Convertible Note Financing

Everything you need to know about raising money with a Convertible Note Financing over Goodlawyer.

1. What is a Convertible Note Financing?
2. Pricing and Scope
3. What is the Process?
4. Advantages of a Convertible Note Financing
5. Frequently Asked Questions
6. Book a Convertible Note Financing

 

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What is a Convertible Note Financing?

A Convertible Note is a common financing instrument used by some startups to raise capital in early-stage financing rounds. Angel investors and startups commonly use Convertible Notes as an alternative financing instrument to SAFEs and series seed preferred equity: two early-stage fundraising instruments also favoured by angel investors. 

A Convertible Note investment contract is entered into between a startup and an investor and gives the investor:

• A creditor’s claim to principal and interest
• The right to receive equity of the company in the future on the occurrence of certain standardized conversion events

The conversion features characteristic of Convertible Notes are very similar to the conversion features of a SAFE investment contract. However, Convertible Notes ARE debt instruments. Convertible Notes contain the following key terms that define debt instruments:

• Principal balance
• Annual rate of interest
• Maturity or repayment date
• Priority on payment ahead of the corporation’s equity holders in a liquidation

Convertible Note Financings are “investor friendly” since the noteholders get down-side protection from the debt characteristics of the notes and because the price of the equity that noteholders receive on conversion is lower than the price of the securities issued to Venture Capital (VC) investors in a conversion event. Noteholders pay less when converting to equity of the company at a conversion event, based on either the:

• Discount rate
• Valuation cap
• Learn more about the key terms that founders need to understand when issuing a Convertible Note in the FAQ

Convertible Note investment contracts include standard event of default provisions, including but not limited to insolvency/bankruptcy, material and unremedied breach of agreements, criminal offense or material breach of law, and failure to make any payment when due. Upon an event of default, all of the obligations of the corporation to noteholders under the Convertible Notes (principal and interest) are immediately due and payable before the equity holders receive any distribution of the corporation's residual assets. Basically, noteholders get their money back first.

Note that Convertible Note Financings may not be the most appropriate investment instrument to raise capital from friends and family. Convertible Note Financings Financings are a sophisticated way to raise capital from investors who understand the startup financing framework and work best for companies with a clear and foreseeable path to a “conversion event”, like a VC financing round. For a simple investment structure more suitable for early-stage fundraising from friends, family and accredited investors, we offer a Common Equity Financing product.

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Pricing and Scope

The lawyers in the Goodlawyer network adhere to the standards set out by National Angel Capital Organization (NACO) and Thomson Reuters Practical Law for Convertible Notes. Learn more in the FAQ.

If you’ve negotiated a Convertible Note financing round that deviates materially from the terms of the NACO or Practical Law Convertible Note, your lawyer will create a custom service to best suit your unique fundraising needs and goals.

 

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What is the Process?

1. Book a call: Pick a time to discuss your Convertible Note Financing with a Good Lawyer. They'll help you determine if it’s the right investment solution for you.
2. Design your Convertible Note Financing: Work with your Good Lawyer to design a Convertible Note Financing that meets your business’ and investors’ needs. You might need to negotiate with your investors on the deal, especially if they are sophisticated investors or exercise their right to seek independent legal advice. 
3. Draft your Convertible Note contracts: Work with your Good Lawyer to prepare a Convertible Note investment contract for each participating investor (up to 5 investors, maximum). One round of minor revisions to your Convertible Note investment contract is included in your Convertible Note Financing. 
4. Secure the bag: Once you and your investors agree on the deal and your lawyer has prepared a Convertible Note investment contract for each of your initial 5 participating investors, it’s up to you to collect signatures and get that money!

 

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Advantages of a Convertible Note Financing 

Investor familiarity.

Convertible Notes are one of the most popular investment instruments for raising seed capital. As a result, most professional seed-stage investors are already familiar with their key terms and function.

Standardization. 

Convertible Note documents tend to follow a standardized structure and form limiting investors’ focus to the key negotiated terms. 

Speed to closing.

