Category: Convertible Debt
Q: On page 105 of the second edition of Venture Deals under Debt Conversion Mechanics, you state: “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”. I infer this to mean that convertible debt cannot bring about the same bad results. Is that correct? How can the company trip conversion so that debt holders cannot enforce these bad results?
A (Jason): Convertible debt only automatically converts (normally) under two circumstances: One, the company completes a financing of X amount or two, the debt holder elects to convert. We’ve never seen convertible debt where the company can unilaterally convert the debt, thus the caution around getting sideways with a debt holder.
Troy Henikoff and I had lunch a month or so ago in Chicago and the conversation turned to convertible debt. I’d recently made an offer to invest in a company Troy was an investor in and the entrepreneur and I got tangled up in the definition of pre and post money in the context of existing convertible debt. In this case there were multiple traunches of convertible debt at different valuation caps. My offer was above the highest cap, but I interpreted the way the convertible debt, and pro-rata rights associated with it, worked differently than the entrepreneur did. Given the magnitude of the convertible debt, the way the debt was handled had a significant impact on the post money valuation dynamics. Ultimately, the entrepreneur and I couldn’t narrow the gap and we didn’t end up working together.
There were no hard feelings on my side (I like the entrepreneurs a lot) but it made for an interesting and awkward discussion. Troy did a great job of processing it and wrote an important, and thoughtful blog post, titled Convertible Debt: really Bridge Loans and Equity Replacement Debt. If you are an entrepreneur who is raising, or has raised, convertible debt, I encourage you to read it carefully.
In our conversation, we talked about a nuance which Troy left out – namely that the magnitude of “equity replacement debt” matters a lot. If it’s a small amount (say – $300k or less) this issue isn’t that severe. But once it gets up to $1m or more, the problem often appears in a big way. My partner Seth covered this nicely in his post That convert you raised last year is a part of your cap table.
All of those convertible debt rounds that happened in 2010, 2011, and 2012 – including a bunch of uncapped ones – are now turning into either equity rounds or unhappy situations. The more everyone on both sides understands the dynamics, the more effective the future financings, including the future convertible debt rounds, will be.
And there you have it. We’ve completed our series on convertible debt and hope that you enjoyed it. If we ever get around to writing a second edition of Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist we’ll be sure to include this as well.
If you go to the resources section of Ask the VC we’ve included standard forms used in a variety of venture deals. As of this posting, we’ll include some standard convertible debt documents subject to the disclaimer that we aren’t you lawyers and make no reps or warranties with respect to these documents, so use at your own risk.
Once again we continue our series on convertible debt deals. Today’s subject is early versus late stage dynamics.
Traditionally, convertible debt was issued by mid to late stage startups that needed a financing to get them to a place where they believed they could raise more money. Thus, these deals were called “bridge financings.”
The terms were basically the same unless the company was fairing poorly and there was doubt about the ability to raise new capital and / or the bridge was to get the company to an acquisition or even orderly shutdown. In these cases, one saw terms like liquidations preferences and in some cases changes to board and / or voting control come into play. Some of these bridge loans also contained terms like pay to play.
Given the traditional complexity and cost of legal fees associated with preferred stock financings, however, convertible debt became a common way to make seed stage investments as it tended to be simpler and less expensive from a legal perspective. Over time, equity rounds have become cheaper to consummate and the legal fees argument doesn’t hold much weight these days. In the end, the main force driving the use of convertible debt in early stage companies is the parties’ desire to avoid setting a valuation.
Earlier in the convertible debt series we talked about the “discounted price to the next round” approach to providing a discount on convertible debt. The other approach to a discount is to “issue warrants”. This approach is more complex and usually only applies to situations where the company has already raised a round of equity, but it still pops up in early stage deals. If you are doing a seed round, we encourage you not to use this approach and save some legal fees. However, if you are doing a later stage convertible debt round, or your investors insist on you issuing warrants, here’s how it works.
