Convertible Instruments – What are they, what are the different types, and how do they work?
What is a KISS, a SAFE, or a CLN and what have they got to do with startup funding? Read on to find out.
What are they?
The term ‘convertible notes’ refers to an investment early in the life of a startup, which, once repaid on agreed terms, will usually be converted into equity. An investment of this type typically occurs at a time when founders might have an exciting idea, but little else in place. At that early point in the process, it is difficult to issue stock because it is almost impossible to assign a value to it. Over time, as the initial idea is fleshed out and validated, it will become easier to put a value on company stock, but in the interim founders will still most likely be seeking out investment, and it is in this scenario that convertible notes typically come into play.
Types and specifics?
Convertible notes usually take the form of a loan or security and, as mentioned above, will almost always be converted into equity at an agreed point in the future. This type of early investment represents a significant risk for the investor, and, as such, the terms on offer will usually be generous.
There are many different types, but among the most commonly used are Simple Agreement for Future Equity (SAFE), Keep it Simple Securities (KISS), and Convertible Loan Notes (CLNs).
A CLN is a loan structured in such a way that it converts to equity when agreed trigger events occur. Typically, the primary trigger will be any subsequent investment received by the company. Triggers may also relate to time and/or achieving specified earning targets.
CLNs became popular after the dot-com bubble collapse, when investors began to look for alternatives to direct equity investments. A key advantage for investors is that the investment is treated as a loan until it is formally converted into equity, whereas for startups, a CLN facilitates a vital early cash injection.
The SAFE was launched by Y Combinator in 2013, partly with a view towards creating an alternative to CLNs. One of the key points of difference is that a SAFE is a convertible security as opposed to a loan. A SAFE will also convert into equity after a triggering event, so in that sense, it plays out similarly to a CLN, but whereas the latter is a loan and therefore includes an interest rate and maturity, the former does not, which is a noteworthy distinction from the startup perspective.
The SAFE has evolved over time. In 2018, a “Post-Money” version was launched, to join the original “Pre-Money” type. One of the key points of difference between the two relates to dilution. The “Pre-Money” SAFE is regarded as being more favourable to startups on this point, in that the initial investment is converted into equity prior to the next round of funding. This creates uncertainty for the early investor on what their equity will be worth in percentage terms, given that they cannot know how much money will be raised during the next round and how that will impact the option pool. The “Post-Money” SAFE looks to address this ambiguity and does so by specifying that the initial investment should be converted into equity at the same time as the next injection of funds. This may or may not make a significant difference to the outcome, but it protects initial investors from ending up with a smaller percentage of the company than first envisaged.
KISS was launched by 500 Startups in 2014, with a view towards simplifying the process and saving both founders and investors time and money. There are two types – Debt Version and Equity Version, with the former billed as an alternative to CLNs, while the latter is seen as an alternative to SAFE. The biggest differences between the two are that the Debt Version has an interest rate and a maturity date, whereas the Equity Version has neither.
Another noteworthy feature is that KISS documents tend to include a Most Favoured Nation clause, under which an early investor’s participation terms can be updated if, for example, the company offers more favourable conditions to later investors.
Comparing KISS with SAFE, we can see some key differences. First, KISS typically carries a 5% interest rate, has a minimum limit for each financing round, and matures or expires after 18 months, whereas none of those points usually apply to a SAFE. Also, SAFEs won’t always include a Most Favoured Nation clause and transfer rights will only be available to affiliates of an existing investor, whereas KISS allows unrestricted transfer rights and, as already mentioned, a Most Favoured Nation clause is the norm.
Overall, convertible notes tend to be most popular with accelerator programmes and pre-seed investors. The logic here is that the investment can happen quickly and that all parties involved will have a clear understanding of the terms.
How do convertible instruments work in practice?
The principal: This is the investment amount received by the company from an investor. When structured as a debt instrument, this principal is likely to accrue interest between the issue date and maturity date.
Conversion discount: Most convertible instruments have a conversion discount. This is a discount applied to the share price paid by equity investors when the note converts and is usually expressed as a percentage. This means that the early investor receives more shares for less when compared to investors in the equity round.
Maturity date: This is the date that the principal plus accrued interest must be repaid if it has not already converted into equity. Investors tend not to insist on being repaid in the event the instrument hasn’t already converted, and instead typically look to extend the term. This is because calling in the note could drive the start-up into bankruptcy whereas extending the deadline creates the opportunity for greater returns down the line. However, in many instances, a conversion will already have occurred.
What triggers a conversion? Most convertible instruments will specify conversion in line with a new equity financing round and even look to specify the equity raise that will trigger conversion.
Qualified financing amount: The equity raise that triggers conversion is known as the qualified financing amount.
Valuation/Conversion cap: If over the term of a convertible instrument, the new equity raise occurs at a very high valuation, then a discount to the share price may not be sufficient to compensate note holders for the risk they took as early investors. Thus, most notes also specify a valuation cap, which limits the valuation at which the note converts. When the note converts, it will convert at the lesser of the two values - the discounted share price or the valuation cap.
Pro rata rights: This is a clause which effectively gives the investor the right to top up their investment with a view towards avoiding dilution. So, if an investor has secured a 10% stake in the company and wants to retain that level of ownership even after subsequent funding rounds, they would look to negotiate a pro rata clause whereby they would inject the necessary funds to retain their 10%.