What is Convertible Debt?
Startups and entrepreneurs seek to raise early stage capital in a variety of ways, but one of the most common is through a convertible debt structure utilizing a promissory note that can be converted into equity securities of the issuing company on the occurrence of various events stated in the note.
In the last few years you may have also heard of alternatives to convertible note financings through similar instruments like a “SAFE” (Simple Agreement for Future Equity) or “KISS” (Keep It Simple Securities). These instruments are very similar to convertible notes in that they contain some of the same conversion features as convertible notes, but lack certain debt features such a maturity date and interest.
Convertible notes are technically debt and could be called due by the holder on the maturity date or a default event just like any other promissory note. However, the primary purpose of a convertible note is not that it be repaid like a loan, but rather that the note investor, in exchange for making a lower priced but higher risk early-stage debt investment, convert that debt to equity and ultimately realize on the upside of a later liquidity event for the issuing company, such as a sale, recapitalization or IPO.
Benefits of Convertible Debt.
Permits Seed and Early Stage Companies to Raise Capital Without Measurable Valuation
It is difficult to determine the “pre-money valuation” of an early stage company that has an idea or technology, but little or no revenues, net asset value or cash flows. A convertible note structure allows both the issuing company and its early stage investors to “defer” the valuation determination to a later date when the company raises more money based on more reliable valuation components down the road, such as achievement of a product development milestone, realization of revenues or profitability, a stated offer from a third party to acquire the company or raise additional financing based on a specific and more quantifiable valuation, or an IPO. At one of those specific points in time, where a reliable valuation exists, the outstanding principal amount of the note plus accrued interest would ‘convert’ into equity of the issuing company.
Investor Avoids Overpaying for its Investment; Rewards Early Stage Investors With Equity at a Discounted Price in a Later Financing Round
The note investor typically avoids “overpaying” for any equity securities it receives upon a conversion, such as could happen if it instead purchased straight equity based on overinflated pre-money valuations that are literally pulled out of thin air – which is not uncommon in VC and other early stage investments. The expectation is for the investor’s debt investment to convert into equity securities upon a later equity financing (typically a Series A round led by institutional or venture capital investors, but it may also be for common stock), whereby the investor will receive the same type of equity and associated shareholder rights as the later-stage investors, but will pay less for that equity because of the higher risk it took by making its debt investment when the company’s valuation was low or not yet established.
Founders of Seed and Early Stage Companies Can Raise Capital Without Giving Away Too Much Equity Upfront
With convertible notes, the founders mitigate the risk of “giving away too much ownership” out of the chute on the first investment dollars received from investors when there’s little to no operating history for the company. As noted above, a convertible note is debt, not equity, and therefore the investor has fairly limited rights and protections, and the issuing company has few obligations to the note holders outside of standard debt obligations.
More Straightforward Terms and Documentation
Memorializing the terms of a convertible note financing is typically less cumbersome than a straight equity investment. The operative documents are a convertible note and vanilla ‘note purchase agreement’, whereas an equity financing requires, in addition to a purchase agreement, the negotiation and preparation of a number of agreements covering various shareholder rights (such as voting, registration, and co-sale rights, board rights and protections, etc.).
Key Terms in Convertible Notes.
A convertible note will include terms stating the principal amount, interest rate, and maturity date like any other note. However, the key terms in a convertible note center around its conversion features, which include the conversion triggers and the conversion price as further discussed below.
Qualified Financing (or Other Material Event)
A “qualified financing” is usually one of the triggers for conversion of the holder’s debt (other customary triggers include maturity, a change of control, and an IPO). A qualified financing is an equity financing, such as the sale of Series A Preferred Stock, of a specified total dollar amount that will require the note to convert into the equity securities sold in that financing. The threshold amount necessary to be a “qualified financing” is normally 1x – 2x the principal amount of the convertible notes outstanding, but it varies by company and transaction. Determining the proper threshold for a qualified financing ensures that the issuing company has raised a certain amount of capital, and that the financing is bona fide, before the investor must convert and lose its priority position as the holder of a debt instrument (which legally has priority of repayment over payment to equity holders on their investments).
