Convertible Debt: An Entrepreneur’s Question
“How should I expect Liquidation Preferences for holders of convertible notes to work? If the Series A Preferred Stock investors will get a 1x Liquidation Preference, do the noteholders get a Liquidation Preference for 1x their investment?”
The first thing to remember about convertible debt is that it starts out as debt with the possibility of converting into stock if certain conditions are met. So long as the debt under the convertible promissory note has not converted into stock pursuant to its negotiated terms, you should think of your investment as a debt security. The convertible debt standing alone will not have a Liquidation Preference (i.e., an equity concept that allows a certain class of stock to get paid back first) relative to any class of stock, although as debt it should get paid first before any money is returned to equity investors.
Once the convertible debt is converted into shares of stock under the operative terms of the convertible promissory note, those shares will have the same rights, privileges and preferences as the other shares of that same class of stock. For example, if the convertible debt is converted into Series A Preferred Stock that has a Liquidation Preference, then the shares of Series A Preferred Stock issued upon conversion of the convertible debt will have the same Liquidation Preference rights as the other shares of Series A Preferred Stock.
The typical conversion discount in a convertible promissory note is designed to give to the convertible debt investor an extra benefit for committing his or her money earlier to your company. As a result, the convertible debt investor will receive relatively more shares of stock, because the outstanding debt is converted at a lower or discounted price as compared to the price paid by the new equity investors. Once these shares are issued to the former convertible debt investor, the shares are the same (with the same bells and whistles) as the other shares of that class of stock.
Please let us know how your company has used (or plans to use) convertible debt and please share any tips or areas of caution for your fellow entrepreneurs.