What happens if the Company is sold before the convertible note converts?
Takeaway: Convertible notes and SAFEs typically provide the investors with a predetermined return if the company is sold before the note or SAFE converts. This is usually the greater of a multiple of the principal amount of the note or SAFE (e.g., 1.5x or 2x) or the amount the investor would receive had their note or SAFE converted to equity immediately before the acquisition.
Startups often rely on convertible promissory notes and Simple Agreements for Future Equity (SAFEs) to raise early-stage funding. However, what happens if the company is sold before the maturity date of a convertible note or a subsequent financing round that would trigger a SAFE conversion? In this post, we will explore the implications of an early exit for both the startup and the investor, and how these financing instruments are handled during company sales.
Convertible Promissory Notes and SAFEs: A Brief Overview
Both convertible promissory notes and SAFEs are instruments that convert into equity during a future financing round, typically with a discount or cap on the conversion price. Convertible promissory notes, however, are technically debt, meaning they accrue interest and the startup could have to pay them back if they aren’t converted by the maturity date.
Early Exits and Financing Instruments
An early exit occurs when a company is sold before a convertible promissory note converts or reaches its maturity date or before a financing round that triggers the conversion of a SAFE. In such cases, the handling of these instruments depends on the specific terms and conditions agreed upon by the startup and the investor, as well as the nature of the exit event.
Possible Scenarios for Convertible Promissory Notes and SAFEs during Early Exits
There are a number of outcomes for convertible promissory notes and SAFEs when companies are sold, including:
Conversion into Equity: One common outcome is that the convertible promissory note or SAFE will convert into equity immediately prior to the sale. This conversion typically happens at a pre-agreed conversion price or based on a negotiated valuation. By converting into equity, the investor can participate in the sale and potentially benefit from the proceeds, while the startup avoids repaying the debt.
Liquidation Preferences: Some convertible promissory notes and SAFEs may include liquidation preferences, which outline the specific order in which investors are paid out during a sale. These preferences can influence the payout distribution among debt holders, SAFE holders, and equity holders. In some cases, debt holders and SAFE holders may be entitled to a multiple of their investment before any proceeds are distributed to equity holders.
Payout as Debt: If the terms of the convertible promissory note do not specify a conversion upon the sale of the company, the note may be treated as debt, and the startup would be required to repay the principal and any accrued interest to the investor. Similarly, if the SAFE does not convert into equity, the investor may receive a payout based on the terms of the agreement.
Negotiated Settlement: In some cases, the startup and the investor may negotiate a settlement to address the convertible promissory note or SAFE during an early exit. This could involve a payout to the investor based on a negotiated amount or other agreed-upon terms that satisfy both parties.
Conclusion
It is crucial for both startups and investors to understand the legal implications of early exits and the handling of convertible promissory notes and SAFEs. The specific terms of each instrument, as well as applicable laws and regulations, should guide the decision-making process during a sale.
Open communication between the startup and the investor is key to ensuring a smooth exit process. By discussing potential scenarios in advance and addressing any concerns, both parties can work together to achieve a mutually beneficial outcome during an early exit.