full principal and premium of $3.75 million (plus interest), and the equity holders would receive about $36.25 million. This would grossly undercompensate the lenders, who provided the only economic fuel to reach the $40 million valuation, compared to the amount divided among the equity holders.
In contrast, giving the lenders the option to convert their notes into equity (which essentially treats the principal and interest as a 1X liquidation preference) would alleviate some of these inequities but still protect the lenders’ investment. Consider what would happen in the same scenarios as above if, instead of getting the 1.5X premium payment on a change of control, the lenders could elect to either (i) have NewCo repay the principal and interest or (ii) convert the principal and interest into common stock at the $6 million pre-money valuation cap (i.e., the lenders would own about 20% of NewCo).
Applying the conversion feature to the $4 million exit, the lenders could elect to either have the $1.5 million in principal plus interest repaid or receive about $800 thousand (i.e., 20%) of the purchase price. Clearly, the lenders would elect to get their principal and interest back, and the equity holders would divide the remaining $2.5 million among themselves. And in the $40 million exit, the lenders would elect to convert to common stock to receive $8 million of the purchase price (a 5.33X return instead of the $1.5 million in principal plus interest), and the equity holders would divide the remaining $32 million among themselves.
While this conversion feature does not give the lenders the guaranteed return that a fixed premium would provide, it balances the concerns of the founders and lenders—the lenders get the same upside/downside liquidation protection they would otherwise have in a preferred stock financing, and the founders are able to hedge against overpaying the investors in a very small sale.
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