A convertible instrument is a type of financial contract that can convert into future ownership in a company. In the venture capital industry, the most common forms of convertible instruments are 

Simple Agreements for Future Equity (SAFEs)

. These debt and hybrid securities typically change into common stock or preferred stock when certain conditions are met.

Most convertible instruments convert into equity upon the closing of a 

. They are a popular way for companies to raise capital prior to, or in between, financing rounds, as they require less paperwork than a financing round, have fewer terms to negotiate, and are not tied to a fixed valuation. 

Early stage companies often use convertible instruments to raise capital quickly so they can get back to building their company. Convertible instruments also allow companies to defer setting a valuation, which benefits companies in the pre-product or pre-revenue phase. By not setting a valuation early on, companies can focus on building a product and generating revenue, thus, justifying a higher valuation when raising a financing round.

The following table highlights the differences between 

"Convertible Instruments: A Comprehensive Guide" is a comprehensive resource for individuals and entities seeking to understand and utilize convertible instruments in their financing efforts. This guide provides a thorough overview of the concept of convertible instruments, including the different types, key terms, and financial considerations involved in using these financing tools. Whether you are a founder, investor, or legal professional, this guide offers valuable insights and guidance on the use of convertible instruments in your financing endeavors.

shares of capital stock that are registrable in the event that the company or its stockholders request registration (often in connection with an IPO). Only certain shares are registrable and the IRA defines such shares. In general, the shares included are: (i) shares of preferred stock that can be converted into common stock; (ii) other securities that are issued after the date of the IRA that can be converted into common stock; and (iii) shares of common stock (including in connection with the conversion or exercise of warrants, options, or other securities) issued as dividends or distributions. There can be additions and exemptions to the above list so one should always confirm the shares included in the company’s “registrable securities'' definition.

Registrable securities

a type of capital stock that comes with additional rights, preferences, and privileges as compared to common stock, and is issued to investors in connection with a financing round.

Preferred stock

the current value of one share of the company’s common stock. Typically, a company will get a 409A valuation in which a third party appraiser will determine the FMV of the company’s common stock.

Fair Market Value (FMV)

an entity that is owned by one person or entity. Typically, investors will require that any company subsidiaries are wholly-owned. 

Wholly-owned

the total number of shares issued and actively held by stockholders. This number only includes shares that are issued and outstanding and not shares that are authorized.

Total number of shares outstanding

an indication of how much a company may be worth before any additional capital is raised; also referred to as the “pre-money”. When calculating the price per share, companies and investors will often discuss which shares belong in the “pre-money” vs. the “post-money” with the most commonly negotiated point being the treatment of the option pool increase. The more shares included in the pre-money, the lower the price per share.

Pre-money valuation

a way to calculate the company’s capitalization that assumes (i) all preferred stock has been converted to common stock, (ii) outstanding options, warrants, and securities have been exercised, and (iii) shares reserved for issuance under the equity incentive plan have been exercised.

Fully-diluted capitalization

the initial price at which investors purchase their stock or at which an investor’s convertible note or SAFE converts.

Original issue price

the document that outlines the board composition and drag along rights. One of the five NVCA documents typically used in a financing round.

Voting Agreement (VA)

an exhibit to the SPA, which lists the number and series of shares and total purchase price for each investor.

Schedule of Purchasers (SOP)

a person or entity directly or indirectly controlled by another entity. Venture funds are structured such that one venture fund may have several different entities under which it invests. As a result, you will often see definitions and threshold requirements that aggregate the venture fund and its affiliates.

Affiliates

the corporate document that governs the company’s issuance of options, RSUs, SARs, and restricted stock; also known as an option plan, stock option plan, and ESOP.

Equity incentive plan

investors who hold a specified number of shares of the company’s capital stock and/or preferred stock and are therefore given special rights such as pro rata rights.

Major investors

when the demand to purchase shares of preferred stock is greater than the number of shares authorized for issuance.

Oversubscribed

a class of stock usually given to founders and early employees that ranks junior in rights, privileges, and preferences to preferred stock.

Common stock

a company in which a venture fund owns an equity stake.

Portfolio companies

also called the strike price, is the price at which a share of capital stock can be bought. In order to comply with certain requirements under U.S. law, the exercise price is the fair market value of the stock on the date of grant.

Exercise price

when different series or classes of capital stock convert or participate at the same rate as one another. Most frequently, this term is used in connection with the distribution of dividends to preferred stockholders or liquidation preference.

Pari-passu

individual investors or firms who invest with the goal of acquiring strategic advantages, such as (i) licensing, marketing or distribution agreements, (ii) joint ventures, (iii) or potential acquisition, rather than simply financial returns. They are traditionally corporate venture arms of large companies (i.e., Google Ventures and Salesforce Ventures) that are in the same industry as the company.

Strategics

a way to calculate the total number of shares that would be outstanding if all possible shares were issued upon conversion of all convertible instruments such as options, convertible notes, and warrants.

