Convertible Debt Ben Littauer: viz.me/littauer May 29,
2014
Review of an Equity Deal 2 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 transfer of shares
What is Convertible Debt 3 Many seed-stage companies use an
instrument called Convertible Debt. Convertible debt is not
traditional bank debt Converts exist for several reasons Investors
and Entrepreneurs find it hard to agree on a PM valuation Sometimes
quicker and cheaper to document than equity deals May allow for
rolling close accretion of investment
Basic Structure of Convertible Debt 4 Investor loans $ to
Company anticipating another round of funding, usually triggered by
the size of the next raise Investment accrues small interest (6-8%
typical) Debt is usually unsecured and inferior to most other debt
When the funding occurs, investment + interest convert to equity on
same terms as new money, usually at a discount (15-25% typical) and
subject to a maximum valuation (cap)
Structure of Convertible Debt Ex1 5 Example: Investors loan
$200K to Company 20% discount; $2M cap As of conversion, interest
of $10k has accrued Next Round PM = $2m; 1M shares before financing
New Shares offered at $2/each At Conversion, Noteholders receive
210K / 1.60 shares = 131,250 shares
Structure of Convertible Debt Ex2 6 Example: Investors loan
$200K to Company 20% discount; $2M cap As of conversion, interest
of $10k has accrued Next Round PM = $4m; 1M shares before financing
New Shares offered at $4/each; share price at $2M pre would have
been $2/each At Conversion, Noteholders receive 210K / 2 shares =
105,000 shares Without cap would be 210K / 3.2 = 65,625 shares
Converts Complications! 7 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 doesnt trigger conversion? What happens if
it never converts? What happens if Company gets bought?
Converts Solutions? 8 Caps and Floors Default conversion price
and security at maturity Open round, minimum close Quick sale
preferences (ex. 2x) Governance provisions Careful attention to
conversion conditions Typical legal documents are a Promissory
Note, a Note Purchase Agreement, and (for existing shareholders), a
Shareholder Agreement that codifies other conditions of the note
(e.g creation of board).
Converts: When Do They Work? 9 Bridge financing in anticipation
of an event Another financing A big sale Company sale Seed stage
investment Valuation not understood Rolling closes (often with
ratcheting caps) Proof points as an event When the investor loves
the company (cf. exuberant equity valuations)