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Convertible Debt In the past few chapters, we've gone through the exhaustive, but hopefully not exhausting, terms in a typical venture capital equity financing. As we foreshadowed previously, the popularity of convertible debt has grown over the years. Today, many angel investors and accelerators invest primarily using convertible debt. In the majority of cases, unless the company fails to raise any more money, this is a temporary state of financing, because the debt is intended to convert into equity at a later date. So, what is convertible debt? Simple. It's debt. It's a loan. With a loan, you don't have to argue about valuation, although you may argue about potential future valuations using the concept of a valuation cap, which we will discuss further on. The fundamental notion is that when a company raises a future round of equity financing, the money loaned to the company via the convertible debt round converts into whatever type of stock the company sells under whatever terms it agrees to in the future. In exchange for the convertible debt, the investors get a modest interest rate and typically convert at a discount to the price to the next round. For example, assume you raise $500,000 in convertible debt from angels with a 20% discount to the next round, and six months later a VC offers to lead a Series A round of a $1 million investment at $1 a share. Your financing will actually be for $1.5 million total, although the VCs will get 1 million Series A shares ($1 million at $1 per share) and the angels will get 625,000 Series A shares ($500,000 at $0.80 per share). The discount is appropriate, since your early investors want some reward for investing before the full Series A financing round comes together. In this chapter, we cover the arguments for and against using convertible debt. We then go through the terms in a convertible debt deal, including the discount, valuation caps, interest rate, conversion mechanics, conversion in a sale of the company, warrants, and other terms. We briefly cover the differences between early stage and late stage dynamics and finish up with an example of when convertible debt could be dangerous to use. Arguments for and Against Convertible Debt Most fans of convertible debt argue that it's a much easier transaction to complete than an equity financing. Since no valuation is being set for the company, you get to avoid that part of the negotiation. Because it is debt, it has few, if any, of the rights of preferred stock offerings and you can accomplish a transaction with a lot less paperwork and legal fees. Note, however, that the legal fees argument is less persuasive these days with the many forms of standardized documents. A decade ago there could be a $50,000 pricing difference for legal fees between a seed preferred round and a convertible debt round. These days the difference is less than $10,000 since many lawyers will heavily discount the seed preferred round to get future business from the company. The debate goes on endlessly about which structure is better or worse for entrepreneurs or investors. We aren't convinced there is a definitive answer here; in fact, we are convinced that those who think there is a definitive answer are wrong. Since investors usually drive the decision about whether to raise an equity or a debt round, let's look at their motivations first. One of the primary reasons for an early stage investor to purchase equity is to price the stock being sold in the round. Early stage investing is a risky proposition, and investors will want to invest at low prices, although smart investors won't invest at a price at which founders are demotivated. As a result, most early stage deals get priced in a pretty tight range. With a convertible debt structure, the stock price is not set and is determined at a later date when a larger financing occurs. By definition, if there is a later round the company must be doing something right. Having a discount is nice, but the ultimate price for the early convertible debt investors may still be higher than what they would have paid if they had bought equity in the first place. Some investors try to fix this problem by setting what is called a valuation cap on the price they will pay in the next round. In other words, as an investor, I'll take a 20% discount on the price of the next round up to a valuation of $X. If you get a valuation above $X, then my valuation is $X (hence the notion of a valuation cap). This sounds like it fixes the problem, right? This might for the original investor, but it might not for the company and the founders. First of all, the investors coming into the next round may not like the idea that they are paying that much more than the convertible debt investors paid. Unlike equity, which is issued and can't easily be changed, the new equity investors could refuse to fund unless the debt investors remove or change the cap. Also, keep in mind that VCs will ask you during the fundraising process what your convertible note terms are. You'll say, "Oh, we have a valuation cap of X." VCs will then focus on and peg their valuation of your company on that cap. You are essentially drawing a line in the sand (albeit a small one and in some cases it doesn't actually affect the ultimate valuation) of what your company is worth in the future. From the entrepreneur's standpoint, the choice isn't