Convertible Note

Raising Capital & Term Sheets – what you must know before you sign

Photo Credit – Steve Jurvetson Ed: The backstory to this photo is at the bottom of the page.

Congratulations, so you’ve found an investor interested in investing in your company? What next!

Paul Miller, corporate partner from Deutsch Miller a boutique law firm with experience in London and Sydney working with investors, venture capital firms and entrepreneurs steps you through some of the legal issues.


An experienced investor or early stage fund will provide you with a “Term Sheet” for you to consider. In certain situations you may be asked to provide a Term Sheet. The principal terms of the Investor’s investment into your company will be set out in the Term Sheet and below we have set out some of the key issues, terms and items in a Term Sheet that you should understand and be familiar with.

Structuring the investment – What will the investors receive as consideration for giving the company money?

The first thing to consider is what will the Investors be receiving in consideration for their investment. The options principally vary between equity (shares) on one hand and debt on the other hand.

The benefit of debt is on the downside. This is because if the company is not successful investors holding debt will receive their money back in priority of share (equity) holders in a winding up scenario. Conversely, apart from receiving the agreed interest rate, debt holders will not enjoy the upside of a company becoming successful.

Consequently, by holding ordinary shares (pure equity) investors are in the same position and are aligned with the Founders so that they will enjoy the upside or suffer on the downside of the Company’s business together.

A hybrid between equity and debt are convertible notes and preference shares, both of which give investors protection on the downside but also the ability to enjoy the upside.

Below, I set out a brief summary of the options to consider:

  • Ordinary Shares: an ordinary share represents equity ownership in a company and entitles the owner of that share to a vote in matters put before shareholders in proportion to their percentage ownership in the company. The interests of the investors and Founders (including rights to dividends and sharing any proceeds on a sale or winding up) will be aligned subject to other provisions in a shareholders agreement or in the constitution.
  • Convertible Notes: a convertible note is a debt instrument with an ability to convert into equity. The Investor earns interest on the outstanding amount paid to acquire the note until the principal and all interest has been repaid. The “convertible” in convertible note means that the investor can convert the note into shares in the Company at a pre agreed conversion rate. The convertible note is a popular instrument in the US. (Ed: I have also seen them used locally especially in down rounds or bridging scenarios)
  • Preference Shares: preference shares are equity with some debt characteristics. The preferential rights may include the right to receive a preferential dividend before dividends can be payable to ordinary shareholders or that the right to receive moneys in priority to ordinary shareholders in the event of a sale or where the Company is wound up. Preference Shares may be structured to have the ability to convert into ordinary shares at the election of the preference shareholder. This gives the option for the preference shareholder on a sale event to receive its money back if the sale price is low or on a high price to convert into ordinary shares and enjoy the upside in alignment with the ordinary shareholders.
  • Loan (pure debt): the investors will lend money to the company and receive interest on the monies lent.

Valuation and the percentage of your company that the Investor will hold after the investment?

A Term Sheet will usually set out the amount of the investment round, the valuation of the Company pre and/or post the investment and the percentage of the Company that the Investor will obtain post the investment. The valuation and percentage are usually subject to negotiation.

The investor will want to know the percentage it will hold on a “fully diluted basis” on the assumption that all share options and convertible instruments have been exercised and converted.

I recommend that you produce a share capitalisation table so you see how you will be diluted in this and future fundraisings. You may need to liaise with your accountant with this.

What rights will the Investor want?

Investors may want a range of rights as part of investing into your Company. You should be familiar with the following rights:

  • Right to appoint a director: It is very standard for the investor to want to have a right to appoint a director to the Company’s board. I suggest this right be limited to where the investor holds an agreed minimum percentage of shares, say 10%.
  • Negative Control/Veto Rights: This is a key right that the investor is likely to require, in particular, if it is not controlling the board. These rights will give the investor the right to veto a series of material decisions of the company before the company can proceed and implement them. These decisions are usually listed out in a schedule to a shareholders agreement. These rights can be contentious, such as whether an investor can veto a future investor in the company.
  • Pre-emption Rights on future share issues: Investors will want “pre-emption rights” on future share issues. That is, if the company decides to issue more shares in the future, the Investor will have the right to be offered and purchase those shares on a pro rata basis, before they are offered to any third party. This is a standard protection for investors, it ensures that they have a chance to ensure that they maintain their percentage shareholding.

You should consider various carve outs to this right, such as the ability to issue shares pursuant to an approved employee share ownership plan (ESOP) or in relation to a strategic partnership.

