In this month’s installment of Ophthalmic Product Development Insights, we’ll explore convertible notes for seed financing for the early-stage entrepreneur. (As a general rule, neither this article nor any article constitutes legal advice and you should always consult your attorney when getting down to the specifics.)
Before discussing how to approach and use a convertible note, it helps to define some terms. A convertible note is essentially an I.O.U. issued by the entrepreneur’s company to the investor in exchange for the investor making a loan to that company. The note can usually be paid back in cash or equity and it is usually set up to automatically convert into equity upon a subsequent financing event (usually referred to as qualified financing). While there are certainly a few more details to keep in mind, the beauty of a note is that it allows the entrepreneur to access much needed financing with simple documentation and without the need to negotiate the terms of a larger equity financing. The note also allows the entrepreneur to avoid the complications and costs that can arise from negotiating a company’s valuation without key data points, the impact of that valuation on incentive equity/stock option grants, and the related potential tax implications of equity and/or stock options, giving him the ability to focus more of his time and energy on advancing his vision. On the investor side, the variables, or toggles, referred to as the conversion discount and/or capped price per share (or valuation cap) can allow investors to have the amount of their loan, plus accrued interest, converted into equity at a reduced price relative to the other investors in the subsequent, qualified-financing round. The investors receive these terms to offset some of the early-stage risk they are taking on, as compared to later investors.
Now, on to connecting the dots.
Say you have an idea—maybe even a patent filed—and some early, “reason-to-believe” evidence. The evidence could be preclinical or clinical data and all you need to do is move the project forward to some value inflection point in order to attract investment. Therein lies the proverbial “chicken-or-the-egg” scenario: How do you finance the activities necessary to get to the larger value inflection point when pharma companies, biotech companies, venture capitalists and other institutional investors are often not willing to invest prior to seeing proof of concept? The targeted disease, the in-vivo target, the signaling pathways, the clinical development path and the regulatory path are just a few of the considerations at the forefront of the potential investor’s mind, any one of which could be a gating item to their investment (a gating item is something that the investor needs to see before proceeding to the next step). Objective manifestations of value such as: a crucial animal model showing efficacy against the standard of care; an in-vivo pharmacokinetics study demonstrating sustained release of the delivery platform; or a pre-investigational new drug FDA meeting to firmly establish the development plan and approvable endpoints will help the potential investor get comfortable enough to make that leap. Yet, the achievement of these mileston