Although convertible notes are technically debt instruments, many investors view the instrument as deferred equity. Generally, the goal of an investment in convertible notes is to convert them into the same preferred equity security sold to the first company’s institutional venture capital investor, rather than to receive their principal plus interest at maturity.

As a result, investors typically focus their attention on the conversion features of the convertible note and defer negotiations concerning investors’ preferred contractual rights and protections to the institutional venture capital investor at the company’s next financing round — so you get to closing faster.

 

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Frequently Asked Questions

How does the Goodlawyer Service Fee work?

Because we believe in transparent pricing, we make our best effort to be upfront about additional fees and how they are calculated.

Visit the Goodlawyer Service Fees page for a detailed explanation.

What is an Investment Readiness Assessment?

An Investment Readiness Assessment ensures your company is clean, your record-keeping is up-to-date and you are ready to efficiently close your investment round. Your Good Lawyer’s goal is to identify legal or procedural barriers to completing your investment round by checking things like articles of incorporation, shareholder agreements, share capitalization table (the “cap table” or list of who owns stock) and other documents. 

The information discovered by your Good Lawyer during the Investment Readiness Assessment helps to:

• Draft a high-quality Convertible Note document
• Ensure compliance with applicable securities laws, governing organizational documents and other contractual restrictions

The principal topics of review covered by your Good Lawyer in an Investment Readiness Assessment are:

• Corporate structure — organizational documents, including certificates or articles of incorporation, amalgamation or continuance, by-laws and other organizational documents relating to your company. 
• Corporate governance — minutes of your company's board of directors relating to equity issuances, as well as any documents or contracts relating to shareholders, equity issuances or pre-emptive rights.
• Share capitalization — records relating to all holders of the issued and outstanding classes and series of shares in the capital of your company, including the date of grant, purchase, or transfer. All shareholder or similar agreements to which your company is a party.
• Convertible securities — records relating to all holders of warrants, stock options or any other securities convertible, exchangeable or otherwise exercisable for any class or series of shares in the capital of your company, including date of grant, exercise price, number and type of securities, expiration date, vesting terms, and any other significant term in relation to such rights or interests.
• Promised but unissued securities — records authorizing or granting shares, options, warrants, stock options (including all stock option plans and other equity incentive plans and any shareholder rights plans) or other rights or interests in your company.
• Shareholder voting and governance arrangements — records relating to outstanding proxies, voting rights agreements and voting trusts or other assignment of rights attaching to any securities of your company.

When is a Convertible Note Financing appropriate?

Although popular and preferred among many angel investors, Convertible Note Financings are a sophisticated way to raise capital and best suited to investors who understand the startup financing framework. Convertible Note Financings work best for companies with a clear and foreseeable path to a “conversion event”, like a venture capital financing round.

Are there any disadvantages to Convertible Note Financings?

While Convertible Notes boast many advantages that make them attractive to startups and early-stage investors, they also come with a few disadvantages that founders should consider when picking their investment instrument.

1. Sophistication. Convertible Note Financings are “simple” because they follow clear and recognized investment terms, not because they are necessarily easy to understand. Convertible Note investment contracts demand sophistication to negotiate, understand and execute properly. For this reason, Convertible Note Financings are best suited for investors who understand the startup financing framework and for companies with a clear and foreseeable path to a “conversion event”, like a venture capital financing round. 
2. Dilution uncertainty. Because Convertible Notes convert to equity at the next liquidity event, neither the investor nor the startup knows exactly how much equity the Convertible Note converts into until the company completes a “conversion event”, like a venture capital financing round. Founders planning a Convertible Note Financing are advised to run some pro forma investment scenarios to better understand how their ownership control is impacted by various discount rates, valuation caps and conversion events.
3. Debt attributes (maturity). Many founders dislike that Convertible Notes eventually mature, potentially giving noteholders leverage to extract a better deal if the company fails to reach a conversion event prior to maturity. Even if the noteholders are willing to extend the notes without any financial sweeteners from the company (which they often are), the company still incurs legal fees to document an extension to the maturity date of the notes.
4. Debt attributes (interest). Founders often view the interest accruing feature of Convertible Notes as inconsistent with the premise that these securities are effectively deferred equity.  
5. Simple now, complex later. Although Convertible Note investment contracts make it easy to raise capital with minimal upfront negotiations surrounding preferred investor rights and terms, legal issues and complexities often arise when a company completes a “conversion event”, like a venture capital financing round. This added complexity results from how the economic terms of the Convertible Notes interact with the economic terms of the preferred shares in the next financing. It is not always clear from the Convertible Note documents exactly which type of calculation the holders of those instruments intended at the time of the financing. 
   
