Post Category → Founders

Founder Convertible Notes – Put Your Money on the Cap Table

It’s quite the norm for a startup to run on its own founders’ sweat equity and personal funds (bootstrapping) until the Company is able to raise outside capital.  A very important question that isn’t asked often enough is, “how do I paper the money I’m putting in?” Does it just go in and disappear? Does it pay for my stock?  While there are + and -s to different approaches, the answer that I almost always arrive at is: treat yourself like an investor.  In other words, paper your bootstrapping in a way so that it goes (eventually) on the cap table.  You benefit economically, and investors actually like to see evidence that you put more skin in the game than just your time.

  • Don’t use it to buy Common Stock – Your Common Stock should almost always be issued at par value ($0.0001 per share or some similar number in your Certificate of Incorporation) at the very beginning of the Company. This is proper because the Company is worth very little from a “fair market value” perspective, and issuing it at a higher price sets a FMV precedent that ends up hurting later employees because they then have to pay that higher price too.
  • Don’t buy Preferred Stock – Unless you’re a seasoned entrepreneur, the documentation and terms are too complicated for you to handle at the very early stages, and you’re not experienced enough to set a valuation. You’ll likely end up setting a bad precedent that will come back to bite you if you bring on real investors.
  • Don’t treat it as a loan – How do you think it looks to an investor if you’re asking them to actually invest (not loan) their money and risk losing it all, but you’re only willing to loan your personal funds? Bad.
  • Answer: Founder Convertible Notes – Issue yourselves convertible notes. Pre-financing, they are effectively a debt claim on your own company.  But upon raising the threshold amount that you set in the notes, they’ll convert into Series A Preferred Stock. This means (1) you now have a liquidation preference that will ensure you at least get that money back on an exit alongside future investors (unlike your Common Stock, which will likely sit beneath them), and (2) you get to vote those shares alongside future Series A investors.  Papering this is also a lot easier than buying preferred stock, and you don’t have to set a valuation.

Background Reading

Issues to Consider

  • Interest rate on the notes: 4-8% is fair
  • Discount on conversion: 20% is fair
  • Qualified financing threshold – $500K-$1M is fair
  • Cap on Conversion Valuation – Probably not a good idea for a founder note.
  • Maturity – Give yourself enough time to raise funding. 18-24 months is fair.
  • What happens at maturity? – Realize that at maturity, the notes will become “due.” This means the person holding the note can, if they want to, demand repayment (they could just extend otherwise) and cause all kinds of problems if they don’t get repaid.  If it’s just one founder or a couple of people you trust, this likely won’t be a problem. Make sure the maturity period is long enough, and be aware of the risk.  A lawyer could draft in extra protections to kick in at maturity, but that customization will cost money.

Good Forms to Use

  • Clerky has the ability to issue convertible notes cheaply. For founder notes, you don’t need the term sheet. While these aren’t rocket science, it’s still best to hire a lawyer if you want to completely avoid mistakes. But if it’s just one founder, or a small group of founders with no legal budget, they could probably handle this on a DIY basis if they read carefully.
  • Note that the Company’s Board of Directors should formally consent to the note financing. If you have a lawyer, ask for a simple board consent.  The reality is, however, because only the founders are involved, you can just ratify later when you’ve hired decent counsel.

The Founder’s Stock Issuance

There’s a lot of uninteresting formality that goes on in a startup’s corporate formation, most of which founders rightfully ignore because they have better things to worry about.  But there’s one document that pretty much every founder will make sure to ready carefully – or at least ask lots of questions about: the Founder’s Restricted Stock Purchase Agreement (or some variant of that name).  Here’s a quick outline that an entrepreneur might use to walk through the document:

General Themes: We (1) want to make sure the Company owns all IP; (2) want to incentivize the founder to stay with the Company and add value; and (3) if the founder leaves the Company or someone else gets ahold of the shares, we want to be able to get them back so no one who isn’t involved with the Company has voting power.

  • Number of shares and nominal price – Most of the time the stock is sold at par value, which will be a fraction of a cent.  Because the Company is at the very beginning stages and extremely risky, placing this miniscule value on the stock usually isn’t considered problematic.
  • IP Assignment – In exchange for the issuance of stock, the founder assigns all rights to the IP that he/she may have with respect to previous work.  Look for a very long definition of what constitutes Company IP.
  • Repurchase Right – This is where you’ll find the vesting schedule.  Nutshell: a mechanism to require the founder to earn the shares over time, and giving the Company the right to get the shares back if anyone leaves.  Explaining that in more detail would take too long for this post, so just click that link.  Unless a founder’s gone solo, there should be a vesting schedule in the document.  If not, fire your lawyer, or get one.  Also useful: Vesting Calculator.  You’ll also likely sign some form of Assignment that gives the Company the administrative ability to exercise this right.
  • Acceleration of Vesting – Upon certain events, usually termination of the founder, a Change in Control (think acquisition), or both, a certain percentage of the stock’s vesting is “accelerated.”
  • Miscellaneous Securities Law Reps – Lots of stuff thrown in by lawyers to ensure that the document doesn’t violate any securities laws.
  • Right of First Refusal – Basically, you can’t sell the shares to anyone without the Company first being able to buy them on the same terms.  Meant to keep shares from getting into the hands of strangers.
  • Divorce/Separation Repurchase Right – If you divorce or legally separate from your spouse, and such spouse happens to get ahold of some shares, the Company has the right to buy them back.
  • Death Repurchase Right – This is somewhat more optional and language varies, but still quite common.  If the founder happens to pass away, the Company has the ability to repurchase shares at fair market value to prevent them from being transferred to the founder’s heirs, devisees, etc.
  • Transfer Restrictions – General restriction that you can’t transfer the shares other than through a “Permitted Transfer” (or some variant of that term), which usually includes gratuitous transfers (not sales) to immediate family and affiliate entities, and requires consent of the Company.
  • Escrow of Shares – The Company (actually their attorneys) will hold on to the actual certificates of the shares and handle administrative matters related to them.  This helps the Company enforce the transfer restrictions and other covenants in the document, and for future diligence purposes it just makes it easier to have them in one central place.
  • 83(b) Election Language and Form – Here’s an explanation.  You have 30 days from the issuance of the shares. It keeps you from being taxed as your shares vest.  Do it, or you’ll be sorry.
  • Compensation Agreement/701 Language – In a nutshell, all share issuances need to qualify for a securities exemption in order to avoid having to “register” the shares, which is crazy expensive.  Rule 701 is one such exemption, and it requires that the shares be issued as compensation – in this case they’re being issued in exchange for IP and past service – not for an investment.
  • Spousal Acknowledgement – Your spouse acknowledges all of the restrictions in the agreements, agrees to be bound by them if he/she ever gains ownership of the shares, and gives you (founder) the right to act on his/her behalf with respect to shares.  This makes sure community property won’t muck up the ownership and that nobody has to ask your spouse for permission to vote the shares or do anything else with them.

Obviously, to make all of these provisions work together there will be lots of extra detail providing processes for exercise, waiver, notice, and explanations for how each provision interacts with the other.  The devil is definitely in the details, and, if you’re working with a reputable firm, this document will have been screened by specialists in tax law, employment law, IP, etc. to ensure that they pass legal muster.  A lone generalist with no outside input can be dangerous.