The terms appear to be structured so that founders have a long runway and fewer financial distractions leading to better products and better customer development which leads to better valuations and therefore better angel exits. It appears to have all the elements to create a virtuous cycle.
Aside:The longer term somewhat reminds me of the approach Microsoft takes with BizSpark.
This is the first time I've seen the optional conversion into Series AA at a $5 million valuation. If it's optional at the company's option, that eliminates the one and only risk I could think of: the lender calling back the principal + interest of the note. At 2% interest, that's just another 3.12% dilution to the founder(s) on top of YC's 2-6% (source: http://www.google.com/search?sourceid=chrome&ie=UTF-8...).
So, unless I'm missing something, worst case is you get into YC, you get $165K, and you still own ~90% of your company. That's a no-brainer deal.
IANAL, but I would guess that "optional maturity conversion" means the investor can choose to convert at those terms if the two-year window expires without a prior conversion being triggered. So if the startup doesn't raise a $1 million financing round in the first two years, the investors can grab 3% of the company at their option.
It would be strange if the company would get to choose when the investors' debt converts.
The note stays outstanding. Generally speaking, there's no good reason for the investor to want to convert into equity, as debt is better in a bankruptcy situation.
Some companies might return money to investors before shutting down.
This answers the early sale question. In the event of a sale before the note is converted through other means, the investors can convert at $5 million valuation. That could be a lot of upside for them, though I expect this will not be a common case.
According to the article: Optional change of control/IPO conversion: into common stock at the lesser of (A) fair market value (based on change of control or IPO), or (B) $5M valuation.
I have to agree with Yokum, it is hard to find a better deal than this.
Aside:The longer term somewhat reminds me of the approach Microsoft takes with BizSpark.