Convertible Debt for Startups
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Transcript of Convertible Debt for Startups
Convertible Debt FinancingHow it Works
11.2.11
Benjamin M. [email protected]@HronEsq
Rick M. [email protected]@RickLucash
Convertible Debt Essentials
♦ A loan that can be converted to stock
♦ Originally primarily used as a “bridge” between equity rounds
♦ Has become a typical way to do seed stage deals
Cost - Benefit
♦ Puts off discussion of valuation
♦ Tends towards smaller deals– CAN be simpler, and cheaper to document,
than equity– BUT can become complex; while seed equity
getting simpler
Cycles and Styles
♦ East Coast angel groups have evolved towards Preferred Stock deals
♦ Tends to be used by friends, family, and solo angels
♦ Use by superangels
♦ Good or bad for entrepreneurs? – Will discuss later
How it Works
♦ Loan to (Debt of) the Company– Principal and interest repayable at future
date/circumstances
♦ May convert to equity– By whom (investor or company)– Under what conditions
♦ Conversion typically comes with a benefit – most commonly a discount off next round
Basic terms and Norms
♦ Term/due date: 1 – 2 years– Cash payment of principal and interest is likely
a “fail” scenario
♦ Interest rate: 6-10% – Accrues till maturity
♦ Conversion discount: 15-25%– Increases every 3 – 6 months
Cap on Conversion Value
♦ Protects investor against big increase in value between debt round and preferred round
♦ Arguably more fair to activist investor who helps drive up value
Conversion – When and How
♦ Automatic upon a new round of at least $X ($1M) – same equity as new investors– Discount
♦ [Investor option to convert on smaller round]♦ Automatic immediately before change of control – to
common stock– Discount to acquiror’s price
♦ Investor option: At maturity or default– At discount from FMV or pre-agreed value
♦ [Company option to force conversion at maturity]
Complexities
♦ Note-holder agreement– Board seat– Protective provisions
♦ Discount may be implemented in common shares warrants– Harder for next round to negotiate away
Subtleties
♦ Better for entrepreneurs? For Investors?– Cheaper and faster than equity – maybe– Avoids valuing company– Investors may be unhappy if equity round is
high valuation– Entrepreneur may also be unhappy –
converting into a big valuation at a discount– If cap, effectively values company (CEILING) -
why not lock that in as FLOOR?
Subtleties – continued
♦ Liquidation overhang: Convertible debt investors get preference of $X for Y% of $X.
♦ Special investor cases– Risk of discount being negotiated away by next
round– Incubators – get founders stock; so aligned with
entrepreneurs vs. debt investors– Superangels – quick; just an option on future
rounds; small $ for them so valuation not a concern vs. home run return
McCarter & English LLP
Benjamin M. [email protected]@HronEsq
Rick M. [email protected]@RickLucash
Questions?