The intricacies of convertible debt can seem overwhelming to first-timers, but understanding the fundamentals of convertible debt structure is essential to making the right choice for your company.
Here are the top five things to keep in mind when you’re considering convertible debt.
1. Note maturity
Although both the entrepreneur and investor intend for this investment to ultimately become equity, until that happens, a convertible note is still debt, and you are obligated to repay principal and accumulated interest at maturity. The maturity date is up to you and the investors. Many companies issue convertible debt that matures in one year. But what happens if that year is up and you still haven’t reached the conditions set for conversion? You’ll either need to cough up the cash or you’ll need to get the investors to agree to extend the maturity date of the note.
It’s best to give yourself more time to build your business (we recommend at least two years). Getting a company up and running always take longer than you anticipated.
2. Discount at conversion
In exchange for shouldering the risk of investing in a very young company, convertible debt providers get a discount on equity in later rounds, typically 20–30%. Sometimes investors get warrant coverage instead of a discount, but this is basically the same thing, just a little more complex. It’s okay to give these investors a discount—it’s an incentive to get in early—but do pay attention to liquidation preference multiples.
3. Valuation cap
A valuation cap is the maximum valuation at which the notes will convert into stock. That is, if your company is valued greater than the valuation cap, your early investors who are holding convertible debt will be able to buy shares in your company as if it were worth less than it actually is. This is another special perk to reward early investors.
Overall, there’s no benefit to the entrepreneur of having a valuation cap; it’s there solely for the investors. Remember, when the convertible debt is structured, there’s no priced equity associated with it. Therefore, when it’s converted to equity, and when the equity is priced, the early investors want to make sure it’s not priced too high.
Without the discount and the valuation cap, early angel investors will have little motivation to take a chance on your company.
4. Interest rate and payments
Convertible debt does not always convert to equity. It depends on where your company is at when the note comes due (did you meet the conditions for conversion) and what the investor wants (some convertible notes give investors the option of converting if the conditions are met, while other notes make conversion mandatory when conditions are met). So all convertible debt offerings must include both the terms for how the debt converts to equity and how the debt will be paid off if it is not converted to equity.
Since convertible debt is essentially unpriced equity rather than high-yield debt, interest rates are typically 4—8% per year. The relatively low interest rate reflects that there is a substantial upside if the note does convert.
5. Preventing pitfalls
Structuring convertible debt can be more complex than it initially seems. Now that convertible debt has emerged as the early-stage funding strategy du jour, we’re seeing some significant issues coming back to haunt borrowers when they don’t go through their terms carefully.
The first potential pitfall involves liquidation preferences, which define who gets paid first— and how much they get paid — in the event of a liquidation event, such as a sale. Because of an unintended quirk in the common structure of valuation caps, investors often get a significantly higher liquidation preference than the cash they invested in the company.
The second potential pitfall involves giving convertible debt investors full-ratchet anti-dilutions rights, which can burn founders in a down round. To fully understand the problem — and how to solve it before you issue convertible debt — we recommend you take a moment to read our recent post on convertible debt investors’ full-ratchet anti-dilution rights.
Since convertible debt is the most common financing instrument for angel investment, you want to avoid having too many convertible debt structures with too many angel investors. That can crowd your cap table and make your company less attractive to investors in later rounds.
Don’t let the complexity of convertible debt’s structure turn you off. It can be a very useful instrument for early-stage companies. Just make sure you understand the nuances and get an experienced investment lawyer who can navigate you through negotiations of the terms.
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