CONVERTIBLE DEBT CHECKLIST
Convertible Debt Strategies, Tips, Dos and Don'ts
I'm going to give you some best practices tips for a convertible debt financing.
Concentrate on these points. At the end of the day, these are the issues that really matter.
Use this as a checklist for all of the matters you need to make sure you cover in a convertible debt financing. You're not going to be able to check all of these boxes unless your negotiating position is strong. But what you can do is at least make sure you cover and account and think about these points. If you're able to do that for all of these items, you will be fine.
Use the blank next to the side of the number for you to check off.
SUMMARY & SHORTFORM
_____ 1. Use convertible equity instead of convertible debt if investors will allow
_____ 2. Use convertible debt at the right time of the company
_____ 3. Make sure convertible debt investors are accredited
_____ 4. Find the sweet spot for the qualified financing amount
_____ 5. Keep interest rates low
_____ 6. Do not give away excessive preemptive rights
_____ 7. Don't get tripped up on the valuation cap
_____ 8. Set the discount between 10-30% off of the qualified price per share.
_____ 9. Don't allow both discounts and warrants
_____ 10. Account for Excessive Liquidation Preference
_____ 11. Allow for the investors to convert at their option in certain situations
_____ 12. Address pre-payment
_____ 13. Make sure that non-key terms of the note can be amended by a vote of the majority of the note holders
_____ 14. Spell out what happens when the note matures but allow for flexibility
_____ 15. Have the maturity date be as far out as possible
EXPLANATION & LONGFORM
STRUCTURE OF CONVERTIBLE DEBT
_____ 1. Use convertible equity instead of convertible debt if investors will allow
Convertible equity doesn't have the repayment feature at maturity. Recall that convertible debt must be repaid if there is no qualified financing and if maturity hits. Instead, at maturity convertible equity will convert into equity at some pre-negotiated price or the maturity date will be pushed into the future.
Convertible equity removes the massive threat of the investor being able to push the company into bankruptcy. Many investors will not use convertible equity even if you want them to. This is because convertible equity is founder-favorable.
It is also a relatively new creation. Even big investors tell me that they have never heard of such an instrument. Some have only had to deal with them once or twice.
Additionally, convertible equity can be used by founders investing in the company. If a founder wants to put a fair amount of capital into the company, convertible equity for the founder is a good idea. In such a circumstance, the founder can put money into the company and if certain requirements are met, it will convert into equity. If a trigger point never hits, that founder can't hold it over the heads of the other founders and drive the company into bankruptcy.
Convertible Debt and Texas Startups
Convertible debt is used in Texas for Texas startups all of the time. Structurally these in form are not any different than anywhere else. The concepts and fundamentals in this article are pretty universal. The differences will be in amounts mostly. As I've mentioned before, Texas is pretty heavy in energy/oil & gas tech, health life sciences, and some other industries. Those will have larger amounts used in convertible debt than other industries. A lawyer can help you with that.
_____ 2. Use convertible debt at the right time of the company
Convertible debt is used in 3 circumstances:
i. when the company is young and it's hard to put a proper valuation on the company; and/or
ii. company is between two financings and just needs a bit of cash injection to carry it to the next financing; and/or
iii. the financing amount is relatively low--convertible debt is mostly used for financings less than $1M.
Why: Sizable amounts (i.e. $1M) are much more likely to be done in priced rounds and not as convertible debt. The reason is because purchasing equity allows for the investor to have more defined rights, board positions, etc. When doing a financing of a sizable amount of cash, it becomes worth the trouble of drawing up all of the documents in order to have these rights.
If you know where you are in the process of building a company, you'll know the types of financing deals that are going to be in play and the types of investors you need to appeal to. I've talked to some investors that almost strictly do convertible deals. I've talked to others that almost exclusively do priced rounds.
Know what type of deals your target investors like to do.
_____ 3. Make sure convertible debt investors are accredited
This is a key point. Yes, they have to be accredited. For more information on what is an accredited investor look at Phase 3A: Financing--Fundamental Concepts.
CONVERTIBLE DEBT TERMS
_____ 4. Find the sweet spot for the qualified financing amount
What is the sweet spot? Generally, 2x the amount of the convertible debt is reasonable for a qualified financing or $1M.
If the convertible debt is for $800,000, a $1M qualified financing amount is probably unreasonable--so use something like $1.6M. Think about milestones and where your company is and when it will need more financing.
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.
