CONVERTIBLE DEBT 101
I come across convertible debt deals all of the time as a startup attorney.
It's THE most popular way to do early stage financing.
Convertible debt is used by many investors. I've seen all sorts of investors use them--large healthcare investment groups, oil and gas investors, energy sector investors, etc.
More startups will get convertible debt financing than priced round financings (such as a Series A VC financing) and more investors will offer convertible debt financing than a priced round.
If you want your company to get financing, then you need to know about this topic.
Table of Contents
I. Convertible Debt Definition: A Loan that Converts
II. Terminology
III. Qualified Financing
IV. Reasons to Use Convertible Debt
V. Convertible Debt Investors
VI. How Convertible Debt Differs from a Regular Loan and from Buying Equity
VII. Valuation
VIII. Conversion Example
IX. Tips for Entrepreneurs
I. Convertible Debt Definition: A Loan that Converts
Convertible debt is a type of loan/investment hybrid. It looks very similar to a loan and even has an interest rate, a maturity date, and the like.
However, the difference between regular debt and convertible debt is this: if the company goes out and does a sizable financing before the designated convertible debt maturity-payback time hits, then the convertible debt will convert into equity of the company.
After the debt converts, the convertible debt holder then becomes a stockholder of the company and enjoys all of the benefits that entails.
The sizable financing that triggers conversion is called a qualified financing and I'll explain that in a bit.
If the convertible debt never has a chance to convert to equity because no qualified financing was completed and the convertible debt hits maturity, then the debt must be paid back to the investors. This usually sucks for the company.
Convertible Debt in Texas Startups
The material in this article is pretty fundamental to startups anywhere. Don't worry too much about Texas jurisdictional issues. Yes, there are some practices differences in Houston and Dallas, Texas but for the most part the stuff covered here is the same elsewhere geographically.
II. Terminology
You're likely to come across different terms for convertible debt.
Sometimes convertible debt gets referenced as a convertible note. This is just different terminology. A convertible debt financing is also called bridge financing because it bridges the company over until it can get a certain type of more substantial financing.
Convertible "equity" however is substantially different than convertible debt/note. Convertible "equity" does not have a repayment provision. When maturity hits, the convertible equity converts into equity (the funds don't get paid back to the investor). This type of financial instrument is infrequently used.
III. Qualified Financing
The debt converts when there is a qualified financing. This is the trigger point.
A qualified financing is a financing that the startup does that is for at least a certain amount of money (usually $1M+ but I have seen it more in certain industries). When the startup raises more money in that qualified financing, such as in a Series A financing, the trigger will have been reached and convertible debt will convert into the same shares that the Series A financing is purchasing.
So what is happening is this: startups use convertible debt in a system where the convertible debt investor says: "here is some money to bridge your company over until it can do a proper large fundraising. When that fundraising happens, convert my debt into stock."
[Yes, there are times when the qualified financing never gets triggered. I get into that later down below.]
If the company doesn't raise more money within the specified amount of time, then the debt must be paid back to the investor. Often the company doesn't have this money to pay back. In that case, the investor can drive the company into bankruptcy, or the maturity date can be extended, or the debt can convert into shares of stock at some pre-negotiated price.
IV. Reasons to use convertible debt
So why would an investor want to use convertible debt to invest in a startup? Reasons include:
1. the investor wants to invest, be a shareholder, etc. but a valuation of the company is difficult. The reason that a valuation is useful is because when investors buys shares of stock of a company for investment, they need to know how much each share costs. It's possible that doing this valuation is difficult because the company is too young or otherwise;
2. the financing amount is not so high as to justify the time and effort of a full blown Series round financing; and
3. the startup just needs something now to tide it over until it can do a full round of financing.
V. Convertible Debt Investors
All different types of investors use convertible debt.
Smaller, angel investors typically investing less than $1M use them all of the time.
Even though these investors are often on the smaller side, they must be accredited investors as according to SEC rules.
The amounts in a convertible debt deal also vary greatly; however, the amounts are generally low (less than $1M.) If an investor wishes to invest a substantial amount of funds, then the investor will usually wish to do a full priced round where certain rights and privileges can be assured for the investor.
VI. How Convertible Debt Differs from a Regular Loan and from Buying Equity
Regular loan
Unlike a regular loan, convertible debt might not need to be paid back because it converts into equity. This means that the investor has upside potential if the company does well.
However, if the company does not do well and doesn't raise more money, the investor can demand to be paid back. If a regular shareholder or equity investor's shares tank in price, they can't just demand their money back. Of course, if the company is in dire straits, it probably won't be able to pay back the debt (this is many times the case).