   Even if the method of calculation is clear from the documents, those investors may be forced into renegotiations if the investor leading the next equity financing round requires certain concessions from those investors as a condition to that investor's equity investment. The investor may seek, for instance, to calculate the conversion to minimize the ownership percentages of the noteholders in relation to the corporation's founders and themselves. Sounds complicated, right?

What terms are in a Convertible Note?

The key terms that founders need to understand when issuing a Convertible Note are outlined below:

1. Total Financing Amount and Subscription Period 
   1. The “Total Financing Amount” establishes the total amount of investment the startup is seeking in the Convertible Note Financing.
   2. The “Subscription Period” establishes the time period during which the company is seeking investment in the Convertible Note Financing. 
   3. 90 days is a typical subscription period.
2. Principal Loan Amount
   1. This is the amount of money that the investor is lending the startup through the Convertible Note — the actual amount invested by the noteholder.
   2. The aggregate principal amount of notes sold in a typical Convertible Note Financing can range from tens of thousands of dollars to upwards of $1 million.  
3. Interest Rate
   1. The fixed rate of interest (ranging between 2-10% annually) required to be paid by the company to the noteholder on the outstanding principal loan amount. Accrued interest is either (i) converted together with the principal loan amount on the date of conversion; or (ii) paid to the noteholder in cash at the time of conversion or repayment.  
4. Maturity Date
   1. Most Convertible Notes mature between one and two years after the corporation issues them. At maturity, the principal loan amount plus accrued interest becomes due and payable. 
   2. The corporation's failure to repay the notes at maturity is not automatically an event of default unless payment is demanded by the applicable noteholders. 
   3. If the Convertible Note does not convert and the company cannot repay, then the noteholder has the right to enforce its security in order to seize the assets of the company. This is an extra layer of protection for the noteholders that would not be available if they had committed their funds as equity investors. 
   4. In practice, Convertible Notes are often left outstanding well past their original maturity date if they have not otherwise converted to equity since the likelihood that the company owns any assets of value (possibly some IP) against which security can be enforced is slim.
   5. In other cases, noteholders use the maturity date to negotiate an extension to the term of their Convertible Notes to a future date in return for amendments to their investment terms, like an increased interest rate and/or an improved conversion term.
5. Priority and Security
   1. Convertible Notes issued in seed financings are almost always unsecured obligations of the corporation. This means the noteholders have a claim on the corporation's assets that is senior to the company’s shareholders and equal to the company’s other unsecured creditors. 
   2. Convertible Notes are usually unsecured because the cost of documenting and securing a valid security interest for a seed-stage startup is rarely worthwhile from an investor's perspective.
6. Conversion Events
   1. Convertible Notes may convert into different types of equity on the occurrence of any of the following events:
      1. The closing of a subsequent equity financing of at least a certain minimum size (See Next Equity Financing/Significant Financing/Qualified Financing).
      2. The closing of a sale of the corporation or all or substantially all of its assets (See Corporate Transaction/Change of Control).
      3. Reaching the maturity date of the notes before closing a subsequent equity financing or sale of the corporation (see Maturity Date).
7. Next Equity/Significant Financing/Qualified Financing
   1. A next equity financing triggers the conversion of each Convertible Note (including interest) into the same shares that a new equity investor purchases in the subsequent financing, with the noteholders getting the benefit of the applicable note conversion price. In most cases, a next equity financing means a preferred share financing (though an issuance of common shares may also cause the notes to convert).
8. Corporate Transaction/Change of Control
   1. Generally, if the corporation is sold or completes an IPO while the notes are outstanding, noteholders may elect to:
      1. Receive the principal and accrued interest of their notes.
      2. Convert the value of their notes into common shares at a discount to the price at which corporation is listing or selling its common shares in connection with the corporate transaction. 
      3. Convert at the price implied by the valuation cap or discount rate.
9. Conversion Price
   1. When a conversion event occurs (most often, a next equity financing conversion), convertible noteholders receive equity based on the principal and interest balance of their promissory notes, but at a price that is lower than the price paid by the new equity investors. The price the noteholders pay is calculated based on the valuation cap or discount rate. 
10. Valuation Cap
    1. A ceiling, or cap, on the valuation at which the Convertible Notes convert at a conversion event, like the qualifying financing. The valuation cap prevents a scenario where the startup uses the funds from the Convertible Note Financing and builds a business with a much larger valuation at the next financing round than anticipated at the time of the Convertible Note financing. For example, you were expecting to raise a Series-A at $15 million, but you strike gold and raise at $50 million instead. This outcome would leave the noteholders with a much smaller ownership stake than if they had chosen to structure their investment as equity at the outset. The valuation cap ensures that noteholders still have a meaningful stake if your startup achieves an unusually high valuation in its next financing round.
    2. Founders should be clear and explicit with their team and investors whether the valuation cap is based on a pre-money valuation or post-money valuation. As its name suggests, a pre-money valuation cap does not take into consideration the capital the corporation will receive in the Convertible Note Financing. With a post-money valuation cap, the corporation's valuation is equal to the company's pre-money valuation plus the amount invested in the corporation in the Convertible Note Financing. 
11. Discount Rate
    1. As a reward for investing early before a valuation is set and shares are issued, noteholders may receive a discount on their investment at the time of conversion. This means that the price per share used to calculate the conversion of the Convertible Notes is less than the price per share of the corporation issued to the new equity investors at the Next Equity/Significant Financing/Qualified Financing. 
    2. Discounts in Convertible Note Financings typically range between 10% to 30% off of the preferred share price, with the most common discount being 20%.
12. Events of Default 
    1. Convertible Note investment contracts include standard event of default provisions, including but not limited to insolvency/bankruptcy, material and unremedied breach of agreements, criminal offense or material breach of law, and failure to make any payment when due. Upon an event of default all of the obligations of the corporation to noteholders under the Convertible Notes (principal and interest) are immediately due and payable.

