Convertible Debt Financing for Start-ups: Pros & Cons

Chris Hurley, Co-founder & Principal of Beacon Law Advisors, PLLC

Copyright Chris Hurley 2010. All rights reserved

What is Convertible Debt?

It is debt— i.e., Company must pay it back (plus interest) if it doesn’t convert.

At liquidation (e.g., Company gets acquired or is winding down), convertible debt gets paid back prior to shareholders.It is a liability on your balance sheet until it converts.Typically unsecured for start-ups, but can be secured in certain situations (e.g., distressed situations).

What is Convertible Debt? (cont’d)

It is equity— but only if and when it converts into equity.

Usually conversion is automatic into “Next Equity Financing” of at least a certain minimum aggregate amount.

• Type of security and conversion price set in “Next Equity Financing.”

• Sometimes, investor has option to convert– beware.“Next Equity Financing” is usually preferred stock financing.

• But it could be common stock, although this is less often the case.

Once converted, the convertible note is no longer debt and becomes equity.

liability is removed from Company’s balance sheet.

What is Convertible Debt? (cont’d)

Punchline: psychologically, convertible notes are typically thought of as equity investments because the investors take equity-type risk and seek unlimited, equity-type upside.

The convertible note happens to be structured as a debt until it actually converts into equity.But it is real debt until it converts.

Convertible Debt—Company’s Perspective

Company gets to access funds now, and set price later.If Company hits plan, the valuation of Company and hence the conversion price should go up in Next Equity Financing— i.e., cheaper cost of capital.

Greater flexibility in case events at Company change dramatically one way or another.

Compare if Company does a priced round at too high a valuation then misses plan badly resulting in a subsequent down round.“high resolution” fundraising.

Relatively easy, fast, and cheap from a transaction cost perspective.

But convertible notes are still securities and so you must pay attention to securities laws.

Company typically delays shareholder issues and board representation issues until the noteholders actually convert into equity.

But convertible noteholders are still investors – do not ignore or short change investor relations.

Convertible Debt—Investors’ Perspective

Comfort of being on top of capital structure and thus having priority until conversion.

But what good does priority do me if Company flames out and no practical liquidation value?

Discomfort of not knowing exactly what my price per share is now and exactly what % of the Company investor owns.Discomfort that if Company hits its plan, investors’ conversion price will go up even though investors funded now and therefore started incurring risk now.

Thus, investors need a “kicker” to make this make economic sense.

KickersWarrants

Usually preferred, but can be common sometimes.• Beware of voting issues caused by common warrants once

exercised.“20% Warrant Coverage, 5-Year Warrants”

• This means for investor purchasing a $100k convertible note, investor gets right – but not obligation — to buy an additional $20k of stock issued at Next Equity Financing locked in at low price anytime for 5 years.

• Thus, investor sits back and waits to see if warrant is in money.

Discounts.Interest and Convertibility of Interest. Conversion into Previous Round.Prepayment Premiums if Company Gets Acquired Before Next Equity Financing.

When is Convertible Debt Appropriate?

Right at Beginning– True Friends and Family Round.

Friend and family are betting on founders primarily and on Company’s idea second.Not arms’-length, flinty nosed third party investor driving hardest bargain.

A True “Bridge” Situation (as opposed to a “Pier” Situation).

When Company is just covering a relatively short funding gap to a discreet, identifiable, and visible valuation-raising event – e.g., signing of a key customer deal, product release, financing event, etc.

When Company is a “hot deal.”When investors are clamoring to get into your deal.

When is Convertible Debt Appropriate? (Cont’d)

Punchline: convertible debt is favorable to the Company … but:

You have to convince investors it’s a good enough deal to say yes to.

• This is not as easy as it sounds in every situation.

Don’t give away so many dilutive kickers that you make your true cost of capital prohibitively expensive.Don’t let the aggregate amount of convertible debt “overhang” become too large a % of Next Equity Financing as this can scare off new money.

When is Convertible Debt Not Appropriate?

A True “Pier” Situation– i.e., when Company is financing out into fog (no land in sight); no clearly articulable valuation-increasing milestones or events.When aggregate effect of kickers becomes very dilutive making true cost of capital prohibitively expensive.When the aggregate amount of convertible debt “overhang” becomes too large a % of Next Equity Financing as this can scare off new money.

Avoid MistakesFollow securities laws

Make sure you have exemptions Try to limit to accredited investors if possible unless you have an alternative exemption

It is easier to start giving warrants than to stop.Avoid setting all kinds of valuation constraints that will interfere with free market setting valuation in Next Equity Financing. Make maturity date far out enough that you have a realistic shot of closing Next Equity Financing.Be very cautious of optional conversion and no mandatory conversion.Be wary of giving any single note holder a veto right– consider a clause whereby a majority in interest of noteholders can agree to a change binding on all noteholders.