Buying equity
Unlike in a regular equity financing, the convertible debt investor doesn't have to figure out how much the company is worth. Think about it: an equity purchaser must know how much the company or shares are worth in order to purchase them.
In a nutshell, convertible debt financing is a way for investors to invest in your startup without having to settle on a valuation of the company and without having to negotiate all sorts of rights.
VII. Valuation
A. IMPORTANCE OF VALUATION
So convertible debt converts to a price per share that the qualified financing is for. It is important to understand how the qualified financing determines the price per share.
The price per share is based on the valuation of the company. The qualified financing investors negotiate the valuation with the startup and settle on a number based on the finances of the company, projections, speculations, etc. This valuation number is how much the company is worth.
The price per share will be valuation (not including the investment amount) divided by the amount of shares that are out there. So if the valuation of the company in a qualified financing Series A round is $10,000,000 and there are 10,000,000 shares, the price per share will be $1.00.
The convertible debt will convert at this price point (with the benefit of a discount.)
Note that the valuation was left entirely up in the hands of the Series A investors and company by the convertible debt holder.
B. VALUATION CAP
The valuation cap is the highest valuation that the debt will convert at. The valuation cap is one of the most important terms in a convertible debt deal. It's not in every deal, but it can make a massive difference. While a valuation is not set in a convertible debt deal, the convertible debt deal can call for a valuation cap.
The debt will convert at the lower of the price per share paid by the qualified financing (with a discount) OR the price per share if the valuation was the valuation specified by the valuation cap.
I mentioned that one benefit of convertible debt is that the company/convertible debt investors don't have to bother settling on a valuation of the company. What that means is that it leaves a lot into the hands of the qualified financing investors.
If the qualified financing investor settles on a high or low valuation, that will mean that the convertible debt holder will end up with less or more ownership of the company.
You can understand why. If you invest $100,000 in a company worth $5,000,000, then the price you have to pay per share will be a certain amount. If you invest $100,000 in a company worth $10,000,000, everything else being equal, then the price per share will be higher than the previous company and your $100,000 will not convert into as many shares.
This is why convertible debt holders have an incentive to want the qualified financing valuation of the company to be somewhat low. So that the price per share will be lower and that their investment will convert into more shares, which, all else being equal, allows them to own more of the company.
This is where the valuation cap comes in.
This valuation cap allows the investor to give a maximum valuation that the convertible debt will convert at. So if the cap is at $5M, and the qualified financing valuation is $10M, that $10M might not really matter. The price per share that the convertible debt will convert at is going to be the lower of the price per stock that the qualified financing investor pays (with a discount) or the price per stock if the valuation were set to $5M. If the qualified financing valuation is only $3m, then the cap is irrelevant. The price per share for the convertible debt conversion will be based on that $3m.
VIII. Conversion Example
The loan will convert into however many shares the loan amount would buy. The price would be the same price that the later investors paid (with the benefit of a discount because the convertible debt investor came earlier in time.)
Example
The startup gets $350k in the form of convertible debt with a 15% discount. Down the road, when the startup does a Series A financing for $1,000,000 for $1.00 a share, that $350k loan will convert into however many shares $350,000 would buy at $1 per share (minus the discount.) So $350,000 divided by $0.85 [i.e. the discounted price per share] or 411,765.
The convertible debt investor gets the same shares as the Series A investor, with the same rights and all of the good stuff.
IX. Tips for Entrepreneurs
1. Terminology: Sometimes convertible debt gets referenced as a convertible note. It is also called bridge financing because it bridges the company over until it can get a certain type of financing. Don't get confused on this.
2. Convertible Equity: Consider convertible equity instead of convertible debt. I've seen investors not want to go for it, but if you can get it then do it.
Convertible equity doesn't have the repayment feature at maturity. Instead, at maturity it will convert into equity at some pre-negotiated price or the maturity date will be pushed into the future. It removes the massive threat of the investor being able to push the company into bankruptcy.
3. Discount range: The discount should be about 10-30% off of the qualified financing price per share. Don't allow the convertible debt holder to get both discounts and warrants. Warrants are options to purchase shares at a specified price in the future. Convertible debt holders should either get a discount or warrants. A discount is preferable because it is simpler.
4. Qualified financing size: The qualified financing that triggers a conversion needs to be big enough such that various rights are properly negotiated. But not so big that it never triggers the conversion.
5. Interest rate: Interest rate should be low
6. Valuation caps: Watch out for valuation caps.
Valuation caps are the difference between a great deal for entrepreneurs and a terrible deal. A deal without valuation caps can be great for entrepreneurs. With valuation caps, it can be a nightmare, so take caution. I always stress for reasonableness. And this is definitely an area where it's important to be reasonable.