WHAT SHOULD THE TERMS BE IN A CONVERTIBLE DEBT FINANCING?
Convertible Debt Table of Terms
I have compiled a comprehensive list of all of the terms you will see in a typical convertible debt or convertible note financing and given my recommendations and comments on the right. If you focus on and understand the important terms and don't waste your time worrying about the unimportant ones then you will be fine.
| Term | What it is | Recommendations and Comments |
|---|---|---|
| Offering Amount | Dollar amount the investor is loaning to the company that will convert into equity upon certain events. | How much your startup needs depends on what type of startup you have. Typically, amounts don't go over 500k except for in certain industries I am involved in. Above that amount you will likely see a priced round (e.g. Series Seed or Series A.) Importance: High |
| Valuation Cap | Mechanism used by convertible debt holder to limit how high the valuation of the company can be for purposes of calculating the price per share that the debt will convert at. | Convertible debt holder will want this to be low. Startup will want this to be high. Importance: High |
| Default Provisions | These provisions detail what happens in the case of a qualified financing not taking place, the debt becomes due, and the company is unable to pay (which is highly likely in certain industries). | Without adequate planning, a convertible note holder can drive startup into bankruptcy. Recommendation: have debt convert into preferred shares of a previous round or if no round, then a certain percent of common stock. Allow possibilty of having maturity date extended. Importance: High |
| Voluntary Conversion | The convertible debt deal may allow for voluntary conversion at the election of the convertible debt investor in a number of scenarios: (1) any time the investor wishes; (2) when there is a preferred financing that is not a "qualified financing;" (3) when no qualified financing took place and the note is due; and/or (4) the company is acquired or there is an IPO. | (1) I discourage this except in very few scenarios; (2) this is fine--the convertible debt should convert into the same shares as this nonqualifying financing; (3) and (4) this is fine--the convertible debt should convert into the same shares/price as a previous round of preferred financing--if that no such round exists, then into common stock Importance: High |
| Pro-rata/Preemptive Rights | This is the right for an investor to participate in future financing rounds in order to maintain the investor's ownership percentage in the company. | Founders need to be particularly cautious about giving out super pro-rata rights (rights that allow for greater ownership percentage.) Importance: High |
| IPO or Company Acquired | The company may be acquired or participate in an IPO before the convertible note automatically converted as a result of a qualified financing. A couple of things might happen: a. the note becomes due; b. convertible debt investor can voluntarily convert to equity (see below); and/or c. the note becomes due and the investor gets a premium on their investment. | A repayment premium is not uncommon. This is expressed as a multiple of the investment. Make sure it's not too high (i.e., 2x+) particularly if there's an option for them to convert. Importance: Moderate |
| Discount | Convertible debt converts into equity when the company raises money in a qualified financing. The qualified financing will be scenario where investors buy equity from the company at a certain price per share. Convertible debt, when converting into equity, will convert at that same price the equity investors paid but with the benefit of a discount. The convertible debt holders get this discount in part because they invested earlier in time. | The discount is typically between 10-30% off of the qualified financing price. Be careful to not give a convertible debt holder both discounts and warrants (defined below) as this is a form of double dipping. Importance: Moderate |
| Warrants | Warrants are the rights to purchase shares in the startup at a pre-determined price. It's a type of option some times issued concurrently with preferred stock. | Avoid the warrant route as they can add unnecessary complexity to the deal and can indirectly lead to a lower valuation. Importance: Moderate |
| Qualified Financing | Convertible debt is generally set up in such a manner that the debt will convert into equity when there is a sizeable equity financing ("qualified financing") being done by the company. At that point, the debt will convert into the same type of equity as in the qualified financing. | The qualified financing needs to be big enough (generally about $1m+) such that terms and valuation will properly be negotiated. It should not be so big such that the convertible debt doesn't convert because future financings are not deemed "qualifying." Importance: Moderate |
| Debt Term | Regular debt has a term (time). After the term is over, the debt is due and must be paid. Convertible debt also has a length term. | Convertible debt is for bridging the company over until a qualified financing can take place. The term should not be extremely long (e.g. 10 years.) About one year, depending on the company profile makes sense. Importance: Moderate |
| Security Interest | A security interest is a way to make the debt secured. If the company doesn't pay back the debt, the convertible debt investor can seize certain assets and sell them in a foreclosure. | Unless there's a particular reason, security interests are usually not granted in a convertible debt deal. Importance: Moderate |
| Amendment of Note | This provision details how and in what manner the convertible note can be amended or changed. | Amendment of the note should not be allowed without consent of the company and the investor (or super-majority of the investors if there is more than one.) Importance: Moderate |
| Prepayment of Debt | Prepayment of the debt is where the debt is prepaid before the debt becomes due. | Prepayment should only be allowed with the consent of the company and the investor (or super-majority of the investors if there is more than one.) Importance: Moderate |
| Maturity | Maturity details what happens when the convertible note becomes due and there was no qualified financing (i.e. it's time for the debt to be repaid) | Get this term to be flexible because depending on the circumstances and direction of the company, both investors and the company may wish to play it by ear. Allow flexibility by requiring that a majority of the investors have to elect to have the note paid back before payment is due or that the majority of the investors may elect to have stock issued to them instead of being paid back. Importance: Moderate |
| Liquidation Preference | A liquidation preference allows for preferred shareholders to receive their money back, or a multiple of their investment amount, (if the company gets acquired for example) before common shareholders. Some times these are in convertible debt deals. | The big issue with liquidation preference and convertible debt deals is that, due to the discount and valuation cap, convertible debt investors can receive an extremely disproportionate liquidation preference compared to the qualified financing investors. Deal with this by utilizing common shares or shadow preferred shares. Importance: Moderate |
| Interest Rate | Convertible debt comes with interest. | The interest rate should be low around 1-2% today and definitely not more than 7%. The benefit of regular debt is interest. But convertible debt has upside potential with equity. A high interest rate and conversion into equity is double-dipping. Deal documents should spell out what happens to the interest. Most of the time, the interest will convert as well. Importance: Low |