ALL YOU NEED TO KNOW ABOUT CONVERTIBLE DEBT

In recent years, there has been a particular interest in the negotiations between startup founders and investors. At a recent online startup talk I gave, I was asked a lot about the structure of convertible notes and how they impact on a startup’s future. I have decided to write about convertible notes in order to highlight some of the common mistakes and how to avoid them.

What is a Convertible Debt?

It is a debt that allows investors to convert their interest into equity on a given maturity date. With convertible debt, you don’t sell shares in relation to the ownership of your company. Instead, you borrow money from investors with a promise to repay it. The flexibility of convertible debt offers security for investors wishing to participate in the growth of a particular company where they aren’t sure about the potential downsides and upsides.

There are two different types of convertible debt:

  1. Convertible equity debt.
  2. Traditional convertible debt.

With a convertible equity debt, the investor loans money to a startup in return for equity in the company at a later time. Generally, convertible noteholders invest in early-stage companies that are still pre-revenue and haven’t gained much traction. To remunerate early investors in terms of them taking risks, companies agree on perks for the investors such as valuation caps and discounts in the future. Convertible equity investors can’t ask for a redemption of the debt if the company fails to receive a follow-on round.

The investor’s interest automatically converts to ordinary rather than preferred shares unless they were explicitly written down as preference shares in the first place. Therefore it is more entrepreneur-friendly as the company isn’t forced into bankruptcy.

Traditional convertible debt is where the price of the stock is not determined at the time when the investment is made. Investors receive interest and the conversion price is not ruled out until the company obtains a subsequent round of financing. If the company does not receive another round of funding before the debt matures, then any investors can ask for redemption of the debt in certain trigger conditions. This may result in bankruptcy for the company.

Top 5 Things to Consider Before Getting Convertible Debt

  1. Should you value your startup now or later? Maybe your startup is running out of cash and you have few options left. The one investor that is interested offers a low valuation. Should you take it in exchange for equity or ask for a convertible debt? It all depends on your individual circumstances. Remember that with a convertible debt structure, the share price will be determined at a later date when larger financing occurs. Some startups may not be at a stage where they want to set a valuation and therefore they prefer to wait until there is rapid and substantial growth before they raise equity financing as a possibility.
  2. How fast do you need cash? I recently worked with a self-funded early-stage tech company that discovered that it would run out of money in four to six months — much sooner than it had expected. The startup needed quick cash to complete its first milestone before it went out and raised funds in exchange for equity. They needed cash fast and didn’t want to be valued before they gained some traction. They solved their problem through convertible debt.
  3. How important is to hold on to your board control? If you raise money through equity, you are selling an ownership share in your company to your investors. It is almost always equity investors that will get board rights. Convertible debt holders typically don’t have any right to a board seat. This is because in convertible debt, you don’t sell the ownership of your company, in part or in its entirety. Instead, you borrow money from investors with the promise to repay it. Having said that, regardless of which one you choose, your investors will influence the way that you run your business. With an equity investor, their influence will have significant power related to how you run your company.
  4. Dilution or No Dilution? Convertible debt is a good option for many founders because they don’t have to dilute the existing shareholders. When raising an equity round, a startup needs to issue new shares in the company to new investors. As a result, the existing shareholders’ shares will be diluted post-round. Unlike equity funding, convertible debt deals don’t change the capitalisation of the company by adding new shareholders until the debt is converted into equity.
  5. Take the Money or Run? The best investor will want to build a long-term relationship with you and your startup. It is paramount that you talk to your investor and ask them a lot of questions regarding their vision of your company. The history of your investor is also important. You will want to make sure that they are a sophisticated investor with enough experience in your specific sector. Remember that your investor has leverage over your company if you fail to pay the debt. Investors can force a company into bankruptcy if there is no qualified financing or automatic conversion provision. They can also use their leverage to negotiate more onerous terms or to ask for extra equity in exchange for extending the maturity date.

How Should You Negotiate Convertible Debt?

To prepare yourself for negotiations, you must understand the most common key terms and what they can mean for your company. Your convertible debt agreement will include clauses about the obligations, warrants, interest and discount rates. We have evaluated and explained the critical key terms below.

1. Discount rate: This is an investor-friendly term that brings in a sense of protection from a ‘down-round’. It lets an investor convert the loan into shares at a discount compared to the purchase price paid by the investors during the follow-on round. Discounts, in general, are 20% but they can range from 5% to 30% depending on the parties’ negotiation power and risk. The important caveat to remember is that the discount is only used if the valuation of the next round is less than the cap. Let’s illustrate this with an example. On a note with a cap of £5 million and a 20% discount, the discount will be dismissed if the next equity round is over £6.25 million (£5 million / £0.8). If the valuation at the next round is £10 million after the discount is dismissed, then the investor will receive shares based on a £5 million valuation. If the next round is £4 million instead, then the investor will receive shares based on a £3.2 million valuation (£4 million x £0.8).

