Convertible Debt FinancingHow it Works

11.2.11

Benjamin M. Hronbhron@mccarter.com617.449.6584@HronEsq

Rick M. Lucashrlucash@mccarter.com617.449.6568@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. Hronbhron@mccarter.com617.449.6584@HronEsq

Rick M. Lucashrlucash@mccarter.com617.449.6568@RickLucash

Questions?