Why Start-Ups Use Convertible Debt Part II: How a Convertible Debt Works

10 March 2015 Innovative Technology Insights Blog

In Part I of our “Why Start-Ups Use Convertible Debt” series, we discussed one of the typical start-up financing structures, the sale of common stock, along with the issues that should be considered when setting a valuation. Based on the issues that arise with the sale of common stock, another financing option that tends to make sense for start-up companies is the sale of convertible debt.

In a convertible debt financing, the Company prepares a simple convertible promissory note purchase agreement that contains the same basic representations about the company that would be contained in a common stock purchase agreement and the statement from the investor that he or she understands that this is a risky investment and has had the opportunity to evaluate the opportunity. The convertible promissory note purchase agreement also contains the form of promissory note that would be given to each investor. Each investor signs the same purchase agreement, and the company simply “peels off” the form of note for each investor and inserts the investor’s name, amount of the loan, and date of the investment. Companies often leave these financings open over a period of time – often over 1 year – and will pull in new investors on a rolling basis. Eventually the Company will mature to the point of being able to raise a preferred stock (Series A) round from a venture capital fund or other institutional investor, at which point the outstanding debt will automatically convert into the Series A round.

Typical convertible debt terms provide for interest on the loan – often 6-8% – that accrues and is payable in one lump sum at maturity or conversion, in which case it simply converts into shares along with the principal as discussed below. The debt will have a term of 1-3 years. If the debt is outstanding at maturity, it is typically due and payable upon the request of the holders of a majority of the debt then outstanding under this facility. This is a very important provision and one that should ripple throughout the convertible debt arrangement. By requiring debt holders to act by majority approval, it can prevent a rogue investor from demanding payment from the Company at a time when the funds are not available and such demand could potentially shut down the Company.

If the Company completes a “qualified” equity financing prior to maturity – often at least $1M of new capital from investor in exchange for preferred stock – the debt will automatically convert into the new financing shares.  The price at which the debt converts is often the lesser of (i) a discount on the price per share of the preferred stock (typically a 20% discount) and (ii) the “Cap Price”. The Cap Price is an agreed upon maximum company valuation that is locked in for the convertible debt investors. This way, if the Company takes off and completes a qualified financing raise at a $25M valuation, and the Cap Price is based on a $5M valuation, the debt will convert at the Cap Price. This is because a price per share that is based on a $5M valuation will be significantly less than a 20% discount on a price per share that is based on a $25M valuation.

Check back soon for Part III of our convertible debt series, “The Virtues of Convertible Debt for a Start-Up.”

This blog is made available by Foley & Lardner LLP (“Foley” or “the Firm”) for informational purposes only. It is not meant to convey the Firm’s legal position on behalf of any client, nor is it intended to convey specific legal advice. Any opinions expressed in this article do not necessarily reflect the views of Foley & Lardner LLP, its partners, or its clients. Accordingly, do not act upon this information without seeking counsel from a licensed attorney. This blog is not intended to create, and receipt of it does not constitute, an attorney-client relationship. Communicating with Foley through this website by email, blog post, or otherwise, does not create an attorney-client relationship for any legal matter. Therefore, any communication or material you transmit to Foley through this blog, whether by email, blog post or any other manner, will not be treated as confidential or proprietary. The information on this blog is published “AS IS” and is not guaranteed to be complete, accurate, and or up-to-date. Foley makes no representations or warranties of any kind, express or implied, as to the operation or content of the site. Foley expressly disclaims all other guarantees, warranties, conditions and representations of any kind, either express or implied, whether arising under any statute, law, commercial use or otherwise, including implied warranties of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Foley or any of its partners, officers, employees, agents or affiliates be liable, directly or indirectly, under any theory of law (contract, tort, negligence or otherwise), to you or anyone else, for any claims, losses or damages, direct, indirect special, incidental, punitive or consequential, resulting from or occasioned by the creation, use of or reliance on this site (including information and other content) or any third party websites or the information, resources or material accessed through any such websites. In some jurisdictions, the contents of this blog may be considered Attorney Advertising. If applicable, please note that prior results do not guarantee a similar outcome. Photographs are for dramatization purposes only and may include models. Likenesses do not necessarily imply current client, partnership or employee status.