Congratulations! Your startup has developed a viable product that you are ready to test in the market. But you need some early money to fund this critical phase! Convertible debt can allow a startup to raise money with more speed and with more flexibility than traditional equity such as preferred stock, but at the expense of certainty in the capitalization structure of the company. This makes it important to understand the terms and tradeoffs of using convertible debt when deciding whether it is right to use in a capital raise or as an investment instrument. By understanding how convertible debt functions, the key terms that may be included in a convertible debt offering, and what should be considered when contemplating issuing or purchasing convertible debt, startups and investors can be better positioned for success.
What is convertible debt?
Convertible debt works exactly as its name suggests – it is a loan from a lender to a borrower that, upon one or more agreed circumstances, may convert into equity securities of the borrower. Usually the lender holds an option to convert the debt, however the conversion may be automatic upon certain trigger events, which is discussed further below. The terms of the financing will be memorialized in a convertible promissory note by the borrower, in favor of the lender, also called an “investor.”
How does convertible debt compare to ordinary debt?
Until convertible debt converts into an equity security of the borrower, it has the characteristics of ordinary debt. Ordinary and convertible debt instruments typically have the following in common:
the borrower is obligated to pay back the principal and interest of the note to the lender in accordance with the terms of the note. Both convertible debt and ordinary debt instruments contain a principal amount, an interest rate, and a maturity date on which the outstanding principal and interest must be repaid;
the lenders have rights to repayment senior to shareholders, and at maturity, unless the convertible notes are convertible into equity, the lenders (although rare in practice, at least in theory) can enforce the debt obligations of the notes and cause the borrower to liquidate its assets if it is unable to repay the debt obligations; and
default provisions govern what occurs when either the lender or borrower fail to comply with the terms of the note. A default by the borrower will typically entitle the lender to exercise certain remedies, including acceleration of the unpaid principal and interest.
What features are unique to convertible debt?
Because convertible debt is often used in high-risk ventures, investors typically seek economic terms to increase their return beyond just an interest payment. Otherwise the investors would be taking equity risk for debt returns. There are a number of key differences between convertible debt and ordinary debt which are often intensely negotiated between the parties, including:
Interest Payments at Maturity – Most convertible debt instruments only require interest payments at maturity (or paid in equity at conversion).
Mandatory Conversion – Mandatory conversion provisions set forth circumstances in which the convertible debt automatically converts into equity upon occurrence of the stipulated event. For example, a convertible note may automatically convert on the maturity date. Most convertible notes for early-stage companies convert automatically upon a “qualified financing,” typically defined as a preferred equity round that occurs after the closing of the convertible debt financing. The qualified financing provision memorializes the parties’ expectation that the borrower will raise a minimum amount of additional funding in the near term, and accordingly the convertible debt financing will function as a “bridge” until that future round, or a way of deferring a valuation negotiation until such future round. These mandatory conversion provisions assure the lender that its investment into the company will eventually materialize into an equity position, whether by passage of time or by a successful capital raise.
Optional Conversion – The lender may also negotiate optional conversion rights under which the lender may, but is not obligated to, convert the debt into equity based on its preferred economic outcome. If maturity does not automatically trigger conversion, lenders may alternatively retain the option to convert into equity upon maturity.
Change of Control – A convertible note will often contain an optional conversion trigger on a change of control, or a repayment premium at a change of control. Either term provides an investor with a way of participating in the upside of a sale of the company.
Conversion Price – The “conversion price” is the price at which the convertible debt can be converted into the company’s shares. Dividing the unpaid principal and interest on the note by the conversion price will yield the shares issuable to the investor. The conversion price is typically based on a “discount rate” and/or “valuation cap” negotiated when the notes are issued.
Discount– A “Discount” allows a convertible note to convert at a discount to a priced equity fundraising round as a way of compensating a convertible note investor for the additional risk of making an earlier investment. As a result, the note will convert into a higher number of shares than the lender would have otherwise received without the discount.
Valuation Cap – A valuation cap is another form of compensation to convertible note investors in exchange for the early risk of investing in the borrower. A valuation cap is a mutually agreed dollar ceiling on the effective valuation at which an investor ultimately converts into equity. In convertible note offerings featuring a valuation cap and a discount, the conversion price for a convertible note will be set at the lower of the discounted price of the borrower’s equity or the price per share assuming the borrower was valued at the valuation cap. As a result, a convertible note lender whose note converts at a valuation cap lower than the borrower’s actual valuation in the fundraising round will convert at a lower effective valuation compared to investors in the new round. A valuation cap is particularly beneficial to investors in early stage companies with high growth potential as a way of allowing the investor to participate in the upside of a runaway success.
What should I consider when raising capital in the form of convertible debt?
Any company considering issuing convertible notes has more than just the basic economics to consider. Convertible note offerings can involve numerous documents affecting the rights of the issuer and investors, such as a note purchase agreement or other ancillary documents. The offering documents may contain conditions to closing, representations and warranties of the issuer and investor, and sometimes may include investor protective provisions or operating covenants. If the borrower has existing debt, the existing creditor may require an intercreditor agreement in which one of the creditors is subordinated in priority to the other. Beyond the primary transaction documents, convertible note issuances are also subject to compliance with federal and state securities laws.
Because of the risk that lenders may liquidate the assets of a company if the debt is not repaid, it is important for borrowers to consider the maturity date, and what terms should apply at the maturity date to give the company the runway it needs. Convertible notes can also lead to unexpected consequences at conversion and complicated capitalization table math. Most importantly, convertible notes are designed for flexibility. An attorney experienced in using convertible notes can advise on how to structure convertible note offerings to put the company on the best path towards growth and investors in the best place to see the returns on their investment.
What Market Alternatives Exist for Convertible Notes?
Early stage companies are not limited to convertible notes when searching for alternative financing tools. Simple Agreements for Future Equity, or SAFEs, are an increasingly popular instrument that, like convertible debt, can help a startup avoid the cost and complexity of fundraising through priced equity.
Want to learn more about SAFEs? The COpilot team has you covered! In an upcoming COpilot blog post, the COpilot team will break down everything you need to know about the structure and terms of SAFEs.