CONVERTIBLE NOTE FAQ


Table of Contents

General

Q: What is convertible debt?
Q: What is the difference between a convertible debt and a convertible note?
Q: What is convertible equity? 
Q: Why doesn't the investor just buy shares of the company to begin with?
Q: Why doesn't the lender just loan the funds straight out, get paid back, and not become an owner of the company? 
Q: When is convertible debt used?
Q: Would a simple system be okay? Such as: "I am loaning you 50k, and after a year I will, at my choosing, either be paid back or I want equity."
Q: What are convertible notes like with startups in Texas? 

Conversion Mechanics

Q: When does it convert from debt to equity?
Q: How does it convert?
Q: What is a discount?
Q: What is a valuation cap?
Q: Does a valuation cap guarantee the percent amount of the company that the convertible debt holder will own upon conversion?

Terms

Q: What about interest on the convertible debt?
Q: What is a warrant?
Q: What is this liquidation preference problem?
Q: Can the note be secured?

"What Ifs"

Q: What happens if the company gets sold?
Q: What if it doesn't convert?
Q: What if my startup wants to pay back the note or change the terms of the note?

Pluses and Minuses

Q: What are the advantages of convertible debt?
Q: What are the disadvantages of convertible debt?

 

FAQ

General

Q: What is convertible debt?

It's a way of financing your startup. It's like a loan, except instead of the startup having to pay back the loan, the debt converts at a certain time into equity (shares) of the company. The lender (investor) becomes a part owner of the company. 

The triggering event for when the loan converts into equity is when the company does a large financing for equity (typically by another investor or VC.) Convertible debt is often called bridge financing for this reason.

It is "bridging" the company over until the company can get more financing. The debt will convert into the same terms (with the benefit of a discount because it is earlier in time) as what the large equity financing terms are. The large financing will be done with more scrutiny (because it's a higher amount), with more defined rights, and will set a valuation of the company. The company must have a valuation for the debt to convert into equity. This is of course true because you need to know how much of the company the debt will convert into. You need to know the quantity. 

Q: What is the difference between a convertible debt and a convertible note?

I see both of these terms used interchangeably. Technically, in a debt deal/loan deal, the note is a document where one party promises to pay the other party. It's the tangible document basically--the financial instrument you could call it. You could also say convertible note in the context of a convertible equity deal.

Don't worry about the technical detail of this. Just know that people say convertible debt, convertible note, debt holder, note holder, etc. and almost always mean the same basic thing.  

Q: What is convertible equity? 

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.

I see it used infrequently. But it's a good tool to use if the founder can do so. 

Q: Why doesn't the investor just buy shares of the company to begin with?

Some investors do this as a series seed or full blown series financing. Convertible debt is just another method of financing the company.

Series seed or series investors need to know how much their investment is worth (what the price of the share of the company is) before they buy it. Convertible debt does not require this type of valuation of the company. Valuating a company at its infancy is difficult and an in-exact science. So part of the reason why convertible debt is used instead of equity financing is because valuating the company at such an early stage almost makes no sense. 

Convertible debt is basically: "here, take this money, and by a certain point in the future, either pay me back or convert it into shares of the company when the company does an equity financing." 

Q: Why doesn't the lender just loan the funds straight out, get paid back, and not become an owner of the company? 

Some lenders do this. Convertible debt is just another method of financing the company. 

Investing in or loaning to high tech startups is risky. And often these companies go for quick growth at the cost of immediate revenue. Lacking this revenue can make taking on debt not feasible. 

Q: When is convertible debt used?

Usually early stage companies use convertible debt financing (less than 500k). Higher amounts of financing (+1M) are usually done as full blown series financings with venture capitalists. 

But some times late stage companies do convertible debt financings, and some times the amounts are quite higher than that.  

Q: Would a simple system be okay? Such as: "I am loaning you 50k, and after a year I will, at my choosing, either be paid back or I want equity."

Yes. But it depends.

One big problem is that most companies will not have the funds to pay it back. That 50k is for high growth and is used to build the company even more; not to sit in reserve. 1 year is a short turnaround. 

Q: What are convertible notes like with startups in Texas? 

I get this question a lot as a startup attorney in Texas. Convertible notes are used in Texas all of the time. It's really not very different than in other jurisdictions. 


Conversion Mechanics

Q: When does it convert from debt to equity?

When the company sells shares in an equity financing of at least a certain amount of money (a "qualified financing"), e.g. $1M.

Convertible debt is used to tide the company over until it can get a sizable equity financing deal done, usually within a year. This is why it's also called "bridge-financing."

Q: How does it convert?

The convertible debt will convert into the same shares as the qualified financing.

If you do a convertible debt deal and then down the road do a Series A deal, the convertible debt will convert into Series A preferred shares.

If the convertible deal was for $500k and if the Series A financing was done for $1M at $1 per share, The $500k convertible debt will convert into those shares for $1 per share (actually a little bit less than $1 due to a discount.)   

Q: What is a discount?

Convertible debt deals are earlier in time than the qualified financing. They can also be risky as the company is often in its early growth stage. Therefore, they get a discount when converting.

A discount of 10-30% off the qualified financing share price is typical. 

Q: What is a valuation cap?

