Traditionally the vast majority of NZ startup investment deals have been structured as share (equity) investments. NZ angel investor groups, the most active investors in the NZ startups, were wary of KISS notes and other convertible instruments, preferring the governance and control rights conferred by Series A type equity terms.
But times are changing and our data shows convertible notes are on the increase in NZ. In 2018, 30% of the NZ funding rounds we helped to complete were convertible note deals, and this trend is continuing in 2019. This is similar to the ratio of note rounds to equity rounds that we see in Southeast Asia.
This trend is being driven in part by founders, who want to close rounds quickly on terms familiar to international investors. And at the same time, postpone more detailed governance negotiations until they are raising a bigger funding round. The other driver is the participation of international investors in NZ startup funding rounds, who are happy to use KISS notes as pre-Series A and pre-Series B financing tools.
So what trends are we seeing in NZ and how do terms compare to convertible notes issued in other startup ecosystems?
KISS note or SAFE? Outside of accelerators (the SAFE originated from the accelerator, Y-Combinator) SAFEs are not so common. Investors typically prefer a convertible instrument which includes interest and a repayment date, like a KISS. This is the case overseas as well as in NZ.
The level of interest payable on NZ convertible notes varies from deal to deal. However, rates do appear to be higher in NZ than we see on convertible notes issued overseas. On some notes we’ve seen interest rates as high as 10%, whereas in Singapore, for example, investors often accept rates as low as 1%-2%.
What distinguishes a KISS note from a SAFE is the maturity date and repayment obligation. Having a repayment date starts the clock running and puts pressure on the company to close the next funding round within a reasonable period of time.
In NZ, we typically see 18-24 month periods before repayment is required, but this depends a lot on the stage of the company. This is broadly similar to convertible notes issued by startups in other countries.
The discount applied to the price of the next round is a key negotiation point between investors and founders. This is because it serves as a reward to the investors for taking a chance on the company at an earlier stage. Founders on the other hand want to limit this discount as it means the investor will have a higher stake in the company relative to the money that they put in.
In NZ, discounts are in the range of 15-25%, with 20% the most common. Again, this is the same as what you find in convertible notes issued by startups overseas.
Along with the discount, the valuation cap is a key negotiation point.
We have seen that NZ startup founders and investors have had difficulties getting their head around the valuation cap. One reason to do a convertible note in the first place is to avoid having to think about a valuation at all, in the way you do with a fixed price round. We occasionally see valuation caps in NZ notes set too low compared to overseas.
The cap should not have any relation to the current valuation of the business – rather it should represent a maximum price that investors pay if the company scales quickly before conversion.
On the deals we’ve seen in NZ, investors often want a right to participate in the next funding round. How this right works varies from deal to deal but is often set at a percentage or a fixed amount out of the total amount raised.
Our advice to startups is to avoid participation rights in notes so they are free to allocate the next cap raise without trying to please lots of noteholders. When we negotiate convertible notes in Asia, we are generally successful at removing the participation right completely.
US standard templates normally provide that notes convert into the same class of shares as are issued to investors on the next funding round. This is also the position adopted most commonly in NZ.
We do sometimes see NZ investors agree that the note can convert into ordinary shares, but this is less common and not something VCs or similar professional investors typically agree to.
In template convertible notes used outside of NZ, such as the 500 Startups KISS, warranties are deliberately light so startups don’t have to spend lots of time on disclosure. Instead, the investors rely on the warranties that will apply on conversion in a subsequent financing (e.g. the warranties that are given in a later Series A round).
Some NZ convertible notes include substantive warranties, which is not entirely consistent with the international keep it simple approach.
Overall we don’t see much difference between the type of information rights that investors request here in NZ, than offshore. We recommend that quarterly and annual financial reporting is sufficient (rather than monthly).
If NZVIF are investing, they will likely have additional reporting requirements, but outside of that, NZ investors are pretty sensible on information rights in our experience.
A few years back we would regularly see convertible instruments in NZ which didn’t reflect international market standards (including the template NZVIF convertible note). We saw punitive terms like optional conversion rights for investors, extensive veto rights, and minimum terms for the conversion shares. Some convertible notes were even backed up by a general security agreement (GSA), which would be unheard of overseas. We’ve heard the resulting documents described as toxic by experienced Silicon Valley investors.
The good news for startups is that the market has moved forward in a couple of ways. First, investors are increasingly happy to invest using convertible notes, particularly for small cap raises. Second, the terms of the convertible notes being used are tending to be simpler, similar to our template Kiwi KISS.
We expect the use of convertible notes to increase in NZ startup financings, reflecting founder preferences and (hopefully) increasing levels of professional VC investment activity in the NZ market.
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