Sep 22 2011 by Jason

Convertible Debt – Conversion Mechanics

We continue our convertible debt series today with a discussion about conversion mechanics. This is a very important term, but usually one that everyone can be happy with at the end if they concentrate on it.

In general, debt holders have traditionally enjoyed superior control rights over companies with the ability to force nasty things like bankruptcy and involuntary liquidations. Therefore, having outstanding debt (that doesn’t convert) can be a bad thing if an entrepreneur ever gets “sideways” with one of the debt holders. While it’s not talked about that much, it happens often and we’ve seen it many times leaving the debt holder in a great position of leverage in negotiations.

Here is typical conversion language:

“In the event that Payor issues and sells shares of its Equity Securities to investors (the “Investors”) on or before [180] days from the date herewith (the “Maturity Date”) in an equity financing with total proceeds to the Payor of not less than $1,000,000 (excluding the conversion of the Notes or other debt) (a “Qualified Financing”), then the outstanding principal balance of this Note shall automatically convert in whole without any further action by the Holders into such Equity Securities at a conversion price equal to the price per share paid by the Investors purchasing the Equity Securities on the same terms and conditions as given to the Investors.”

Let’s take a look at what matters in this paragraph. Notice that in order for the note to convert automatically, all of the conditions must be met. If not, there is no automatic conversion.

Term: Here, the company must sell equity within six months (180 days) for the debt to automatically convert. Consider whether or not this is enough time. If we were entrepreneurs, we’d try to get this to be as long as possible. Many venture firms are not allowed (by their agreements with their investors) to issue debt that has a maturity date longer than a year, so don’t be surprised if one year is the maximum that you can negotiate if you are dealing with a VC investor.

Amount: In this case the company must raise $1,000,000 of new money, because the conversion of the outstanding debt is excluded, for the debt to convert. Again, its the entrepreneur’s decision on how much is a reasonable number, but think about how long you have (here 180 days) and how much you think you can reasonably raise in that time period.

So what happens if the company does not achieve the milestones to automatically convert the debt? The debt stays outstanding unless the debt holders agree to convert their holdings. This is when voting control comes into play. It is key to pay attention to the amendment provision in the notes.

“Any term of this Note may be amended or waived with the written consent of Payor and the Majority Holders. Upon the effectuation of such waiver or amendment in conformance with this Section 11, the Payor shall promptly give written notice thereof to the record Holders of the Notes who have not previously consented thereto in writing.”

While one will never see anything less than a majority of holders needing to consent to an amendment (and thus a different standard for conversion), make sure the standard doesn’t get too high. For instance, if you had two parties splitting $1,000,000 in debt with a 60 / 40 percentage split, you only need one party to consent if the majority rules, but both parties would need to consent if a super majority must approve. Little things like this can make a big difference if the 40% holder is the one you aren’t getting along with at the present moment.