clear, either. Some argue that the convertible debt structure, by definition, leads to a higher ultimate price for the first round. We won't go as far as to say they are right, but we can see the argument that with a convertible debt feature you are allowing an inflated price based on time to positively impact the valuation for the past investors. We'd argue that this is missing half of the analysis in that a founder's first investors are sometimes the most important. These are the people who invested in you at the riskiest stage before anyone else would. You like them, you respect them, and you might even be related to them. Assume that you create a lot of value along the way and the equity investor prices the round at a number that is higher than even you expected. Your first investors will own less than anyone anticipated. At the end of the day, your biggest fans are happy about the financing, but sad that they own so little. But does it really set a higher price? Let's go back to the example of a convertible debt round with a cap. If we were going to agree to this deal, our cap would be the price that we would have agreed to in an equity round. So, in effect, you've just sold the same amount of equity to us, but we have an option for the price to be lower than we would have offered you since there are plenty of scenarios in which the equity price is below the cap amount. Why on earth would I agree to a cap that is above the price that I'm willing to pay today? The cap amounts to a ceiling on your price. VCs will focus on that cap as well. There are plenty of situations where the VCs would have been willing to pay $X per share, but after seeing the cap number in due diligence prior to a term sheet they offer only $Y (less than $X) per share because it's within the cap. So while you may have gotten a better deal on your seed round, your Series A round (which normally sees the company raising a lot more money than a seed round) is now underpriced compared to what it could be. In the aggregate, the company actually underpriced itself in this scenario. The Entrepreneur's Perspective To attract seed stage investors, consider a convertible debt deal with two additional features: a reasonable time horizon on an equity financing and a forced conversion if that horizon isn't met, as well as a floor, not a ceiling, on the conversion valuation. There's also some dissonance here since VCs spend a lot of their time valuing companies and negotiating on price. If your VC can't or won't do this, what is this telling you? Do you and the VC have radically different views of the value proposition you've created? Will this impact the relationship going forward or the way that each of you strategically thinks about your company? The Discount Remember that a convertible debt deal doesn't purchase equity in your company. Instead, it's simply a loan that has the ability to convert to equity based on some future financing event. Let's begin our discussion of terms for convertible debt with the most important one, the discount. Until recently, we had never seen a convertible debt deal that didn't convert at a discount to the next financing round. Given some of the current excited market conditions at the seed stage, we've heard of convertible deals with no discount but view this as irregular and not sustainable over the long term. The idea behind the discount is that investors should get, or require, more upside than just the interest rate associated with the debt for the risk that they are taking by investing early. These investors aren't banks. They are planning to own equity in the company but are simply deferring the price discussion to the next financing. So how does the discount work? There are two approaches: the discounted price to the next round and warrants. We'll cover the discounted price approach in this section, as it's much simpler and better oriented for a seed round investment. For the discounted price to the next round, you might see something like this in the legal documents: This Note shall automatically convert in whole without any further action by the Holders into such Equity Securities at a conversion price equal to eighty percent (80%) of the price per share paid by the Investors purchasing the Equity Securities on the same terms and conditions as given to the Investors. This means that if your next round investors are paying $1 per share, then the note will convert into the same shares at a 20% discount, or $0.80 per share. For example, if you have a $100,000 convertible note, it will purchase 125,000 shares ($100,000 $0.80), whereas the new equity investor will get 100,000 shares for his investment of $100,000 ($100,000 $1). The range of discounts we typically see is 10% to 30%, with 20% being the most common. While occasionally you'll see a discount that increases over time (e.g., 10% if the round closes in 90 days, 20% if it takes longer), we recommend entrepreneurs and investors keep this simple. It is the seed round. Valuation Caps We've touched on this concept, but let's go deeper. The cap is an investor-favorable term that puts a ceiling on the conversion price of the debt. The valuation cap is typically seen only in seed rounds where the investors are concerned that the next round of financing will be at a price that is at a valuation that wouldn't reward them appropriately for taking a risk by investing early in the seed round. For