Do Convertible Note Financings typically contemplate special investor rights and protections?

Holders of Convertible Notes do not typically receive contractual rights or protections above and beyond the key terms noted above. In order to enhance their rights or protections investors may negotiate side letters with the corporation that provide for some or all of the following rights:

• The right to subscribe for additional preferred shares when their securities convert in a next equity financing (referred to as Pre-Emptive Rights)
• The right to appoint a director or a board observer 
• The right to regularly receive financial statements or other information about the corporation's business (referred to as Information Rights)
• The right to receive the benefit of any more favourable terms given to other investors (referred to as Most Favoured Nation Rights)

Note that any side-letters like the ones outlined above are not included in our standard Convertible Note Financing service and are subject to additional fees.

What’s the difference between a SAFE and a Convertible Note?

SAFEs and Convertible Notes are extremely similar investment instruments but there are some key differences. The most important difference is of course that SAFEs are not debt securities, meaning they are interest free and do not have maturity dates. This is advantageous to the founder(s) and startup, but is more risky for the investors.

What does Post-money and Pre-money mean?

The value of your company before you take on external investment is called the pre-money value. The post-money value is the pre-money value of your company, plus the amount of cash that was invested.

Before an investor puts money into your company, that investor owns 0% of the pre-money shares. After accepting external investment, your new investors own a percentage of the post-money shares. For example, if your company’s pre-money valuation is $2 million and you accept a $1 million investment, your investor purchased 1/3, or 33%, of your company, not 1/2. If the pre-money value of your company is $3 million, a $1 million investment buys 1/4, or 25%, of your company.

Post-money value = Pre-money value + Money invested

% investor owns = Money invested / Post-money value

In a way, the valuation cap embeds a share valuation in your Convertible Note Financing, which was originally conceived with just a discount rate sweetener to avoid any valuation discussion. The use of valuation caps came into practice for the benefit of investors once it became clear that if the company performed very well it would negatively impact the total equity holdings of noteholders. 