Why: A convertible debt converts into the same type of security with the same rights as in the qualified financing round. This means that the convertible debt holder is putting a good amount of faith that whoever is the investor in the qualified financing round will do a sufficient job in acquiring and negotiating proper rights appropriate for the situation. Small investments may not receive the same type of scrutiny as larger investments.
On the other hand, the qualified financing needs to not be so high that the conversion provisions for the debt never gets triggered.
_____ 5. Keep interest rates low
The interest should be nominal. A nominal rate of up to 2% makes sense. If you see something more than 7% then that is a red flag.
Why: Convertible debt is not like regular debt. The upside of regular debt is that the lender gets the benefit of collecting interest. The upside of convertible debt is that if the company does well, the debt will convert into shares and the convertible debt holder will then be able to enjoy all of the benefits of an equity holder. Therefore, if the interest were high, the convertible debt holder is in essence double-dipping.
_____ 6. Do not give away excessive preemptive rights
In particular, always be careful of preemptive rights and be sure that they are not excessive. Convertible debt holders do get some rights but they should not be as robust as rights received in priced round financings.
Why: Generally, convertible debt holders receive a few rights during a convertible debt financing. They'll get their benefits when the debt converts. Additionally, excessive preemptive rights might discourage other future investors to come on board--so watch out for these.
_____ 7. Don't get tripped up on the valuation cap
Valuation caps can be 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 make sure they are reasonable. This not one of those terms to simply overlook.
It also serves as an anchor for future investments so keep that in mind.
_____ 8. Set the discount between 10-30% off of the qualified price per share.
If you can get it less than 10%, then that's great. But make sure it's not excessive (i.e. greater than 30%.)
Why: convertible debt comes ahead in time of the qualified financing so it should be rewarded in some way. This is normal and expected.
_____ 9. Don't allow both discounts and warrants
Warrants are options to purchase shares at a specified price in the future. Convertible debt holder should either get a discount or warrants. A discount is preferable because it is simpler.
Why: getting both would be a form of double dipping and should be discouraged
_____ 10. Account for Excessive Liquidation Preference
If the convertible debt note comes with a valuation cap, the convertible debt investors may receive a disproportionately high liquidation preference (advantageous to them) that should be dealt with. This can be dealt with in two ways: (a) issue common stock to account for the discount; or (b) have the convertible debt convert into a shadow series of preferred stock (this would be just like the terms of the qualified financing stock except for the liquidation preference.)
CONVERTIBLE DEBT MATURITY AND OTHER SITUATIONS
_____ 11. Allow for the investors to convert at their option in certain situations
There are going to be certain events that may happen in the during the course of business with the company. The convertible debt documents should account for what happens in those circumstances. Here are the possible events that need to be addressed:
- An IPO of the company
- A change of control of the company
- If there's a preferred stock financing that's not a qualified financing
- If there's no qualified financing
The best strategy in these events is to have the debt convert into a stock of a previous round of preferred stock financing or if that none such exists, to convert into common at a negotiated amount.
Additionally, in the event of an IPO or a change of control of the company, the investors may require a repayment premium. This allows them to enjoy some upside if the company does well. 2x is reasonable.
_____ 12. Address pre-payment
Ideally if you're on the company side, then you'd want to be able to pre-pay the debt any time you want. But convertible debt is not like regular debt. The more reasonable position is that pre-payment of the debt will typically only be allowed if a majority of the investors allow for it.
Why: The investors are not doing a convertible debt deal just because they hope to be paid back the investment amount. They are in it to enjoy some potential upside one day. It is reasonable that investors are asked if they would allow for pre-payment of the note.
_____ 13. Make sure that non-key terms of the note can be amended by a vote of the majority of the note holders
Allow that most of the non-key terms of the note can be amended by a vote of the majority of the note holders.
Why: convertible debt is often use when the company is young and can go in many directions. Allowing some flexibility helps account for this. It's important that allowances for amendments and changes to the deal are made.
_____ 14. Spell out what happens when the note matures but allow for flexibility
Pay attention to what happens when note matures. The language here should spell it out clearly what happens but have everything be changed according to agreement. Perhaps holders can request payment before maturity or allow for holders to receive stock instead of being repaid. Or allows them to extend payment as necessary.
_____ 15. Have the maturity date be as far out as possible
Ideally, the maturity date should never hit. The plan is for convertible debt to convert so if that doesn't happen, that can be an indication of some type of problem. Having the maturity date as far out as possible allows the company the most time to get to the point it wants to.
Conclusion: If you make sure all of these points are covered, you're on your way to getting a deal that is fair and reasonable. Now what's left is to continue operating and growing your company, and then financing again. Rinse and repeat.