On Air

Convertible DebtNovember 19, 2014

Today’s Expert

• Robert Bishop– Partner Goodwin Procter LLP

– Over 18 years experience representing venture capital firms and high growth companies

– Founding team member of the Founders Workbench

Convertible Debt

Robert Bishoprbishop@goodwinprocter.com

Structure of an Equity Deal

• Company and Investors agree on a “pre-money valuation” (PM) which leads to a price per share

• Investors put in $X

• Investors then own: X / (X + PM) of the company

Example:

PM = $1M

X = $0.5M

Investors own 0.5/1.5 = 33%

Remember: New issuance NOT a transfer

What about Convertible Debt?

• Many seed-stage companies use an instrument called Convertible Debt.

• Convertible Debt is not traditional bank debt

• Converts are principally used in seed deals for two reasons:

– Investors and Entrepreneurs find it hard to agree on a PM valuation

– Usually quicker and cheaper to document than equity deals

Convertible Debt provides Optionality

• Convertible Debt = (Usually) unsecured debt obligation of the Company that may be converted into equity of the Company.

• Conversion Trigger = Qualified Financing usually at some minimum amount of funds (ex. $500,000)

• If Notes Don’t Covert = (In theory,) the investors get back their principal and interest ahead of equity on maturity

• If Notes Convert = Convert amount of debt and interest into equity at the valuation in the next round

• after application of a Discount (often 15 – 25%)• often, subject to a maximum valuation amount (a “Cap”)

Basic Structure of Convertible Debt

• Investor loans $ to Company anticipating another round of funding• Investment accrues small interest (6-8% typical)• When the funding occurs, investment + interest convert to equity,

usually at a discount (15-25% typical)

Example:• Investors loan $200K to Company • 20% discount• As of conversion, interest of $10k has accrued• Next Round PM = $2m; 1M shares before financing• New Shares offered at $2/each

At Conversion, Note holders receive 210K / 1.60 shares = 131,250 shares

Converts – Complications!

• What if only a little money comes in?

• When does the debt convert?

• What happens if PM of next round is huge?

• Does the investor have any say in things?

• What if there is an equity investment that doesn’ttrigger conversion?

• What happens if it never converts?

• What happens if Company is sold?

Converts – “Solutions”

• Caps (and sometimes) Floors

• Default conversion price and security at maturity

• Open round, minimum close

• Quick sale preferences (ex. 2x) or hardwired conversion on a sale

• Governance provisions

Converts: Worse Than Equity?

• Multiple liquidation preference– Ex. $500k of Notes with cap at $2m PM– Next Round at $6m PM– Issue Note holders 3x number of shares– 3x shares equals 3x liquidation preference!

• Without a floor, effectively Full Ratchet Anti-dilution• Preference Overhang

– In prior example, Note holders bought $262,500 of preference for $200,000.

– All other Series A Holders bought 1:1 preference

• Not Just a Price Adjustment

Converts: When Are They Used?

• “Bridge” financing in anticipation of an “event”

– Another financing

– Company sale

• Seed stage investment

– Valuation not understood

– Small amount raised; does not justify the cost of an equity round

– Rolling closes (some with ratcheting caps)

What is a “SAFE”?

• New security that acts like Convertible Debt

• But it is not debt – no maturity date, no creditor rights

• Right to buy equity at a price to be determined in the next round, subject to a discount, cap and/or floor.

On Air

Convertible DebtNovember 19, 2014