Guaranteeing Startup Rights in Convertible Debt Structures
In the realm of startup law, the structuring of convertible notes is a common practice among early-stage investors and entrepreneurs. This article explores how to incorporate essential features such as tag along rights, non-dilution rights, and governance into a convertible note agreement. While the advice provided herein acknowledges the utility of these features, it also provides practical insights on the placement and implementation of these rights.
Tag Along Rights
Tag along rights are a pivotal component in a startup's equity structure, ensuring that convertible note holders have the ability to sell their equity in tandem with the majority shareholders. This right is typically discussed in documents like "Startup Law: How can tag along rights be guaranteed to convertible note holders?" However, when integrating tag along rights into a convertible note, it's important to consider the mechanics of converting the note into equity. Consequently, the most suitable placement for these rights would be within the note itself.
Non-Dilution Rights
Non-dilution rights are a standard feature in convertible notes, protecting investors from share dilution due to future issuances. These rights are often addressed by the conversion mechanics already specified in the note. Therefore, the inclusion of non-dilution provisions within the note agreement is the most logical approach, ensuring that investors are protected without additional documentation.
Governance Rights
Governance rights are a multifaceted aspect of startup law, encompassing various elements such as board seats, board observer rights, and protective provisions.
Board Seats and Board Observers
When an investor is entitled to a board seat, it's customary to include a voting agreement in a broader document known as the investor rights agreement, or it can be a stand-alone voting agreement. Similarly, board observer rights are typically included in the investor rights agreement or can be specified in a side letter.
Protective Provisions
Protective provisions, commonly found in preferred rounds, can be replaced with negative covenants. These covenants should be embedded in the note agreement to provide clarity and enforceability.
Informational Rights Other Affirmative Obligations
Other typical rights found in full-fledged preferred rounds, such as informational rights, option pool size requirements, and conditions for key man insurance, can be incorporated as affirmative covenants. These can be included either within the note or in a separate investor rights agreement.
Placement Considerations
The placement of these rights is largely a matter of preference, but there are strategic considerations to keep in mind. For example, if certain rights are to expire upon the conversion of the note into equity, it would be prudent to include them in the note itself. Conversely, if the right is intended to survive the conversion or specific types of conversion, it's advisable to have the right specified in a separate document or the note body.
Qualifying Terms
In cases where rights may expire upon a qualified financing but continue upon a conversion at the investor's option after a certain period, it's important to define these terms clearly. This ensures that both parties understand the rights and their limitations.
Conclusion
While the landscape of startup law continues to evolve, the principles outlined here remain relevant. Understanding and effectively implementing the provisions of convertible notes is critical for both investors and entrepreneurs. It is also important to recognize the unique aspects of convertible debt, such as the relationship between convertibility and rights.