Understanding Convertible Debt
Convertible debt is a popular type of early-stage financing. Convertible debt is a loan that converts to equity (typically preferred stock) when the startup raises another round (of a specified amount). An important benefit of convertible debt is that it avoids the need to value the company. In a preferred stock financing, an investor will pay $X for Y% of the company (thus valuing the company at X divided by Y/100). Valuing an early stage company can be next to impossible and the negotiations concerning valuation can be distracting and time-consuming, if not destructive. Convertible debt avoids this messy valuation question by putting it off to the next round of investment. Here is some basic information on convertible debt financings:
B. Advantages – As mentioned above, the primary advantage of convertible debt is that it defers the valuation question until the next round. Convertible debt also tends to be quicker, more flexible, and less expensive than a preferred stock financing.
C. Mechanics – The following is sample language from the TechStars Model Term Sheet for a convertible note financing demonstrating the automatic conversion of the loan at a Qualified Financing of $X.
Automatic Conversion in a Qualified Financing. If the Company issues equity securities (“Equity Securities”) in a transaction or series of related transactions resulting in aggregate gross proceeds to the Company of at least $X including conversion of the Notes and any other indebtedness (a “Qualified Financing”), then the Notes, and any accrued but unpaid interest thereon, will automatically convert into the equity securities issued pursuant to the Qualified Financing at a conversion price equal to Y% of the per share price paid by the purchasers of such equity securities in the Qualified Financing.
D. Key Terms
1. Discount – The discount provides the investors upside for their early investment. A typical discount is 20%. See Wilson Sonsini’s Entrepreneur’s Report finding that more than half of their convertible note financings in 2012 had a conversion discount of 20%.
2. Cap – It is common for convertible notes to have a conversion cap. This means that the note will convert based on a pre-money valuation no higher than the cap.
3. Maturity – The term of the note can range from less than a year to several years, with a median of roughly 18 mos.
4. Interest Rate – Convertible debt typically carries an interest rate providing the minimum upside for the investor. Interest rates can range from 5-12%.
5. Control of Note Holders – When working with multiple convertible note investors, it is often a good idea to provide in the note purchase agreement that a majority of note holders (based on their investment amounts) can agree to amend the terms of the note. It is often the case that the terms of the note need to be amended (for example, upon the note maturing without a qualified financing, or in the case of subsequent investors seeking to change the terms of the notes in the prior round). Startup counsel should seek to avoid the situation where a single note holder can hold up a necessary amendment.
E. Security – Even though convertible debt does not make the investor a shareholder, the convertible note does generally qualify as a “security” subject to regulation by the SEC and state securities laws. Accordingly, startup counsel will typically need to consider the relevant exemption to registration covering the investment.
F. Additional Resources on Convertible Debt – With the rise in popularity of convertible debt, there are many helpful resources available online. Startup attorney Scott Walker has an excellent blog series (part 1, part 2, and part 3) on convertible debt published on TechCrunch. Additionally, several firms have term sheet generators aimed at simplifying the process of creating a term sheet for an early stage financing. In particular, Wilson Sonsini’s term sheet generator and Orrick’s term sheet generator are both publicly available.