In the Start-Up Entrepreneur Series, I will be taking a deeper look into some of the most common questions early stage founders face in putting together and operating their new businesses.
Unless your new start-up is fully capitalized by its Founders, one of the first questions a new company must ask itself is “How are we going to fund this thing?”.
Over the next few weeks, we’ll be looking into different funding avenues available to the start-up entrepreneur, as well as at the various types of investors from which a company might pursue those funds. And for more in-depth analysis of preferred equity financings in particular, be sure to check out our Financing Term Sheet Deep Dive Series.
Today, we’ll talk a bit about one of the most prevalent forms of early fundraising: “convertible debt”.
What is Convertible Debt?
Almost every start-up faces a similar problem when it initially seeks funding: “What is the value of the thing that I am trying to sell (i.e., my company)?”. “Convertible debt” smartly answers that question in the simplest way possible: avoiding it.
At its most basic level, a convertible debt instrument is a promise made by the Company to repay funds received by it from Investors. Usually evidenced in a document called a “promissory note”, convertible debt is simply a loan, bearing interest and a maturity date just like any other loan one might make or receive.
Where the magic happens is in the term “convertible”. In a “convertible” debt instrument, the principal and interest of the loan automatically converts into the preferred equity of the issuing Company if and when that Company conducts a more formal preferred equity offering (where the Company would necessarily need to be “valued” in order to establish the price of the stock sold).
So the noteholders get the benefit of the upside if and when their investment “converts” into equity, and the Company gets money today without having to value the enterprise (which can be a notoriously difficult thing to do, particularly for a pre-commercial start-up formed yesterday).
Now from the perspective of the convertible debt Investor, the loan it made to the Company is “riskier” than any future investment (such as the one that would trigger the debt’s “conversion”), because the Company is further away from proving its viability. Due to that increased “riskiness”, the Investors in a convertible debt offering generally do not want to simply receive the same deal offered to future investors. They want to receive a “better” one. This is usually articulated in a convertible debt instrument through the concept of a “discount”.
Simply put, a “discount” in this context means that the price “paid” by the convertible debt holders in the future equity round would be less than that paid by the new purchasers by some pre-agreed upon percentage. As an example, if the Company’s new Series A preferred stock is sold at $1 per share and the convertible debt instrument in question bears a 20% discount, the principal and interest of the convertible debt instrument would be divided by $0.80 (i.e., a 20% discount to the Series A price) and the resulting number of Series A shares would be issued to the convertible debt holder as the “conversion” of their interest.
A standard discount rate is usually between 5 and 20%, and some instruments may even provide for a sliding scale to reflect the change in risk associated with holding convertible debt for longer periods of time (i.e., if the Company is able to attract institutional investment very shortly after the convertible debt is issued, the thought is that the discount should be smaller because the risk disparity between the two groups is not as great).
As the discount term (together with the debt’s stated interest) is the primary reflection of the “cost” of the money to the Company, it is a term that should be considered carefully by both Company and Investor alike.
In terms of process, a convertible debt offering is relatively simple. The Company will usually generate a set of business terms (interest, maturity, discount, conversion, etc.) that it will seek to go out with to prospective investors. As it negotiates with those proposed investors (and gets feedback on the terms it was considering) it will refine that offering until it has enough potential investors to properly capitalize a “round” of financing.
At that point, the Company will generally commission the drafting of a “Note Purchase Agreement” (together with the notes themselves) that describes the offering and also puts the note purchasers on the same footing in respect of the information they are receiving and the ability of the group to make amendments or waivers to the instruments. On this latter point, it is also useful to the Company to be able to communicate with the note purchasers as a group rather than as separate transaction parties.
One final note: in almost all cases convertible debt instruments will be deemed “securities” under both federal and state securities laws. While generally not an overly large concern early in a company’s life-cycle (when it is more likely requesting funds from friends and family rather than from more institutional groups), it is important to note this fact, as it does mean that the offering in question must either be registered with the government (not generally viable for a small company) or exempt from registration.
We’ll discuss the application of securities laws in significantly more detail later in this series, but for now it is simply important to note that counsel should be reviewing the nature of any convertible debt (or other) offering and reviewing the laws of the states in which Investors are located to ensure that all proper filings (or notes on applicable exemptions) are made.
This is but an overview of some of the items a new company should consider when it is contemplating raising funds in a convertible debt offering. As with most legal topics, there is a vast array of variations and options available in pursuing such a transaction (including optional conversions back into common stock, tiered or waterfalled discount approaches, participation and overallotment rights attaching to the initial loan, warrant coverage, and more). Because of that, the Company (and its Investors) should consider carefully how such a transaction is conducted.
As always, if you have any insights on today’s post or would simply like to discuss further, please leave a comment down below or contact me at firstname.lastname@example.org. I’d love to hear your thoughts.