2. Interest rate: This provides investors with a minimum level of return when the debt reaches maturity. Investors leverage their interest in order to increase their overall return on investment. The whole point of convertible debt is to obtain cash to invest and grow your business, but there is a catch. The last thing that you want is large interest payments that will hurt the company’s cash flow. The market rate for interest ranges between 3 and 10% in Europe.

3. Maturity date: This defines the date when the debt is due to be paid back to the investor with interest if it hasn’t yet been converted into equity. A maturity date allows the investor to force the conversion into shares after a given date. In practice, investors won’t ask to be paid back on the maturity date. Instead, they can extend the maturity date if there is no subsequent equity round. Investors will prefer to do this because destroying the startup that they engaged in would be a futile strategy. It can also hurt the investor’s reputation. Investors are in this to make money, not to destroy startups. David Kirkpatrick explained the convertible debt agreement between Facebook and Peter Thiel in his book, ‘The Facebook Effect’. He said that Peter Thiel invested $500,000 in Facebook as a loan that would convert to equity if Facebook achieved its milestone of 1.5 million users. He said to Zuckerberg “Just don’t f — it up,” at the time of investing. In the end, Facebook did not meet the milestone of acquiring 1.5 million users but Thiel converted his loan to equity and joined the board. Thiel’s $500,000 got him a 10.2% equity in Facebook.

4. Pro-rata rights: Pro-rata rights lets investors keep their equity stake by investing in further financing rounds. This clause is crucial for an investor. Why? Because if the startup is successful, then the investor will want to invest more to double down on the winnings. Investors don’t get a discount when they exercise pro-rata rights. It is a very investor-friendly term. Investors will want to negotiate and have it in writing explicitly as it isn’t automatically included in a convertible debt agreement. New investors might ask any prior investors to waive their pro-rata rights before they invest in the company.

5. Conversion cap: I think that this is the most crucial term in the context of convertible debt. The conversion cap sets the maximum company valuation at which point the note will convert into equity. The investor either will pick either a cap or discount with which to value the share price. If the next round is below the cap, then the discount rate will be a better option for investors to pay per share when it converts into shares.

6. Warrant: A warrant is a financial instrument that can be used by a warrant holder to acquire shares from the borrower at a pre-determined price. It provides investors with the right to buy a certain amount of company shares at a later date. Depending on what price you negotiate for the warrants, you might be giving away too many shares in your company for too little money. You also need to consider what type of shares — be they ordinary or preference — you are giving to an investor. If an investor acquires preference shares, they will receive payments on their shares ahead of the ordinary shareholders in a liquidation event. The important distinction that I want to make is that generally, a warrant approach is used in late-stage startups where the company has already raised a round of equity. It is rather rare to see it in seed investments. When issuing warrants, as a founder, you must think diligently about two things. The first is what percentage of your startup the warrant will represent and the second is which class of stocks you will be issuing. Some stocks have voting rights which could limit the founder’s decisions in relation to spending, hiring, expansion etc.

Having negotiated and worked on negotiations in different industries and countries, one of the things that I have come to appreciate is that at the end of the day, negotiations aren’t about money or deal terms. Negotiation is always about human interaction. Conversations and emotions are what make us human, and negotiating is a human activity. Therefore, we can’t eliminate feelings from negotiations. Convertible debt negotiations are like any other type of contract negotiation. They are part conversation, and part numbers, starting with a preliminary dialogue to evaluate the fit for both sides. Whether it is a convertible debt or a merger and acquisition, negotiations are always about more than just money and influence. It is fundamentally about picking the right partner and building a mutually-beneficial relationship that can pull through the inevitable setbacks and failures, bounce back from adversity, build up resilience and obtain success. Whenever we are dealing with humans, we need to look beyond what is agreed at a contractual level.

Lastly, there will be times when your negotiation skills can’t yield the result that you want. You may need to walk away or learn how to craft an agile strategy on your feet in changing circumstances. At the end of the day, it is a process that demands diligent preparation and planning, and understanding the value that you bring to the table for the other side. This means that above all, thinking is about not just what the cap table and discount rate are today but also about what will help you to generate and show value in the long run.

Ariella, Tech Enthusiast, Supporting Companies @Axis. Lawyer in Former life @Baker&Mckenzie.