Convertible Debt Ben Littauer: viz.me/littauer May 29, 2014

Review of an Equity Deal 2 Company and Investors agree on a pre-money valuation (PM) which leads to a price per share Investors put in $X Investors then own: X / (X + PM) of the company Example: PM = $1M X = $0.5M Investors own 0.5/1.5 = 33% Remember: New issuance NOT transfer of shares

What is Convertible Debt 3 Many seed-stage companies use an instrument called Convertible Debt. Convertible debt is not traditional bank debt Converts exist for several reasons Investors and Entrepreneurs find it hard to agree on a PM valuation Sometimes quicker and cheaper to document than equity deals May allow for rolling close accretion of investment

Basic Structure of Convertible Debt 4 Investor loans $ to Company anticipating another round of funding, usually triggered by the size of the next raise Investment accrues small interest (6-8% typical) Debt is usually unsecured and inferior to most other debt When the funding occurs, investment + interest convert to equity on same terms as new money, usually at a discount (15-25% typical) and subject to a maximum valuation (cap)

Structure of Convertible Debt Ex1 5 Example: Investors loan $200K to Company 20% discount; $2M cap As of conversion, interest of $10k has accrued Next Round PM = $2m; 1M shares before financing New Shares offered at $2/each At Conversion, Noteholders receive 210K / 1.60 shares = 131,250 shares

Structure of Convertible Debt Ex2 6 Example: Investors loan $200K to Company 20% discount; $2M cap As of conversion, interest of $10k has accrued Next Round PM = $4m; 1M shares before financing New Shares offered at $4/each; share price at $2M pre would have been $2/each At Conversion, Noteholders receive 210K / 2 shares = 105,000 shares Without cap would be 210K / 3.2 = 65,625 shares

Converts Complications! 7 What if only a little money comes in? When does the debt convert? What happens if PM of next round is huge? Does the investor have any say in things? What if there is an equity investment that doesnt trigger conversion? What happens if it never converts? What happens if Company gets bought?

Converts Solutions? 8 Caps and Floors Default conversion price and security at maturity Open round, minimum close Quick sale preferences (ex. 2x) Governance provisions Careful attention to conversion conditions Typical legal documents are a Promissory Note, a Note Purchase Agreement, and (for existing shareholders), a Shareholder Agreement that codifies other conditions of the note (e.g creation of board).

Converts: When Do They Work? 9 Bridge financing in anticipation of an event Another financing A big sale Company sale Seed stage investment Valuation not understood Rolling closes (often with ratcheting caps) Proof points as an event When the investor loves the company (cf. exuberant equity valuations)