In this blog series, we review the most common types of securities used in financing emerging companies, and highlight key issues worth considering for each. Over the course of four posts, we’ll touch on the sale of (1) equity securities, (2) convertible debt, (3) SAFEs/KISSes, and (4) debt (non-convertible), non-dilutive funding and bootstrapping. In this second post of four, we address the financing of a venture through the sale of convertible debt.
Convertible Debt
Another very common vehicle for financing startups is convertible debt. Like conventional (non-convertible) debt (discussed below), the investor provides cash to the company that accrues with a maturity date for when the loan comes due. However, in contrast to conventional debt, if all goes as planned, the parties generally don’t expect the company to pay the loan back. Rather, the note provides that the principal (and typically the interest) will convert into equity (typically, preferred) in a future equity financing. In contrast to straight equity, the parties delay valuing the company, and thus the price per share, until the future equity round. Convertible debt is often a more feasible option than equity for a founder who needs time to de-risk his or her idea before being able to obtain equity investors willing to invest at a more company-friendly valuation, if at all.
To trigger the conversion of debt to equity, the parties typically negotiate a minimum amount that the company must raise in the equity financing (often called a “qualified financing”), as the investor will want to make sure that the venture has enough capital upon conversion of the debt to carry out the business plan. The maturity date and qualified financing threshold provide benchmarks for when the equity financing should occur, how large that round should be, and potentially even the sophistication of the investors. Although the intent of convertible debt is that the loan need not be repaid, this depends on the company raising sufficient investment to trigger conversion. If the company fails to reach a qualified financing, founders can face consequences similar to those related to failure to repay straight debt, such as default and foreclosure. Founders will therefore want to make sure that these benchmarks align with the company’s business plan and that the business team vigorously seeks to execute that plan.
Another key aspect of convertible debt is the size of the investor’s ultimate investment. Convertible debt rewards investors for supporting early-stage, higher-risk companies through discounts and valuation caps applied to the securities issued upon conversion of the debt. Typically, investors receive a percentage discount off of the price per share paid by cash investors in the qualified financing. Investors sometimes also, or alternatively, demand the inclusion of a valuation cap, whereby the investor sets the maximum company valuation at which the debt converts to equity. If at the equity round the company has a higher valuation than the cap, then the debt still converts at the valuation cap and thus receives a discount off of the price paid by cash investors. When a company’s valuation increases significantly above the valuation cap, it provides tremendous upside for investors, and its effects may be shocking to founders who may be diluted substantially by the conversion. This is especially true when companies undergo multiple rounds of convertible debt financings. In such cases, the company will need to pay close attention to how the different securities interact with each other so there are no unintended outcomes. Founders will also want to make sure that the preferred stock issued upon conversion has a liquidation preference and anti-dilution protection keyed off of the conversion price of the debt (rather than the price paid by cash investors), as to avoid providing convertible debt investors an additional premium on their investment.
For this reason, while negotiating a convertible debt instrument is generally faster and cheaper than straight equity, the several issues that the parties tend to negotiate heavily – including the valuation cap, discount percentage, interest rate, maturity date and qualified financing threshold – can end up having important ramifications. An entrepreneur who chooses convertible debt for its efficiency and rushes through these key terms can end up giving away a bigger chunk of the company than anticipated.
Finally, founders should note that convertible debt, like straight debt, may come with strings attached. These may include operational restrictions, investor protective provisions, security interests (i.e. the right to foreclose on collateral if the loan is not repaid), and potentially even board seats. Founders should take care to evaluate these provisions to the extent possible, in order to align the terms of the loan with the company’s goals.
When to use it:
- Your company is at a stage where valuation is difficult to determine
- You need cash and growth to attract potential shareholders in the near term
- You have done the homework and are comfortable with the potential range of the investor’s share
In the next post, we will consider SAFEs, KISSes and similar instruments as options to fund your venture.