Setting the Max Authorized Amount on Your Convertible Note

By October 25, 2014Fundraising
convertible note

Let’s assume you have already determined $500K is the ideal amount of money to raise in your current fundraising round (see related article titled “How Much Should You Raise”) and you’ve also decided a convertible note is the right instrument to use (see related article titled “Convertible Note Basics”). Most convertible note templates have a statement/clause that mentions how much you are authorized to raise in that round (as a series of individual notes with multiple investors). $500K is the amount you should show as the maximum authorized amount, right? Not so quick. There are reasons you might want to set the amount lower or higher. Let’s explore the dynamics and trade-offs using $500K as the amount you truly think you need.

Setting the Amount Lower than $500K

Appearance of Hot Investment Opportunity – If you plan/hope to raise $500K (for example), you might want to set the max authorized a little lower (like $400K) in the hopes of showing that your round is almost closed once you cross the $300K mark.  When talking to prospective investors you can say things like “there is still a little room left in the round” to demonstrate that your opportunity is hot and in demand by investors.

Immediately Open Another Round – If you include in your note an amount that is lower than you truly hope to raise, there is a chance you will be successful but not have enough authorized on the note.  It is not a big problem to open another note with the same economic terms but it will probably be for a small amount of money and you might get questions from investors that say “I thought you were raising $400K but this note only says $100K is authorized”.  You can answer that you originally were raising $400K but it got oversubscribed and you decided to raise an additional $100K.

Be prepared to answer questions about how you will use the additional funds. But that should be easy as long as you aren’t doubling the amount. Also be careful about changing the economic terms on the second note. Clearly you are allowed to make changes but I only recommend doing so if you realize you were way too generous with your original terms and you feel the fundraising is going so well that you can tighten some of the terms (more favorable to your startup) and still close the additional amount. Changing the terms to be more favorable to the investors will cause the investors in the original $400K note to request a change to their note as well.

Setting the Amount Higher than $500K

Appearance of Cold Investment Opportunity – If you set the amount at $750K and struggle to get half way there it accentuates the appearance that something is wrong with your investment opportunity and that you might not raise enough to survive.  Maybe you really only need $500K but you set the authorized amount at $750K just in case you are more successful than expected with investors.

The problem comes if you reach the half-way mark ($375K) and then lose fundraising momentum. In reality you’re only $125K away from the real amount you needed to raise but that’s not how it looks to investors. You can easily appear defensive if you try to explain how only reaching $450-500K is OK.  Remember that your term sheet showed $750K and that sends a message to investors that you need $750K to properly execute your business plan.

Gordon’s Recommendations

  1. Don’t circulate the term sheet for your convertible note too early in your fundraising process.  Instead, make the rounds with investors to deliver your pitch and gauge their interest.  And “interest” doesn’t mean if they like you or your idea.  What matters is whether or not they are inclined to invest.  Give them a range of fundraising amounts you are considering (for example, $400-600K) and tell them you are still refining your business plan for multiple scenarios.  You can also mention the key terms you are considering (mostly the discount and valuation cap – see related article titled “Justifying the Cap Amount in Your Convertible Note“).  Your purpose for doing this is to get feedback and gauge reaction so you can lock things down and proceed.
  2. Combine feedback you get from #1 above with the analysis you did to determine how long you can go and what you can accomplish with various amounts of cash (see related article titled “How Much Should Your Raise“).  Then set the Max Authorized amount towards the high end of the range but while having confidence that you can get to at least 75% of it.
  3. When asked by investors how much you are raising, you can say something like “The term sheet authorizes $600K but that gives a little headroom and is more for a scenario in which we get excessive investor demand.  Our financial models are built around a $500K raise.”
  4. Make sure to have a financial model for your “upside” scenario ($600K in my example in #3 above). It will show that you are prepared with the actions you will take if you raise the full authorized amount. In other words, don’t communicate that the extra will serve as a cushion/contingency or to give additional runway. Your investors want to know you are putting their money to work for aggressive growth and to help their investment convert to equity as soon as possible.

Related articles you might want to check out:

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