Raising Money with Convertible Debt
You are meeting with a potential investor in a few days and they are interested in structuring a possible investment as convertible debt. You need to get up to speed quickly on the key terms and negotiation points for this type of investment. While you can raise money relatively quickly, you will need to focus on certain key deal terms and plan for repayment if the debt is not converted into stock.
What’s Convertible Debt?
As its name suggests, convertible debt has the typical bells and whistles of a debt instrument, with additional terms that allow for the conversion of the debt into an equity security (e.g., such as the type of stock to be used in the company’s next round of financing).
Key terms of a convertible note include:
- Amount of principal (i.e., money to be invested);
- Interest rate;
- Term of note (e.g., two years);
- Whether the debt is secured or unsecured;
- Protective covenants;
- Automatic conversion of the debt and when it will be triggered; and
- Discount off the equity price in the next round of financing upon its automatic conversion.
Depending on the deal, the investors also may negotiate stock warrants as an equity kicker and extra repayment protection with a security agreement.
Although there may be a strong expectation that the convertible notes will convert into equity, they are still debt instruments that will become due and payable at the end of their term.
A convertible debt deal often can be structured, negotiated, documented and funded more quickly and cost-effectively than an equity transaction, especially if the equity investment would involve preferred stock.
In addition, this type of debt structure allows you to side step the difficult valuation issues that otherwise would be negotiated with an equity investment structure. The convertible debt transaction delays the valuation question until later, either when the debt automatically converts in connection with a subsequent equity investment or when the company and the investors separately and voluntarily agree on a certain valuation for the debt conversion.
The deal documentation typically is straightforward and includes a term sheet, note purchase agreement and individual convertible notes. Sometimes the investors negotiate stock purchase warrants and/or an additional security agreement to secure the debt. There also can be one or more closings to fund the convertible note investment.
This type of debt is often is used during the early stages of a company when it is more difficult to determine and negotiate the company’s valuation. A lower valuation would create extra dilution for the founders (or the then existing stockholders). The convertible debt deal delays the valuation discussion for a later day. In addition, convertible debt often is used in a “bridge” situation where the money to be raised will help fund the operations of the company until its next equity financing.
Practical Tips & Next Steps
You should consider the following points when structuring and negotiating a convertible debt financing:
- Do not set the automatic conversion discount too high and analyze how it might affect the next round of equity investment;
- Avoid securing the convertible debt with all of the company’s assets, because it could transfer the entire company to the investors if the convertible debt is not repaid after becoming due;
- Calendar when the convertible notes come due for payment and plan in advance if a conversion to equity is not likely;
- Comply with the applicable federal and state securities laws, make the related filings and only deal with Accredited Investors in the convertible debt deal; and
- Consult with experienced legal and financial advisors so that you properly structure and document the financing for your immediate and future needs.
- Convertible Debt Term Sheet Explained
- Convertible Debt – It’s Not Stock Until the Debt Converts Into Equity
- Get Funded Now: 6 Key Issues to Help You Determine Whether Debt or Equity Financing is Right for Your Company
We’d love to hear your experience raising money through convertible debt for your startup company!