Founders should be clear and explicit with their team and investors whether the valuation cap included in their Convertible Note investment contract is based on a pre-money valuation or post-money valuation.

Would it be better to just do a priced equity financing round?

As previously noted, a company completing a Convertible Note Financing with a valuation cap must complete a valuation exercise to establish an appropriate post-money valuation cap. 

With a valuation and pricing exercise required in both cases, the question of priced round versus Convertible Note Financing is more accurately reduced to what other rights an investor is looking for — e.g. board seats, investor veto rights, info rights, etc. that often come attached to a priced round — and whether those rights are important or appropriate for the fundraise being proposed.

How do I set a post-money valuation cap? 

Traditional valuation methods for established companies with stable cash flows (e.g. discounted cash flow, projections of future profits, asset value, book value) are totally inappropriate for valuing your company at an early-stage investment round. 

Valuations for startups at early-stage investment rounds must instead emphasize the value of a company's human capital, intellectual property, key reference accounts and solid strategic partners, and are generally the items that require most negotiation between founders and SAFE investors.

Here are some common methods by which experienced founders and angel investors determine and negotiate pre-money valuation ranges for early-stage investments in startup companies. 

1. Revenue multiple method

If your company has any revenues, you can establish a minimum valuation as a multiple of your revenue. 2–3X revenue is commonly accepted by angel investors for early-stage investment rounds. 

This method is commonly pushed by angel investors when evaluating an early-stage startup investment because it is easy to calculate and favourable to the investor. As a founder, however, you should be wary of this method since it assumes very low growth rates for your company and ascribes no value to the quality of your management team. Consider applying this method to determine the very bottom of your pre-money valuation range.

2. Market value method / Scorecard and risk factor summation methods 

Many angel investors argue that all interesting startups have essentially the same valuation at the very early growth stages (seed and pre-seed); typically, between $2.5 – 6 million. 

In many angel investors' eyes, your startup falls somewhere on this typical early-stage valuation spectrum depending on factors such as: 

• Strength of your business idea 
• Size of your market opportunity 
• Your prototype or MVP (Minimum Viable Product)
• Quality of your management team 
• Sales traction
• Strategic relationships 
• Value of your company’s Intellectual Property 
• Other investors on your capitalization table
• Other factors that might be unique to your startup

What if the pre-money valuation of the next financing round is higher than the Convertible Notes’ post-money valuation cap?

The noteholder’s ownership will be the greater of (1) what’s implied by the post-money valuation cap, or (2) what could be purchased for the original amount invested under the Convertible Note (the Purchase Amount) at the price per share paid by the new money investors in the priced round.

In most situations where the pre-money valuation of the company in the next (preferred) equity financing is higher than the post-money valuation cap, the post-money valuation cap will apply.

What if the pre-money valuation of the next financing round is lower than the Convertible Notes’ post-money valuation cap?

As noted above, the Convertible Note provides that the noteholder gets the benefit of applying the post-money valuation cap or receiving equity at the same price per share paid by the new money investors, whichever results in a greater number of shares. 

When the pre-money valuation of the company in the next equity financing is lower than the post-money valuation cap, the noteholder will always receive a greater number of shares by using the price per share paid by the new money investors, and the post-money valuation cap will not apply.

Why am I limited in who I can take investment from for my Convertible Note Financing?

In Canada, securities laws state that any corporation, even a private issuer, must file and deliver a prospectus any time there is an issuance of securities (although not technically equity, Convertible Notes are deemed a security and, as such, Convertible Note Financings are subject to this rule under securities laws). However, private issuers are exempt from the prospectus filing requirements so long as they issue securities to certain categories of investors:

1. Employees, officers, directors or consultants
   Exempt from the prospectus requirement so long as participation in the distribution in each case is voluntary and they have not been coerced into investing
2. Family and friends
   Friends and family are individuals who know the director, executive officer, founder or control person well enough and have known them for a sufficient period of time to be in a position to assess their capabilities and trustworthiness 
   1. The relationship between the individual and the director, executive officer, founder or control person must be direct. For example, the exemption is not available to a close personal friend of a close personal friend
   2. An individual does not qualify simply because the individual is a relative, a member of the same organization, association or religious group, or a client, customer, former client or former customer of the issuer
3. Close business associates
   Close business associates are individuals who have had sufficient prior business dealings with a director, executive officer, founder or control person of the issuer to be in a position to assess their capabilities and trustworthiness 
   1. The relationship between the individual and the director, executive officer, founder or control person must be direct. For example, the exemption is not available for a close business associate of a close business associate 
   2. An individual does not qualify simply because the individual is a client, customer, former client or former customer of the issuer
4. Accredited investors
   An accredited investor is an individual, entity, or financial institution that reaches certain financial thresholds that enable them to invest in certain opportunities that are not legally available to ordinary investors. If the investor does not fit the criteria of 1, 2, or 3 listed above, then they must be “accredited” by meeting 1 or more of the following criteria
   1. An individual who, alone or with a spouse, owns financial assets that exceed $1,000,000. Financial assets include cash and securities, but do not include a personal residence
   2. An individual who owns financial assets that exceed $5,000,000
   3. An individual whose net income before taxes exceeded $200,000 in each of the last two most recent calendar years or whose net income before taxes combined with that of a spouse exceeded $300,000 in each of the two most recent calendar years and who, in either case, reasonably expects to exceed that net income level in the current calendar year
   4. An individual who, alone or with a spouse, has net assets of at least $5,000,000. Personal residences are included
   5. A person, other than an individual or investment fund, that has net assets of at least $5,000,000 as shown on its most recently prepared financial statements, where a "person" is defined as a corporation, trust, etc.
5. Persons, other than individuals, for an investment amount that is at least $150,000, where a “person” is defined as a corporation, trust, etc. and the investment is paid in cash at the time of trade

What is the difference between common and preferred shares?

Common shares are the most common form of ownership interest in a corporation. Common shares give their holders voting rights, the right to receive dividends when declared, and the right to a distribution of the corporation's assets on a liquidation or dissolution. Common shares do not have any special priority over your corporation’s assets. 

Preferred shares, on the other hand, give investors rights that the other shareholders in a company (like the founders and previous investors), don’t get. Primarily, they include a preference at the next round of fundraising or liquidity event like an acquisition or wind down. Other common preferred rights include things like special control rights, but there are many more rights that your investors might ask for. 

Holders of Convertible Notes do not typically receive contractual rights or protections above and beyond the rights discussed above, including the right to convert their securities into equity. In order to enhance their rights or protections investors may negotiate side letters with the corporation that provide for preferential rights. Talk to your Good Lawyer if you wish to negotiate side letters for preferred investment terms with your noteholders.

What materials should I have ready for Investors in my Convertible Note Financing?

It really depends on the sophistication of your investors and how far along you are, but here is a list of some materials that we suggest founders prepare when seeking investment.

1. Investor materials 
   1. Business Plan or Executive Business Summary
   2. Slide deck — see FAQ note below
2. Organized minute book, specifically
   1. Incorporation documents
   2. Share Register
   3. Capitalization Table
   4. Shareholder Agreement
3. Intellectual Property (IP)
   1. Documentation relating to your corporation’s critical copyrights, trademarks, patents or other intellectual property
   2. IP Assignment Agreements
   3. IP Licensing Agreements
4. Financials
   1. Historical financial statements, if any
   2. Budgets and forward-looking projections
   3. Any recent tax filings 
   4. Tax and payroll numbers from the Canada Revenue Agency
   5. Any grant related documentation
5. Team information
   1. Founder & employee contracts
   2. Team biographies and resumes
6. Business development
   1. Sales pipeline (AKA deals in progress)
   2. Sales deck and any other marketing collateral (i.e. case studies)
   3. Copies of any commercial contracts in place
7. Media
   1. Press clippings
   2. Links to online coverage and reports from third parties
8. Other: any other relevant information

Does the information that we share with investors create any legal risk or consequences for my company or leadership team?

