Due Diligence When Reviewing a Convertible Note Term Sheet

As a business owner, there are several methods available if you are looking to raise capital. One such way is through convertible loans. Where an investor loans money to your startup, they can issue a convertible note term sheet. The term sheet will detail the critical terms of the investment, and as such, is vital to understand. This article discusses key due diligence considerations when reviewing a convertible note term sheet prepared by a potential investor.

Convertible Notes

A convertible note is a loan from an investor to your company. This loan converts into equity at a later trigger event. The convertible note term sheet is a document that sets out the key commercial terms of the investment. Consequently, due diligence is an important exercise, the findings of which can assist you in negotiating with potential investors. 

Either you or the investor can prepare a convertible note term sheet. Generally, for early rounds of investment, the term sheet is prepared by the business owner. Likewise, for later rounds and larger amounts of investment, the investor usually prepares the term sheet. The convertible note term sheet is not legally but morally binding. However, once agreed upon, it usually forms part of the final investment agreement. 

It is essential to review and understand an entire term sheet. In this exercise, there are some due diligence considerations to ensure you completely understand how the investment will work and how it can benefit your business. 

Ensure Founders’ Warranties Are Reasonable

The term sheet will usually contain several warranties to be imposed on the founders of the business. These may include a requirement that you assign any intellectual property to the company and restrictions on your ability to work on other ventures during the early phase of the business. It is crucial to review such clauses to ensure that the warranties are reasonable. This is especially the case if you are already working on other ventures or wish to negotiate ownership of the intellectual property. 

Check the Timing of the Trigger Event

Before bringing on investors, a business owner needs to have a clear business plan and goals. In addition, it is critical to ensure that the proposed nature and timing of trigger and exit events are realistic. Importantly, you want to ensure the timing of the trigger events do not compromise your business plans. 

Trigger events refer to the agreed times at which the convertible notes will convert into shares. Exit events refer to when you sell your company. When reviewing your convertible note term sheet, you might find that the proposed trigger or exit events seem too close in future. Likewise, you may have a key milestone you aim to reach before the noteholders become shareholders. In that case, you should negotiate this trigger or exit period to a time that aligns with your business goals. 

Consider the Shareholding Amount and Class of Shares

When the convertible notes convert to shares, the noteholders become shareholders in the company. Therefore, it is vital to be clear on how much shareholding the investors will have and what this will mean for your company’s ownership. Failure to consider this may result in the investors collectively owning the majority of the shares and having more control than you initially intended. 

It is also essential to be clear on the type of shares that the investors will receive upon conversion. This may vary depending on the type of trigger event. However, it is important to clarify which shares you include in the term sheet because different classes of shares have different entitlements. For example, handing out ordinary shares gives shareholders voting rights and some say in the management of your business. For this reason, you want to perform due diligence and ensure you are not giving out more rights than you intend. 

Include Confidentiality and Exclusivity Clauses 

While the term sheet as a whole is not legally binding, it usually includes confidentiality and exclusivity clauses that are legally binding. The confidentiality clause imposes an obligation on both parties not to disclose or discuss the terms of the prospective investment deal with third parties (except with their legal teams). Likewise, the exclusivity clause restricts the business owner from seeking investment from other investors. The aim is to allow the investor enough time to undertake due diligence and make a decision. 

As a business owner, you may want to negotiate the application of the exclusivity clause to be limited to a specific time. This would ensure that you have enough time to secure other investors if the initial investors do not proceed. 

Key Takeaways  

Raising capital can be an exciting time for your business, as it can open the doors for growth. Convertible loans is one method of capital raising, though it is essential to conduct due diligence when reviewing the convertible note term sheet. You want to ensure any warranties placed on you, as the founder, are reasonable. Likewise, the timing of the trigger or exit events should align with your business plans. It is also crucial to consider the shareholding amount and class of shares, and include confidentiality and exclusivity clauses.

For more information on capital raising, or assistance with your convertible note term sheet, contact LegalVision’s capital raising lawyers on 1300 544 755 or fill out the form on this page. 

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