Assume that once again the investor is investing $100,000 and receives warrant coverage in the amount of 20% of the amount of the convertible note. In this case the investor will get a warrant for $20,000.
This is where it can get a little tricky. What does $20,000 worth of warrants mean? A warrant is an option to purchase a certain number of shares at a pre-determined price. But how do you figure out the number of warrants and the price that the warrants will be at? There are numerous different ways to calculate this, such as:
- $20,000 worth of common stock at the last value ascribed to either the common or preferred stock;
- $20,000 worth of the last round of preferred stock at that’s rounds price of the stock; or
- $20,000 worth of the next round of preferred stock at whatever price that happens to be.
As you can see, the actual percentage of the company associated with the warrants can vary greatly depending on the price of the security that underlies it. As a bonus, the particular ownership of certain classes may affect voting control of a particular class of stock.
If there is a standard, it’s the second version where the warrants are attached to the prior preferred stock round. If there is no prior preferred, then one normally sees the stock convert to the next preferred round unless an acquisition of the company occurs before a preferred round is consummated and in that case, it reverts to the common stock.
For example, assume that the round gets done at $1.00 / share, just like in the previous example. The investor who holds a $100,000 convertible note will get $20,000 of warrants, or 20,000 warrants, at an exercise price of $1.00, to go along with the 100,000 shares received in the financing from the conversion of the note.
Warrants have a few extra terms that matter.
Term Length: The length of time the warrants are exercisable which is typically five to ten years. Shorter is better for the entrepreneur and company. Longer is better for the investor.
Merger Considerations: What happens to the warrants in the event the company is acquired? We can’t opine more strongly that all warrants should expire at a merger unless they are exercised just prior to the transaction. In other words, the warrant holder must decide to either exercise or give up the warrants if the company is acquired. Acquiring companies hate buying companies that have warrants survive a merger and allow the warrant holder to buy equity in the acquirer. Many a merger have been held up as warrants with this feature have upset the potential acquirer and thus as part of the closing requirements mandated that the company go out and repurchase and / or edit the terms of the warrants. This is not a good negotiating spot for the company to find itself in. It will have to pay off warrant holders while disclosing the potential merger (so the company will have little leverage) and at the same time will have a sword over its head by the acquirer until the issue is resolved.
Original Issue Discount: This is an accounting issue that is boring, yet important. If a convertible debt deal includes warrants, the warrants must be paid for separately in order to avoid the OID issue. In other words, if the debt is for $100,000 and there is 20% warrant coverage, the IRS says that the warrants themselves have some value. If there is no provision for the actual purchase of the warrants, the lender will have received an “original issue discount” (OID) which says that the $100,000 debt was issued at a “discount” since the lender also received warrants. The issue is that part of the $100,000 principal repaid will be included as interest to the lender, or even worse, it will be accrued as income over the life of the note even before any payments are made. The easy fix is paying something for the warrants, which usually is an amount in the low thousands of dollars.
The difference between warrants and discounts is probably insignificant for the investor. We suppose if the investor is able to get warrants for common stock, then perhaps the ultimate value of warrants may outweigh the discount, but it’s not clear. As evidenced by the number of words above, warrants add a fair amount of complexity and legal costs to the mix. On the other hand, some discounts will include valuation caps (more on this in our next post) and that can create some negative company valuation ramifications. Warrants completely stay away from the valuation discussion.
Finally, in no case should an entrepreneur let an investor double dip and receive both a discount and warrants. That’s not a reasonable position for an investor to take – he should either get a discount or get warrants.
In today’s episode of our convertible debt series, we discussion a few other terms that come into play with a transaction.
Interest Rate: We believe interest rates on convertible debt should be as low as possible. This isn’t bank debt and the funders are being fairly compensated through the use of whatever type of discount has been negotiated. If you are an entrepreneur, check out what the Applicable Federal Rates (AFRs) are to see the lowest legally allowable interest rates are and bump them up just a little bit (for volatility) and suggest whatever that number is. Typically we see an interest rate between 7% and 10%.