A convertible debt deal avoids setting a valuation of the company. Neither the company nor the convertible debt holder knows what the company is worth (or can agree to it.) 

The convertible debt holder puts it in the qualified financing investors' hands to negotiate a proper valuation of the company. However, the debt holder wants a guarantee that it won't be excessive. The valuation cap puts a maximum valuation for the debt to be converted. 

Stock will be issued in the qualified financing at a certain price using this formula: price per share = valuation / number of fully diluted shares

The higher the valuation, the higher the price will be for the investors to pay. The investors want a low price at which to invest in. The debt holder will pay this same price (with the benefit of a discount) or they will pay the price based upon the valuation cap. The convertible note will convert at whichever is lower. 

So the lower the valuation, the better for the convertible debt holder. A valuation cap helps protect the investor. It sets the highest valuation that the debt will convert at. 

Q: Does a valuation cap guarantee the percent amount of the company that the convertible debt holder will own upon conversion?

No. The valuation cap will guarantee the maximum valuation for which the debt will convert. Price per stock is figured out using the formula: price per stock = valuation / number of fully diluted stock

So the valuation cap will set the maximum that the valuation in that formula will be. It does not guarantee a certain percentage ownership of the company.

You can't just do this: 

Have a cap of $2M and invest 500k  via convertible note guaranteeing you 1/4 of the company. THIS IS WRONG.  
 

Terms

Q: What about interest on the convertible debt?

It used to be 7-10%, but lately I have been seeing more deals where the interest rate is near 1-2%. This is a reflection of the general direction of the market. Unlike real debt, convertible debt has potential for upside and so it shouldn't have as high of an interest rate. 

Q: What is a warrant?

As mentioned, convertible debt deals are earlier in time than the qualified financing. They can also be risky as the company is often in its early growth stage. Therefore, they should get some benefit when converting. 

Instead of a discount, some times warrants are issued instead. Warrant coverage vaguely mimics a discount. A warrant is an option. It is an option to buy certain number of shares at a certain price. These are some times given in more complex deals.

Q: What is this liquidation preference problem?

This answer will get technical. So I will go through it step-by-step. If you don't understand it, don't waste too much time on it and instead ask your lawyer to do a person-to-person walk-through on it. 

Summary of the problem: with the discount that a valuation cap gives convertible debt holders, convertible debt holders can receive a high liquidation preference compared to what others receive. This is a great benefit to the convertible debt holder, but it may be seen as unfair to other stockholders. There are techniques to minimize this problem. 

a. Recall that a convertible note converts into the preferred stock in a qualifying financing. 

b. Those preferred shares come along with a liquidation preference. 

c. A liquidation preference is the amount of money that preferred shareholders receive in an event of liquidation (such as a sale of the company) before common stockholders.

d. The liquidation preference is expressed as a multiple of the purchase price of stock such as 1x, or 2x or similar. This 1x or 2x means 1 times the amount they invested or 2 times the amount they invested. If the qualified financing investor invests at $1 per stock with a 2x liquidation preference, the investor will receive $2 per share of stock from the proceeds of a sale of the company.

e. In a qualified financing, the convertible debt will convert into the same series of preferred stock in that financing. So the debt holder will have the same terms and everything, including receiving $2 per share of stock from the proceeds of a sale of the company.

f. However, with a valuation cap and all of that, the debt holder may actually have only paid a small amount for their stock. The debt holder may have paid $0.20 per share of stock. If this person receives $2 per share of stock, that is a 10x return. 

g. Effectively, the debt holder received a 10x liquidation preference. Generally, 1x liquidation preference is the standard. Anything more is seen as excessive. 

h. This disproportionate return is seen as unfair to the other investors and stockholders. 

i. In order to deal with this perceived unfairness a few things can be done: (i) have the convertible debt not convert into that series of preferred stock but instead convert into a "shadow" series of preferred stock where everything else is the same except for the liquidation preference or (ii) convert into preferred and additionally issue common stock in order to account for shares that would be given if the valuation cap applied. 

Q: Can the note be secured?

Yes, but it's rare unless it's for big money in certain industries. 


"What Ifs"

Q: What happens if the company gets sold?

The terms of the convertible debt will state what happens. Usually the investor gets a multiple return of what the investment was for. They took a risk and should be compensated for that. Or they can convert.

Q: What if it doesn't convert?

This situation occurs in two scenarios: (a) the company gets sold (see above); (b) the company doesn't do a qualified financing. In that case, the convertible debt note should go into this. A few things can happen:

1) Company can pay back the debt;
2) Investor can cause company to go into bankruptcy;
3) Maturity date can be extended;
4) Debt can convert into shares at some negotiated price.

Q: What if my startup wants to pay back the note or change the terms of the note?

Should only be done if the investor consents to it. 
 

Pluses and Minuses

Q: What are the advantages of convertible debt?

Can be faster; can be cheaper; don't have to figure out a valuation of the company; company doesn't have to give up control to the convertible debt holder (no voting rights, no board seat.)

Q: What are the disadvantages of convertible debt?

Convertible debt can be deceptively complex (e.g., dealing with convertible debt holders receiving multiple liquidation preference); valuation cap can mean that the investor can own a huge percentage of the company even if the value of the company is very high.