A convertible note investor would not be rewarded for its early investment risk if it had to convert into equity at the identical price being provided to later investors as part of a qualified financing. Therefore, the price at which the debt will be converted into equity will usually be discounted to the lower of the price obtained by applying one of the following two mechanisms (and what’s common is to give the investor the benefit of the “lower of” conversion price that results from the calculation between the these two following mechanisms).
1. Conversion Discount. A “conversion discount” is a discount on the price per share of the conversion securities to be received by the note investor upon a qualified financing and is almost always included in a convertible note. A 20% conversion discount is typical, but a range between 15% and 25% is not usual. Using the example of a 20% discount, the note holder would be able to convert into equity of the issuing company at just 80 cents on the dollar to obtain the same amount of equity as it would have were it to invest 100 cents on the dollar at the time of the qualified financing or other conversion event.
2. Valuation Cap. A valuation cap entitles convertible note investors to equity in the company that is priced at the lower of the “valuation cap” or the pre-money valuation of the subsequent qualified financing. Like the conversion discount, a valuation cap rewards seed and early stage investors for taking additional early risk, and it also helps ensure that their stake in the company following conversion upon an extremely large next equity financing will not be unduly small. For example, if a convertible note provides for a $2mm valuation cap and in the qualifying financing, Series A preferred shares are purchased by investors on the basis of a $4mm valuation at $1.00 per share, the note would convert into shares of Series A preferred stock as if the price per share was actually based on a $2mm valuation, resulting in an effective price of $0.50 per share for the note investor. With this valuation cap, the note investor would receive double the number of shares of Series A preferred stock than it would have if the note did not provide for a valuation cap.
Founders Be Aware of Unintended “Liquidation Windfall”
One issue that founders must think through closely in convertible note financings with valuation caps or conversion discounts is the possible unintended consequences (a windfall of sorts) of inordinately benefitting the note investors at the expense of the founders and other later round equity investors. This risk relates to the “liquidation preference” tied to the equity securities into which the note will convert.
In its broadest sense, a “liquidation preference” provides that certain shareholders, such as holders of Series A Preferred Stock, will receive a return on their investment prior to the right of other shareholders, such as holders of Common Stock, to receive any proceeds when a company is liquidated, sold, or goes bankrupt. For example, a 1x liquidation preference entitles the investor to be paid back 100% of its full investment, and a 1.5x liquidation preference entitles the investor to be paid 150% of its full investment, before any common shareholders are paid anything. Multiples are typically 1–2x the original investment but depending on market conditions, they can be 3x or higher.
If a company completes a Series A round at a $5mm pre-money valuation but the convertible notes previously issued have a $2.5mm valuation cap (and assuming the Series A investors have negotiated a liquidation preference above 1x), then in that instance the note investors would receive a 50% discount on the Series A shares they receive on conversion and, if treated exactly like the Series A shares, would also receive the same liquidation preference. This would likely result in a disproportionately high return for the note investors.
Savvy founders can combat this issue through one of two different approaches. The first option is to issue common stock, and not preferred stock, as the “discounted” conversion shares and issue the balance of the conversion shares as preferred stock. The note investor would receive preferred shares in the qualified financing such that the liquidation preference matches the actual dollars invested in the note financing pre-conversion, but the remainder of the conversion shares will be common stock, which would not be entitled to a liquidation preference.
The second option is to include terms in the note that gives the company the right to convert the note into a “shadow series” of preferred stock in the next qualified financing. The shadow series is identical in all respects to the preferred stock issued in the qualified financing, except that the aggregate liquidation preference of the shadow series will equal the principal amount of the note.
Convertible debt can be an effective and convenient financing structure for both startups and their early investors. However, there are key nuances for both sides of the deal that require strategic planning and evaluation in order to avoid unintended adverse consequences for founders and investors alike. At Linden Law Partners, we have negotiated and advised companies, founders and investors on hundreds of early stage and venture capital investments, including convertible debt, KISS, SAFE and other early stage financing structures.
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