Under Canadian securities laws, corporations that market and sell their securities with the assistance of slide decks, investor presentations and/or marketing materials may be liable for statutory penalties and direct damages payable to the purchasers of their securities where such materials contain a misrepresentation. This risk of liability is known under Canadian securities laws as the “Offering Memorandum” risk. 

In order to avoid the Offering Memorandum risk when sharing company documentation and/or marketing materials with prospective investors, some corporations carefully limit the information they deliver to prospective purchasers and choose to present or share investor presentations rather than leaving them with a prospective purchaser. 

If you are using slide decks, investor presentations, and/or marketing materials to help market your business to prospective purchasers, take extra care of the following:

• Ensure your materials do not contain false or misleading statements that could be expected to have a significant effect on the price or value of your company’s securities
• Limit use of and/or reliance on future-oriented financial information, unless you have a  reasonable basis for presenting such information
• Update previously disclosed forward-looking information that is no longer accurate
• Limit exaggerated reports and potentially misleading promotional commentary

Finally, corporations should always include a representation from the investor in the subscription agreement that they did not receive an Offering Memorandum or other offering document.

Nextblock Global Limited (Nextblock) and their executive team learned about the Offering Memorandum risk the hard way, in 2019. In a settlement with the Ontario Securities Commission over misleading statements in materials provided to potential investors, Nextblock and their CEO agreed to pay administrative penalties of more than $1,000,000, including $300,000 personally from the CEO. Nextblock’s investor deck wrongly stated that four people in the blockchain industry had agreed to be advisors to the company. 

The Nextblock case is a clear warning to founders that false statements in your slide deck can result in liability for both your company and your executive team and that the associated penalties may be severe.

If you’re unsure about the legal consequence of your investment materials, book a Legal Strategy Session with a Good Lawyer. 

Will my Good Lawyer negotiate with investors on my behalf?

No, your lawyer will draft the required documents based on the information provided about the business and the structure and economics of your Convertible Note Financing round. Your Good Lawyer will NOT negotiate on your behalf with any particular shareholder, founder, or investor. If requested, your lawyer will be happy to expand the scope of work relating to your Convertible Note Financing round to manage investor negotiations, investment mechanics and closing matters.

How should I think about dilution and future investment rounds?

Your company may require multiple rounds of financing before it grows sustainably. Each additional round of financing will reduce, or dilute, the ownership positions of founders and prior investors.

Here’s a simplified investment scenario to illustrate: 

Your angel investors purchase $500,000 of equity at a pre-money valuation of $1.5 million for 25% of your company ($2 million post-money). You successfully grow the company, validating your business model and generating revenue to justify a new pre-money value of $8 million. 

Your company is now seeking an additional round of investment to further accelerate growth. Let’s assume VC-A invests $2 million for 20% of the company. If the Founders do not co-invest, they will be diluted down from their original 75% to 60%. Here’s the math: 

Original Ownership Stake % (75%) x (1 – Stake of New Investors (0.20)) = Diluted Ownership Stake % (60%)].

When the company grows 3X to $30 million, it becomes eligible for a Series B financing. Again, the numbers work well if VC-B puts in $15 million for 33% of the company. This will dilute the founders down from 60% to ~40% [60% x (1 – 0.333) = ~40%]. 

See a summarized breakdown of this scenario in the table below.

	Seed	Series A	Series B
Pre-Money Valuation	$1.5 million	$8.0 million	$30.0 million
Angel Investment	$500,000	—	—
VC-A Investment	—	$2.0 million	—
VC-B Investment	—	—	$15.0 million
Post-Money Valuation	$2.0 million	$10.0 million	$45.0 million
Founder Ownership	75%	60%	~40%
Angel Ownership	25%	20%	~13%
VC-A Ownership	—	20%	~13%
VC-B Ownership	—	—	~33%

Are Shareholder Agreements legally required?

No, it is not a legal requirement that every corporation has a Shareholder Agreement in place. When raising early-stage investment capital with Goodlawyer, however, we recommend your corporation have a Shareholder Agreement in place to manage control matters among your new minority investors. Critically, your Shareholder Agreement should accommodate future minority investment and investors, while protecting the founders’ interests to efficiently manage the corporation’s operations. 

Learn more about Shareholder Agreements.

 

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