example, an investor wants to invest $100,000 in a company and thinks that the pre-money valuation of the company is somewhere in the $2 million to $4 million range. The entrepreneur thinks the valuation should be higher. Either way, the investor and the entrepreneur agree to not deal with a valuation negotiation and instead decide to consummate a convertible debt deal with a 20% discount to the next round. Nine months pass and the company is doing well. The entrepreneur is happy, and the investor is happy. The company goes to raise a round of financing in the form of preferred stock. It receives a term sheet at a $20 million pre-money valuation. In this case, the discount of 20% would result in the investor having an effective valuation of $16 million for his investment nine months ago. On one hand, the investor is happy for the entrepreneur; but on the other hand, he is shocked by the high valuation for his investment. He realizes he made a bad decision by not pricing the deal initially, as anything below $16 million would have been better for him. Of course, this is nowhere near the $2 million to $4 million the investor was contemplating the company was worth at the time he made the convertible debt investment. The valuation cap addresses this situation. By agreeing on a cap, the entrepreneur and the investor can still defer the price discussion but set a ceiling at which point the conversion price caps. In our previous example, let's assume that the entrepreneur and the investor agree on a $4 million cap. Since the deal has a 20% discount, any valuation up to $5 million will result in the investor getting a discount of 20%. Once the discounted value goes above the cap, then the cap will apply. So, in the case of the $20 million pre-money valuation, the investor will get shares at an effective price of $4 million. As we've mentioned, in some cases, caps can impact the valuation of the next round. Some VCs will look at the cap and view it as a price ceiling to the next round price, assuming that it was the high point negotiated between the seed investors and the entrepreneur. To mitigate this, entrepreneurs should try to not disclose the seed round terms until a price has been agreed to with a new VC investor. However, it's become pretty common for VCs to ask for the terms of the convertible debt round before they are willing to issue a term sheet, and it is hard for an entrepreneur to say no to a potential funding partner's request. Clearly, entrepreneurs would prefer not to have valuation caps. However, many seed investors recognize that an uncapped note has the potential to create a big risk-return disparity, especially in frothy markets for early stage deals. We believe that over the long term caps create more alignment between entrepreneurs and seed investors as long as the price cap is thoughtfully negotiated based on the stage of the company. Interest Rate Since convertible debt is a loan, it usually has an interest rate associated with it, because that's the minimum upside an investor is going to want to have for the investment. We believe interest rates on convertible debt should be as low as possible. This isn't bank debt, and the funders are being fairly compensated through the use of whatever type of discount has been negotiated. If you are an entrepreneur, check out what the applicable federal rates (AFRs) are to see the lowest legally allowable interest rates; bump them up just a little bit (for volatility), and suggest whatever that number is. Realizing that the discount and the interest rate are often linked, we'll usually see an interest rate between 5% and 12% (the mean is 8%) associated with a discount between 10% and 30% (the mean is 20%). Conversion Mechanics Eventually the convertible debt will convert into equity. There are several nuances around how and when the note will convert. These conversion mechanics are important but can usually be configured in a way where everyone will be happy with them if they concentrate on defining them up front. In general, debt holders have traditionally enjoyed superior control rights over companies and the ability to force nasty things like bankruptcy and involuntary liquidations. Therefore, having outstanding debt (that doesn't convert) can be a bad thing if an entrepreneur ever gets sideways with one of the debt holders. While it's not talked about that much, it happens, and we've seen situations where the debt holder has excessive power in a negotiation. Here is typical conversion language: In the event that Payor issues and sells shares of its Equity Securities to investors (the "Investors") on or before (180) days from the date herewith (the "Maturity Date") in an equity financing with total proceeds to the Payor of not less than $1 million (excluding the conversion of the Notes or other debt) (a "Qualified Financing"), then the outstanding principal balance of this Note shall automatically convert in whole without any further action by the Holders into such Equity Securities at a conversion price equal to the price per share paid by the Investors purchasing the Equity Securities on the same terms and conditions as given to the Investors. Let's take a look at what matters in this paragraph. Notice that in order for the note to convert automatically, all of the conditions must be met. If not, there is no automatic conversion. Term. Here, the company must sell equity within six months (180 days) for the debt to automatically convert. Consider whether this is enough time. If we were entrepreneurs, we'd try to get this period to be as long as possible. Many venture firms are not allowed (by their agreements with their investors) to issue debt that has a maturity date longer than a year, so don't be surprised if one year is the maximum that you can negotiate if you are dealing with a VC investor. Amount. In this case the company must raise $1 million of new money for the debt to convert because the conversion of the outstanding debt is excluded. The entrepreneur often gets to decide the amount based on the minimum the company is hoping to raise. When you determine this number, think about how long you have and how much you think you can raise in that time period. So, what happens if the company does not achieve the milestones to automatically convert the debt? The debt stays outstanding unless the debt holders agree to convert their holdings. This is when voting control comes into play. It is important to pay attention to the amendment provision in the notes. Any term of this Note may be amended or waived with the written consent of Payor and the Majority Holders. Upon the effectuation of such waiver or amendment in conformance with this Section 11, the Payor shall promptly give written notice thereof to the record Holders of the Notes who have not previously consented thereto in writing. While one will never see anything less than a majority of holders needing to consent to an amendment (and thus a different standard for conversion), make sure the standard doesn't get too high. For instance, if you had two parties splitting $1 million in convertible debt with a 60-40 percentage split, you only need one party to consent if the majority rules, but both parties would need to consent if a supermajority must approve. Little things like this can make a big difference if the 40% holder is the one you aren't getting along with at the present moment. Conversion in a Sale of the Company What happens to the convertible debt if the company gets acquired before there is an equity financing and before the debt is converted to equity? There are a few different scenarios. The lender gets its money back plus interest. If there is no specific language addressing this situation, this is what usually ends up happening. In this case, the convertible debt document doesn't allow the debt to convert into anything, but at the same time mandates that upon a sale the debt must be paid off. So the lenders don't see any of the upside on the acquisition. The potentially bad news is that if the merger is an all-stock deal, the company will need to find a way to get cash to pay back the loan or negotiate a way for the acquiring company to deal with the debt. The lender gets its money back, plus interest plus a multiple of the original principal amount. In this case, the documents dictate that the company will pay back outstanding principal plus interest and then a multiple on the original investment. Usually we see a multiple of two to three times, but in later stage companies this multiple can be even higher. The typical language follows: Sale of the Company: If a Qualified Financing has not occurred and the Company elects to consummate a sale of the Company prior to the Maturity Date, then notwithstanding any provision of the Notes to the contrary (i) the Company will give the Investors at least five days prior written notice of the anticipated closing date of such sale of the Company and (ii) the Company will pay the holder of each Note an aggregate amount equal to ___ times the aggregate amount of principal and interest then outstanding under such Note in full satisfaction of the Company's obligations under such Note. Some sort of conversion does occur. In the case of an early stage company that hasn't issued preferred stock yet, the debt converts into stock of the acquiring company (if it's a stock deal) at a valuation subject to a cap. If it's not a stock deal, then one normally sees one of the preceding scenarios. With later stage companies, the investors usually structure the convertible notes to have the most flexibility. They either get a multiple payout on the debt or get the equity upside based on the previous preferred round price. Note that if the acquisition price is low, the holders of the debt may usually opt out of conversion and demand cash payment on the notes. While in many cases issuing convertible debt is easier to deal with than issuing equity, the one situation where this often becomes complex is an acquisition while the debt is outstanding. Our strong advice is to address in the documents how the debt will be handled in an acquisition. Warrants A few sections ago we discussed the "discounted price to the next round" approach to providing a discount on convertible debt. The other approach to a discount is to issue warrants. This approach is more complex and usually applies only to situations where the company has already raised a round of equity, but it occasionally pops up in early stage deals. If you are doing a seed round, we encourage you not to use this approach and instead save some legal fees. However, if you are doing a later stage convertible debt round or your investors insist on you issuing warrants, here's how it works. Assume that once again the investor is investing $100,000 and receives warrant coverage in the amount of 