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Convertible DebtNovember 19, 2014
Today’s Expert
• Robert Bishop– Partner Goodwin Procter LLP
– Over 18 years experience representing venture capital firms and high growth companies
– Founding team member of the Founders Workbench
Structure of an Equity Deal
• 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 a transfer
What about Convertible Debt?
• Many seed-stage companies use an instrument called Convertible Debt.
• Convertible Debt is not traditional bank debt
• Converts are principally used in seed deals for two reasons:
– Investors and Entrepreneurs find it hard to agree on a PM valuation
– Usually quicker and cheaper to document than equity deals
Convertible Debt provides Optionality
• Convertible Debt = (Usually) unsecured debt obligation of the Company that may be converted into equity of the Company.
• Conversion Trigger = Qualified Financing usually at some minimum amount of funds (ex. $500,000)
• If Notes Don’t Covert = (In theory,) the investors get back their principal and interest ahead of equity on maturity
• If Notes Convert = Convert amount of debt and interest into equity at the valuation in the next round
• after application of a Discount (often 15 – 25%)• often, subject to a maximum valuation amount (a “Cap”)
Basic Structure of Convertible Debt
• Investor loans $ to Company anticipating another round of funding• Investment accrues small interest (6-8% typical)• When the funding occurs, investment + interest convert to equity,
usually at a discount (15-25% typical)
Example:• Investors loan $200K to Company • 20% discount• As of conversion, interest of $10k has accrued• Next Round PM = $2m; 1M shares before financing• New Shares offered at $2/each
At Conversion, Note holders receive 210K / 1.60 shares = 131,250 shares
Converts – Complications!
• 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 doesn’ttrigger conversion?
• What happens if it never converts?
• What happens if Company is sold?
Converts – “Solutions”
• Caps (and sometimes) Floors
• Default conversion price and security at maturity
• Open round, minimum close
• Quick sale preferences (ex. 2x) or hardwired conversion on a sale
• Governance provisions
Converts: Worse Than Equity?
• Multiple liquidation preference– Ex. $500k of Notes with cap at $2m PM– Next Round at $6m PM– Issue Note holders 3x number of shares– 3x shares equals 3x liquidation preference!
• Without a floor, effectively Full Ratchet Anti-dilution• Preference Overhang
– In prior example, Note holders bought $262,500 of preference for $200,000.
– All other Series A Holders bought 1:1 preference
• Not Just a Price Adjustment
Converts: When Are They Used?
• “Bridge” financing in anticipation of an “event”
– Another financing
– Company sale
• Seed stage investment
– Valuation not understood
– Small amount raised; does not justify the cost of an equity round
– Rolling closes (some with ratcheting caps)
What is a “SAFE”?
• New security that acts like Convertible Debt
• But it is not debt – no maturity date, no creditor rights
• Right to buy equity at a price to be determined in the next round, subject to a discount, cap and/or floor.
On Air
Convertible DebtNovember 19, 2014
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