In our last blog post, we reviewed what convertible notes are, their key features, when, and why they’re used. We also briefly touched on the crowd note as a modified version of a convertible note that was designed specifically for crowdfunded offerings.
This week, we’ll be diving further into what crowd notes are, how they work, why they tend to be better suited to crowdfunded raises, and how they differ from convertible notes.
The Need for a New Security Type
With the implementation of Title III of the JOBS Act in May 2016, non-accredited individuals were permitted to invest in private startup companies and small businesses. While these new regulations, colloquially known as Title III, T3, Regulation Crowdfunding, or Reg CF, were intended to offer new potential for opportunity to both investors and small businesses, the challenges involved in valuing equity securities for very early stage companies and managing investor financials and communications for many small shareholders was a deterrent for some small companies. Further, while sourcing funds from the “crowd” is appealing, adding that same crowd to a company’s capitalization table can make a small business less appealing with respect to potential later investment, mergers, and acquisitions. To address these concerns, the crowd note was developed as a new type of security specifically for equity crowdfunding.
Crowd Note vs. Convertible Note
To understand the crowd note, it’s helpful to have a basic understanding of the convertible note from which the crowd note is derived:
“A convertible note is a loan that converts to equity at a pre-determined maturity date or company milestone, oftentimes a financing event outlined within the note’s investment documentation. A convertible note sometimes referred to as simply a “note,” is debt with the potential to become equity.”
As a quick recap, convertible notes have the following features:
- Maturity date – The date that the convertible note converts from a loan (debt) to equity ownership (usually 18-24 months)
- Conversion milestone – The set marker that triggers the conversion of the note from debt to equity, usually an equity financing event
- Discount rate – Given to early investors to as an incentive to take on risk
- Valuation cap – A pre-set maximum valuation on a company in which the investor agrees to convert their shares
- Interest rate – Usually 5-7% (but can also be 0%), and is paid out on the maturity milestone
A crowd note is essentially a convertible note that has been adapted specifically for regulation crowdfunding investing. The primary difference between a convertible note and a crowd note is the lack of maturity date/conversion milestone – meaning the crowd note does not automatically convert to equity shareholders, which keeps them off the cap table.
Other differences include limited investor voting and information rights, the ability to extend the crowd note after locking in an initial conversion price, and provision for a corporate transaction payout that provides investor protection against early exits.
Goals & Benefits of the Crowd Note
As was mentioned earlier, the crowd note was created to help remedy some of the challenges that arise when raising funds from a large number of shareholders; i.e., Regulation Crowdfunding offerings. The main challenges being:
1) Keeping a “clean” cap table
Because crowd note offerings allow for large numbers of investors, a lot of “noise” can be added to a company’s cap table, which can deter future institutional or venture capital investors, in turn, deterring companies from pursuing crowdfunding. The crowd note remedies this with the option to extend the crowd note after the trigger event. However, it’s important to understand that the trigger event locks in the conversion price for holders of the crowd note – regardless of later financing events and valuations.
2) Balancing business with shareholders
For small companies, running a company while simultaneously trying to provide information to, solicit shareholder votes from, and meet reporting requirements for a large pool of investors can quickly become an overwhelming burden. Crowd notes help startups and small companies keep their focus on their day-to-day business initiatives, rather than juggling obligations to a large number of individual shareholders.
Features of Crowd Notes
- Incentive – Generally, crowd notes include a valuation cap or discount (or both) as an incentive for early investors.
- Flexibility – This is where the lack of maturity date comes in: upon each qualified equity financing event, a company can choose to convert or extend the crowd note.
- Price Lock – Even if the crowd note is extended, investors still receive the conversion price set at the first qualified equity financing.
- Simplicity – After conversion, investors have limited voting, information, and inspection rights.
- Protection – In the event of an early exit, a corporate transaction payout provision offers early investors an acquisition premium, generally 2x their purchase price. (If company funds are insufficient to pay crowd note investors in full, then proceeds from the transaction are distributed in proportion with each investor’s purchase price.)
By helping to maintain a clean cap table, effectively manage a large number of shareholders, maintain the ability to raise from institutional investors, and protect early investors, the crowd note offers startups the means to better leverage equity crowdfunding as a part of their funding strategy.