20% of the amount of the convertible note. In this case the investor will get a warrant for $20,000. This is where it can get a little tricky. What does $20,000 worth of warrants mean? A warrant is an option to purchase a certain number of shares at a predetermined price. But how do you figure out the number of warrants and the price that the warrants will be at? There are numerous different ways to calculate this, such as: $20,000 worth of common stock at the last value ascribed to either the common or the preferred stock; $20,000 worth of the last round of preferred stock at that round's price of the stock; or $20,000 worth of the next round of preferred stock at whatever price that happens to be. As you can see, the actual percentage of the company associated with the warrants can vary significantly depending on the price of the security that underlies it. As a bonus, the particular ownership of certain classes may affect voting control of a particular class of stock. If there is a standard, it's the second version, where the warrants are attached to the prior preferred stock round. If there is no prior preferred, then one normally sees the stock convert to the next preferred round unless an acquisition of the company occurs before a preferred round is consummated; in that case, it reverts to the common stock. For example, assume that the round gets done at $1 per share as in the previous example. The investor who holds a $100,000 convertible note will get $20,000 of warrants, or 20,000 warrants at an exercise price of $1, to go along with the 100,000 shares received in the financing from the conversion of the note. Warrants have a few extra terms that matter, such as: Term length. The length of time the warrants are exercisable, which is typically 5 to 10 years. Shorter is better for the entrepreneur and company. Longer is better for the investor. Merger considerations. What happens to the warrants in the event the company is acquired? We can't opine more strongly that all warrants should expire at a merger unless they are exercised just prior to the transaction. In other words, the warrant holder must decide to either exercise or give up the warrants if the company is acquired. Acquiring companies hate buying companies that have warrants that survive a merger and allow the warrant holder to buy equity in the acquirer. Many mergers have been held up because warrants with this feature have upset the potential acquirer and thus as part of the closing requirements the acquirer has mandated that the company go out and repurchase or edit the terms of the warrants. This is not a good negotiating spot for the company to find itself in, as it will have to pay off warrant holders while disclosing the potential merger (so the company will have little leverage) and at the same time will have a sword hanging over its head by the acquirer until the issue is resolved. Original issue discount (OID). This is an accounting issue that is boring, yet important. If a convertible debt deal includes warrants, the warrants must be paid for separately in order to avoid the OID issue. In other words, if the debt is for $100,000 and there is 20% warrant coverage, the Internal Revenue Service (IRS) says that the warrants themselves have some value. If there is no provision for the actual purchase of the warrants, the lender will have received an original issue discount, which says that the $100,000 debt was issued at a discount since the lender also received warrants. The problem is that part of the $100,000 principal repaid will be included as interest to the lender or, even worse, it will be accrued as income over the life of the note even before any payments are made. The easy fix is to pay something for the warrants, which usually is an amount in the low thousands of dollars. The difference between warrants and a discount is insignificant for the investor. We suppose if the investor is able to get warrants for common stock, then perhaps the ultimate value of warrants may outweigh the discount, but it's not clear. As evidenced by the number of words we have devoted to the topic, warrants add a fair amount of complexity and legal costs to the mix. However, some discounts will include valuation caps, and that can create some negative company valuation ramifications while warrants completely stay away from the valuation discussion. Warrants are not as popular as they once were, as discounts are more typically used. Finally, in no case should an entrepreneur let an investor double dip and receive both a discount and warrants. That's not a reasonable position for investors to take—they should either get a discount or get warrants. Other Terms There are a few other terms that can show up in a convertible debt deal. You'll recognize these from the earlier chapters on terms in an equity financing, as they are the terms that more sophisticated angels or seed investors will insist on to preserve their rights in later financings. The first term you'll occasionally see in a convertible debt financing is a pro rata right, which will allow debt holders to participate pro-ratably in a future financing. Since the dollars invested in a convertible debt deal are often small, investors may ask for super pro rata rights. For instance, if an investor invests $500,000 in a convertible debt deal and the company later raises $7 million, the investor's pro rata investment rights wouldn't allow