Fully-diluted basis

pooled investment funds that infuse capital in privately-held companies in exchange for equity. Venture funds typically have industry expertise relevant to the company and invest in certain stages of a company’s life cycle.

Venture fund

a document outlining the company’s capital stock and ownership percentages. In the past, companies used spreadsheets to maintain their cap table, however, most companies now use an online cap table management system such as Carta or Pulley.

Cap table

equity compensation granted to employees, consultants, or advisors that can be in the form of options, restricted stock, RSUS, or SARs.

Equity grant

stockholders who own shares of preferred stock, often investors or lenders of the company.

Preferred stockholders

directors of the Board elected by the preferred stockholders and often designated by the lead investor.

Preferred directors

a type of legal structure in which the stockholders are taxed separately from the entity. Most privately-held corporations are formed as C-corporations because of the tax benefits associated with the separate taxation that apply to both the company and investors.

C-corporation

a right to attend and participate in meetings of the Board in a non-voting manner and to receive all information provided to the Board. This right is typically reserved for lead investors who do not have a board seat.

Observer rights

a method for privately-held companies to raise additional capital by issuing shares of preferred stock to investors at a fixed pre-money or post-money valuation. Each financing round is typically associated with a series of preferred stock (i.e., “Series Seed” or “Series A”), each with their own rights, preferences, and privileges. Also referred to as a “qualified financing round” or “equity financing”.

Financing round

a form of equity compensation typically issued to employees at later-stage privately-held companies in connection with achieving certain performance milestones or remaining at the company for a certain time period. Unlike options, once RSUs vest the individual receives the shares underlying the RSUS and does not have to buy them. RSUs also have different tax implications than options as they become taxable income the day they vest. Be sure to speak with a tax advisor to understand any tax implications associated with RSUs.

Restricted Stock Units (RSUs)

any person or entity that is not leading the equity financing round, but is investing in the round.

Non-lead investor

the valuation of the company after additional capital is raised; also referred to as the “post-money”. When calculating the price per share, companies and investors will often discuss which shares belong in the “pre-money” vs. the “post-money” with the most commonly negotiated point being the treatment of the option pool increase. The more shares included in the post-money, the less dilution felt by existing stockholders.

Post-money valuation

the document that governs the sale of common stock by founders and key holders and the rights of investors to participate in such sales. One of the five NVCA documents typically used in a financing round.

Right of First Refusal (ROFR) Agreement

a way to calculate a company’s capitalization, which assumes that shares of preferred stock have been converted into common stock. Because shares of preferred stock do not always convert to common stock on a “one share for one share” (1:1) basis, the as-converted basis takes into account any additional shares that would be issued when the preferred stock converts.

As-converted basis

the governing body which drafted the venture financing documents and MRL used in most equity financing rounds. 

National Venture Capital Association (NVCA)

shares of common stock reserved for issuance as equity compensation in the form of options, SARS, RSUs, or restricted stock.

Option pool

a fraction of a share, such as ¾ of a share. Most privately-held companies do not allow the issuance of fractional shares.

Fractional shares

an agreement that gives an individual the right to buy a specific number of shares of stock at a set price within a certain timeframe. Warrants are similar to options and can be subject to vesting and/or reaching certain milestones, but unlike options they are not granted under the equity incentive plan and are typically granted to investors or lenders as an added incentive in connection with a financing round or debt financing round.

Warrants

the document that establishes the rights and privileges of the investors such as information rights, board observer rights (if any), inspection rights, pro rata rights, and the right to conduct activities. One of the five NVCA documents typically used in a financing round.

Investors' Rights Agreement (IRA)

stands for the “Committee on Foreign Investment in the United States” and is an inter-agency committee of the US government that reviews certain foreign investment transactions within its jurisdiction and advises the government on matters of national security arising from foreign investments.

CFIUS

a process by which a company can go public without going through the IPO process by allowing its employees and/or investors to directly sell their stock to the public.

Direct listing

the document that outlines the purchase and sale of shares of preferred stock in connection with a financing round, including the purchase price of the shares, representations and warranties made by both the company and investors, and the requirements for closing the financing round. One of the five NVCA documents typically used in a financing round.

Stock Purchase Agreement (SPA)

a form of convertible instrument issued to investors in exchange for their capital investment that entitles the investors to shares of the company’s preferred stock (or common stock) upon the occurrence of certain company events, such as a financing round or acquisition.

Simple Agreement for Future Equity (SAFE)

a form of equity compensation similar to options except that instead of the right to purchase shares, the individual receives the right to receive cash equal to the difference between the grant price of the SARs and the common stock’s FMV at the time of exercise.

Stock Appreciation Rights (SARs)

the process by which a privately-held company goes “public” and lists its shares on a stock exchange to be publicly traded.

Initial Public Offering (IPO)

an independent U.S. governmental agency that monitors capital markets, enforces securities laws, and develops new market regulations.