  • Further anti dilution rights. Investors may ask for this if they want protection if the company undertakes a future fundraising at a lower valuation than the valuation they invest in. In such circumstances, a clause can be included in a shareholders agreement, which provides that in such circumstances the Investor is issued further shares as if they invested at that lower valuation.
  • Vesting of Founder Shares: This is very common in the US and becoming more popular here in Australia. The investor may request for a percentage of the Founders shares to be “unvested” and only vest subject to the Founders remaining and working in the company over a period of time, known as the vesting period. If a Founder leaves the Company during the vesting period, the Founder’s unvested shares will be able to be “bought back” by the Company or recirculated to another employee or shareholder.
  • Lock up of “Founder Shares: The Investor may require there be a prohibition on Founders selling or transferring their shares for a certain period after the Investment. This is another mechanism whereby the Investor can incentivise the Founders in whom they invested in remain with the Company.
  • Tag along rights: “Tag Along” rights are a minority shareholder protection that are activated if a certain percentage of majority shareholders are selling their shares to a third party. In such a situation the minority shareholders have a right to “tag along” in such sale to a third party. If the investor exercises their tag along right, the selling shareholders will be obligated to obtain the same offer from the third party to those remaining shareholders for their shares. (ED: VCs typically use this to ensure they get a deal if a founder has a buyer)
  • Protection from being “Dragged Along” in a sale: A Drag Along clause provides that if a certain majority of shareholders (or a obtain an offer from a third party to buy their shares, they can “drag along” the remaining shareholders and effectively force those shareholders to sell their shares to that third party on the same terms. This is an important clause for Founders, who retain a majority of shares in the company. An investor may require that they cannot be dragged along unless they receive a minimum return, say 2 or 3 times, on their investment. You may be able to negotiate that this investor protection only lasts for a period of time, such as two years. (ED: Investors can also use drag along clauses to force the sale of the company where the investor might hold preference shares but not have a majority shareholding and the sale outcome might be a poor result for the founder, such as a scenario where there are liquidity preferences ie 2 or 3 x money back before conversion, or conversion discounts that end up with a massive leverage of the invested funds, essentially wiping out returns to founders, sad but happens, most acquihires are in this position)

Representations and warranties

Investors will usually require the Company and the Founders to make representations and warranties about the state of the Company at the time that they invest in the Company. These representations and warranties are usually included in a Subscription Agreement and will include:

  • the Company owns the intellectual property used in the business free from any third party interests;
  • the Company does not infringe any intellectual property rights of any third party;
  • the shareholdings in the Company are as set out in schedule to the shareholders agreement;
  • there are no options or rights of conversion over shares save as disclosed to the Investor;
  • all material/key contracts of the Company are enforceable;
  • the Company is not party to any litigation and is not aware of any potential disputes or litigation; and
  • information provided to the Investor by the Company during its due diligence exercise is true and accurate and not misleading.


Investors may want to ensure that their negotiations with the Company are exclusive for a certain period of time, usually 4 weeks from the date of signing the Term Sheet. This is to give the Investor comfort that for a certain period of time it can incur the costs of undertaking a due diligence exercise and negotiating long form documents, without the Company being able to negotiate or discuss terms with another investor.

General Process

A Term Sheet is generally not legally binding except for the clauses that deal with exclusivity (discussed above) and costs with respect to the preparation of the Term Sheet.

If the investment goes ahead, it is usual for the parties to move forward to longer form documents with respect to the deal, this will usually include:

  • a Shareholder’s Agreement;
  • a Subscription Agreement (which will include representations and warranties that are usually given jointly and severally by the Company and the Founder(s));
  • a Constitution; and
  • an Executive Service Agreement with respect to the Founder(s) ongoing engagement with the Company,.

The above is not an exhaustive explanation of clauses that might go into a market practice Term Sheet on an investment. If you want further information or specific advice, contact Paul Miller of Deutsch Miller.

NOTE: This is general and informational only it does not constitute legal advice.

Paul Miller

Paul Miller

Paul is a Corporate Partner at corporate and commercial boutique Sydney law firm Deutsch Miller, that specialises in transactional, advisory and dispute resolution work.

Paul has over 10 years experience as a partner at top firms in both Australia and the UK advising a variety of companies and investors on various fundraising transactions.

Paul has significant transactional experience obtained in the Sydney and London markets across the full spectrum of transactional and advisory work, in areas that include capital raisings, floatations, joint ventures, mergers & acquisitions, MBOs, venture capital/private equity and a variety of commercial contracts. Paul has extensive experience in advising technology companies and companies in the online space. You can contact Paul via Linkedin


About the Image

Ed: There is an interesting backstory to the guys with the Term Sheet in the feature image, see below, thanks to DFJ VC Steve Jurvetson

I have never seen a company go so far in stealth mode on a Series A… to space in this case. Twice. Here are the Planet founders, Chris, Will and Robbie, with a bottle of my favorite J Curve bubbly. They took this photo during a little signing ceremony of our Series A term sheet.

The blue marble of Apollo 17 provides a wonderful backdrop for the company as they are taking a radically different approach to Earth imaging satellites to boost the frequency and universality of coverage to new levels. The data will be open for developers of cloud services from beyond the cloud!

Planet Labs

Planet Labs

They have a passion for humanitarian applications: instead of lamenting illegal fishing or deforestation in the Amazon months after the fact, imagine being able to catch them in the moment. When a natural disaster occurs somewhere on the planet, it often is in an area that was not an imaging hot spot and so it can be difficult to get timely before and after imagery surrounding the event. Imagine every farmer in the developing world having access to crop health and over-watering data, like the rich farmers do today. Existing imaging markets want better frequency and coverage, and if you push it far enough, entirely new markets will arise. The sky is not the limit. =)

Planet Labs announced their existence this morning with a revealing imagery from their first two satellites. (SpaceReview,Dow Jones, MIT Tech Review, TechCrunch,SpaceNews, VentureBeat)

Stepping back a bit, we are seeing unprecedented innovation in the space industry, triggered by SpaceX lowering the cost of access, and now with companies like Planet Labs revolutionizing how a satellite company should operate in this new space market.

I first met them while launching rockets in the Black Rock Desert with my son, where these NASA scientists came to test fly a Google Android phone as a satellite….