the investor to purchase a large portion of the next round. As a result, the seed investor may ask for a pro rata right for two to four times the investor's current ownership or for a specific percentage (say 5% to 20%) of the next financing. While pro rata rights are pretty typical, if you have people asking for super pro rata rights or a specific portion of the next financing, you should be careful, as granting these will limit your long-term financing options. Every now and then you'll see a liquidation preference in a convertible debt deal. It works the same way as in a preferred stock deal: the investors get their money back first, or a multiple of their money back first, before any proceeds are distributed to anyone else. This usually happens in the case when a company is struggling to raise capital and current investors offer a convertible debt (also called a bridge loan) deal to the company. Back in the good old days, usury laws prevented such terms; but in most states this is not an issue and the investors are allowed to have not only the security of holding debt, but the upside of preferred stock should a liquidation event occur. Early Stage versus Late Stage Dynamics Traditionally, convertible debt was issued by mid to late stage startups that needed a financing to get them to a place where they believed they could raise more money. These deals were called bridge financings. A common cliche around bridge loans is for the investor to contemplate whether it is a "bridge to the next round" or a "pier that drops into the ocean." The terms were similar to early stage terms unless the company was performing poorly and there was doubt about the ability to raise new capital, or the bridge was to get the company to an acquisition or an orderly shutdown. In these cases, one saw terms like liquidation preferences and in some cases changes to board or voting control came into play. Some of these bridge loans also contained terms like pay-to-play, which we discussed in Chapter 5. Given the traditional complexity and cost of legal fees associated with preferred stock financings, convertible debt became a common way to make seed stage investments because it tended to be simpler and less expensive from a legal perspective. Over time, equity rounds have become cheaper to consummate, and the legal fees argument doesn't carry much weight these days. In the end, the main force driving the use of convertible debt in early stage companies is the parties' desire to avoid setting a valuation. Can Convertible Debt Be Dangerous? One final issue with convertible debt is a technical legal one. You'll have to forgive us, but Jason is an ex-lawyer and sometimes he can't help himself. If a company raises cash via equity, it has a positive balance sheet. It is solvent, and the board and executives have fiduciary duties to the shareholders in the efforts to maximize company value. The shareholders are all the usual suspects: the employees and VCs. Life is good and normal. However, if a company is insolvent, the board and company may (based in large part on state law—ask your attorney) now owe fiduciary duties to the creditors of the company. By definition, if you raise a convertible debt round, your company is insolvent. You have cash, but your debt obligations are greater than your assets. Your creditors include your landlord, anyone you owe money to (including former disgruntled employees), and founders who have lawyers. How does this change the paradigm? To be fair, we have had no personal war stories here, but it's not hard to construct some weird situations. Let's look at the hypothetical situation. Assume the company is not a success and fails. In the case of raising equity, the officers and directors owe a duty only to the creditors (e.g., the landlord) at such time that cash isn't large enough to pay their liabilities. If the company manages it correctly, creditors are paid off cleanly even on the downside scenario. But sometimes it doesn't happen this way and there are lawsuits. When the lawyers get involved, they'll look to establish the time in which the company went insolvent and then try to show that the actions of the board were bad during that time. If the time frame is short, it's hard to make a case against the company. However, if you raise debt, the insolvency time lasts until your debt converts into equity. As a result, if your company ends up failing and you can't pay your creditors, the ability for a plaintiff lawyer to judge your actions has increased dramatically. And don't forget, if you have any outstanding employment litigation, all of those folks count as creditors as well. The worst part of this is that many states impose personal liability on directors for things that occur while a company is insolvent. This means that some states will allow creditors to sue directors personally for not getting all of the money they are owed. Now, we don't want to get too crazy here. We are talking about early stage and seed companies, and hopefully the situation is clean enough that these doomsday predictions won't happen; but our bet is that few folks participating in convertible debt rounds are actually thinking about these issues. While we don't know of any actual cases out there, we've been around this business long enough to know that there is constant innovation in the plaintiff's bar as well. |
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