Securities and Exchange Commission (SEC)

a form of equity compensation in which the company grants an individual the right to purchase shares of common stock at a set price known as the “exercise price”. The options typically have a vesting schedule such that the individual is not able to purchase the options for a set period of time. Ideally, the value of the options increases overtime such that the individual is able to purchase the shares at a price below the current market value of the shares.

Options

a formation document that includes important company information such as the corporate name, type and number of shares that the company is authorized to issue, and investor protections such as protective provisions, dividends, conversion, and anti-dilution rights. Also known as the “Charter” and one of the five NVCA documents typically used in a financing round.

Certificate of Incorporation (COI)

a type of security that is typically convertible into shares of preferred stock or common stock. Examples include SAFEs, convertible notes, and warrants.

Convertible instrument

an agreement between a company and an investor which provides the investor with the ability to participate in, or substantially influence the conduct of, the management of the company. The management rights letter ensures that the venture capital fund can obtain exemption from certain federal regulations under the Employee Retirement Income Security Act of 1974 (i.e., federal regulations that are severe and onerous to comply with).

Management Rights Letter (MRL)

a form of convertible instrument that operates as short-term debt and in which the principal amount plus interest converts into shares of preferred stock upon the occurrence of certain company events, such as a financing round or acquisition.

Convertible note

typically one of the largest investors (by investment amount) in a financing round who enters into a term sheet with the company and negotiates the round on behalf of the other investors.

Lead investor

an agreement entered into by the company and a specific investor, which grants such investor certain additional rights.

Side letters

a decrease in ownership percentage due to the issuance of additional stock such as in connection with a subsequent financing round (usually in a subsequent fundraising round).

Dilution

a transaction, such as a merger, acquisition, IPO, or direct listing, that allows stockholders to convert their ownership stakes into cash or publicly traded securities.

Liquidity event

a stockholder of the company that owns a certain percentage of the company’s common stock or options that are exercisable for shares common stock (often 1%). Key holders are typically early employees and key executives of the company and are often required to sign onto the company’s Voting Agreement and ROFR agreement.

Key holder

an independent appraisal to determine the fair market value (FMV) of a privately-held company’s common stock. 409A valuations are valid for up to one year and may expire earlier if the company undertakes a “material event” such as a financing round. It is important that privately-held companies have a valid 409A when issuing options to ensure compliance with applicable tax securities laws.

409A valuation

the governing body of a company, also known as the board of directors.The Board controls many of the company’s actions and typically grows in size over time.

Board

stock that a company is authorized to issue, which includes both common stock and preferred stock.

Capital stock

stockholders that make up the requisite voting percentage necessary to perform certain company actions, such as approve of a liquidity event or amend the company’s protective provisions.

Requisite holders

a set of accounting principles that investors may require companies to comply with when auditing their financing statements.

Generally Accepted Accounting Principles (GAAP)

the date vesting begins on shares of common stock issued in connection with an equity grant.

Vesting commencement date

any person or entity that is participating in the financing round and investing additional capital into the company.

New money investors

the minimum number of votes needed to approve a company action.

Voting threshold

shares of common stock often granted to early employees and founders that are subject to vesting (i.e., “restricted”).

Restricted stock

means all shares of the company’s outstanding capital stock on a fully-diluted, as-converted basis, including any treasury shares, shares underlying unexercised options, RSUs, warrants and other equity grants and convertible instruments, or any shares reserved under the option pool.

Company capitalization

a set of written rules that govern a company’s internal processes, such as director and stockholder voting, transfer restrictions, the rights and responsibilities of the officers, directors and stockholders, and the requirements for the annual stockholder meeting.

Bylaws

THE ELECTRIC TOME COMPANY PRESS

When you're ready to raise capital for your company, there are many different ways to do so — convertible instruments, institutional debt, or traditional venture capital funding. "Understanding Convertible Instruments" is a comprehensive resource for individuals and entities seeking to understand and utilize convertible instruments in their fundraising efforts. This guide provides a thorough overview of the concept of convertible instruments, including the key terms, conditions, and considerations involved in these financing tools. In addition, the guide covers the various legal and financial implications of convertible instruments, as well as practical advice and real-world examples to help readers better understand and navigate the complexities of using these tools to raise money for their business ventures. Whether you are a business owner, investor, or legal professional, this guide offers valuable insights and guidance on the use of convertible instruments in your fundraising efforts.

Term	Convertible Notes	SAFEs
Valuation cap	Yes	Yes
Discount	Yes	Yes
Interest rate	Yes	No
Acquisition premium	Yes	No
Maturity date	Yes	No
Liquidation priority	Senior to SAFEs and other Preferred Stock	On par with other Preferred Stock
Trigger to convert	Minimum qualified financing amount	Any sale of Preferred Stock to outside investors

Convertible Instruments: A Comprehensive Guide

Convertible Instruments: A Comprehensive Guide

Overview

SAFEs vs. Convertible Notes