Pro-Rata Rights: This term allows debt holders to participate pro-ratably in a future financing. Since many times the dollars amounts are low / lower in a convertible debt deal, investors may ask for “super pro-rata” rights. For instance, if an investor gave a company $500,000 in a convertible debt deal and the company later raises $7,000,000, the investor’s pro-rata investment rights wouldn’t allow them to purchase a large portion of the next round. Sometimes investors will ask for pro-rata rights that are a multiple of their investment. In this case the investor may ask for two to four times their amount. While pro-rata rights are pretty typical, if you have people asking for super pro-rata rights, or a specific portion of the next financing, you should be careful as this will likely limit your long term financing options.
Liquidation Preferences: Every now and then you’ll see a liquidation preference in a convertible debt deal. It works the same as it does in a preferred stock deal – the investors get their money back first, or a multiple of their money back first, before any proceeds are distributed to anyone else. This usually happens in the case when a company is struggling to raise capital and current investors offer a convertible debt (also called a bridge loan) deal to the company. Back in the good old days usury laws prevented such terms, but in most states this is not an issue and allow the investors to not only have the security of holding debt, but the upside of preferred stock should a liquidation event occur.
Other Terms: If you see other terms in a proposed deal outside of these, we’d guess that they are unique to your situation, as the ones we’ve discussed should cover the vast majority of debt transactions.
In today’s installment of our convertible debt series, we cover a specific case where the company is acquired before the debt converts into equity. There are a few different scenarios.
The lender gets its money back plus interest. If there is no specific language addressing this situation, this is what usually ends up happening. In this case, the convertible debt document doesn’t allow the debt to convert into anything, but at the same time mandates that upon a sale the debt must be paid off. So the lenders don’t see any of the upside on the acquisition. The potential bad news is that if the merger is an all stock deal, the company will need to find a way to find cash to pay back the loan or negotiate a way for the acquiring company to deal with the debt.
The lender gets its money back, plus interest plus a multiple of the original principle amount. In this case, the documents dictate that the company will pay back outstanding principle plus interest and then a multiple on the original investment. Usually we see 2-3x, but in later stage companies, this multiple can be even higher. Typical language follows.
Sale of the Company: If a Qualified Financing has not occurred and the Company elects to consummate a sale of the Company prior to the Maturity Date, then notwithstanding any provision of the Notes to the contrary (i) the Company will give the Investors at least five days prior written notice of the anticipated closing date of such sale of the Company and (ii) the Company will pay the holder of each Note an aggregate amount equal to _____ times the aggregate amount of principal and interest then outstanding under such Note in full satisfaction of the Company’s obligations under such Note.
Some sort of conversion does occur. In the case of an early-stage startup that hasn’t issued preferred stock yet, the debt converts into stock of the acquiring company (if it’s a stock deal) at a valuation subject to a cap. If it’s not a stock deal, then one normally sees one of the above scenarios.
With later stage companies, the investors usually structure the convertible notes to have the most flexibility. They either get a multiple payout on the debt, or get the equity upside based on the previous preferred round price. Note that if the acquisition price is low, the holders of the debt may usually opt out of conversion and demand cash payment on the notes.
While in many cases issuing convertible debt is often easier to deal with than issuing equity, the one situation where this often becomes complex is an acquisition while the debt is outstanding. Our strong advice is to address how the debt will be handled in an acquisition in the documents.
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  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.
Today, in our series on convertible debt, we examine the conversion valuation cap.
The cap is an investor-favorable term that puts a ceiling on the conversion price of the debt. The valuation cap is typically only seen in seed rounds where the investors are concerned that the next round of financing will be at a price that is at a valuation that wouldn’t reward them appropriately for taking a risk by investing early in the seed round.
For example, an investor wants to invest $100,000 in a company and thinks that the pre-money valuation of the company is somewhere in the $2 to $4 million dollar range. The entrepreneurs thinks their valuation should be higher. Either way, the investor and entrepreneurs agree to not deal with a valuation negotiation and consummate a convertible debt deal with a 20% discount to the next round.
Nine months pass and the company is doing well. The entrepreneurs are happy and the investor is happy. The company goes to raise a round of financing in the form of preferred stock. They receive a term sheet at $20 million pre-money valuation. In this case, the discount of 20% would result in the investor having an effective valuation of $16 million for his investment nine months ago.
One on hand the investor is happy for the entrepreneurs but is shocked by the relatively high valuation for his investment. He realized he made a bad decision by not pricing the deal initially as anything below $16 million would have been better for him. Of course, this is nowhere near the $2 to $4 million the investor was contemplating the company was worth at the time he made his convertible debt investment.
The valuation cap addresses this situation. By agreeing on a cap, the entrepreneur and investor can still defer the price discussion, but set a ceiling at which point the conversion price “caps”.
In our previous example, let’s assume that the entrepreneurs and investor agree on a $4 million cap. Since the deal has a 20% discount, any valuation up to $5 million will result in the investor getting a discount of 20%. Once the “discounted value” goes above the cap, then the cap will apply. So, in the case of the $20 million pre-money valuation, the investor will get shares at an effective price of $4 million.
In some cases, caps can impact the valuation of the next round. Some VCs will look at the cap and view it as a price ceiling to the next round price, assuming that it was the high point negotiated between the seed investors and the entrepreneurs. To mitigate this, entrepreneurs should never disclose the seed round terms until a price has been agreed to with a new VC investor.
Clearly, entrepreneurs would prefer not to have valuation caps. However, many seed investors recognize that an uncapped note has the potential to create a big risk / return disparity especially in frothy markets for early stage deals. We believe that – over the long term – caps create more alignment between entrepreneurs and seed investors as long as the price cap is thoughtfully negotiated based on the stage of the company.
As we start our convertible debt series, we’ll focus on the discount. Remember that a convertible debt deal doesn’t purchase equity in your company. Instead, it’s simply a loan that has the ability to convert to equity based on some future financing event (we’ll tackle the conversion mechanics in a later post.)
Until recently, we had never seen a convertible debt deal that didn’t convert at a discount to the next financing round. Given some of the excited market conditions at the seed stage, we’ve heard of convertible deals with no discount, but view this as irregular and not sustainable over the long term.
The idea behind the discount is that investors should get, or require, more upside than just the interest rate associated with the debt for the risk that they are taking by investing early. These investors aren’t banks – they are planning to own equity in the company, but are simply deferring the price discussion to the next financing.
So how does the discount work? There are two approaches – the “discounted price to the next round” or “warrants.” We are only going to focus on the discounted price to the next round approach, as it’s much simpler and better oriented for a seed round investment. We’ll cover warrants in a later post in the series.
For the discounted price to the next round, you might see something like this in the legal documents:
“This Note shall automatically convert in whole without any further action by the Holders into such Equity Securities at a conversion price equal to eighty percent (80%) of the price per share paid by the Investors purchasing the Equity Securities on the same terms and conditions as given to the Investors.”
This means that if your next round investors are paying $1.00 per share, then the note will convert into the same shares at a 20% discount, or $0.80 per share. For example, if you have a $100,000 convertible note, it’ll purchase 125,000 shares ($100,000 / $0.80) whereas the new equity investor will get 100,000 shares for his investment of $100,000 ($100,000 / $1.00).
The range of discounts we typically see is 10-30% with 20% being the most common. While occasionally you’ll see a discount that increases over time (e.g. 10% if the round closes in 90 days, 20% if it takes longer), we generally recommend entrepreneurs (and investors) keep this simple – it is the seed round, after all.