Pros and Cons of Convertible Debt - Chris Hurley

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A primer on convertible debt as a financing vehicle for startups. Presented by Founder of Beacon Law Chris Hurley at StartupDay 2010.
http://www.seattle20.com/startupday

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Pros and Cons of Convertible Debt - Chris Hurley

  1. 1. Convertible Debt Financing for Start-ups: Pros & Cons Chris Hurley, Co-founder & Principal of Beacon Law Advisors, PLLC Copyright Chris Hurley 2010. All rights reserved
  2. 2. What is Convertible Debt? <ul><li>It is debt— i.e., Company must pay it back (plus interest) if it doesn’t convert. </li></ul><ul><ul><li>At liquidation (e.g., Company gets acquired or is winding down), convertible debt gets paid back prior to shareholders. </li></ul></ul><ul><ul><li>It is a liability on your balance sheet until it converts. </li></ul></ul><ul><ul><li>Typically unsecured for start-ups, but can be secured in certain situations (e.g., distressed situations). </li></ul></ul>
  3. 3. What is Convertible Debt? (cont’d) <ul><li>It is equity— but only if and when it converts into equity. </li></ul><ul><ul><li>Usually conversion is automatic into “Next Equity Financing” of at least a certain minimum aggregate amount. </li></ul></ul><ul><ul><ul><li>Type of security and conversion price set in “Next Equity Financing.” </li></ul></ul></ul><ul><ul><ul><li>Sometimes, investor has option to convert– beware. </li></ul></ul></ul><ul><ul><li>“ Next Equity Financing” is usually preferred stock financing. </li></ul></ul><ul><ul><ul><li>But it could be common stock, although this is less often the case. </li></ul></ul></ul><ul><li>Once converted, the convertible note is no longer debt and becomes equity. </li></ul><ul><ul><li>liability is removed from Company’s balance sheet. </li></ul></ul>
  4. 4. What is Convertible Debt? (cont’d) <ul><li>Punchline: psychologically, convertible notes are typically thought of as equity investments because the investors take equity-type risk and seek unlimited, equity-type upside. </li></ul><ul><ul><li>The convertible note happens to be structured as a debt until it actually converts into equity. </li></ul></ul><ul><ul><li>But it is real debt until it converts. </li></ul></ul>
  5. 5. Convertible Debt— Company’s Perspective <ul><li>Company gets to access funds now, and set price later. </li></ul><ul><ul><li>If Company hits plan, the valuation of Company and hence the conversion price should go up in Next Equity Financing— i.e., cheaper cost of capital. </li></ul></ul><ul><li>Greater flexibility in case events at Company change dramatically one way or another. </li></ul><ul><ul><li>Compare if Company does a priced round at too high a valuation then misses plan badly resulting in a subsequent down round. </li></ul></ul><ul><ul><li>“ high resolution” fundraising. </li></ul></ul><ul><li>Relatively easy, fast, and cheap from a transaction cost perspective. </li></ul><ul><ul><li>But convertible notes are still securities and so you must pay attention to securities laws. </li></ul></ul><ul><li>Company typically delays shareholder issues and board representation issues until the noteholders actually convert into equity. </li></ul><ul><ul><li>But convertible noteholders are still investors – do not ignore or short change investor relations. </li></ul></ul>
  6. 6. Convertible Debt— Investors’ Perspective <ul><li>Comfort of being on top of capital structure and thus having priority until conversion. </li></ul><ul><ul><li>But what good does priority do me if Company flames out and no practical liquidation value? </li></ul></ul><ul><li>Discomfort of not knowing exactly what my price per share is now and exactly what % of the Company investor owns. </li></ul><ul><li>Discomfort that if Company hits its plan, investors’ conversion price will go up even though investors funded now and therefore started incurring risk now. </li></ul><ul><ul><li>Thus, investors need a “kicker” to make this make economic sense. </li></ul></ul>
  7. 7. Kickers <ul><li>Warrants </li></ul><ul><ul><li>Usually preferred, but can be common sometimes. </li></ul></ul><ul><ul><ul><li>Beware of voting issues caused by common warrants once exercised. </li></ul></ul></ul><ul><ul><li>“ 20% Warrant Coverage, 5-Year Warrants” </li></ul></ul><ul><ul><ul><li>This means for investor purchasing a $100k convertible note, investor gets right – but not obligation — to buy an additional $20k of stock issued at Next Equity Financing locked in at low price anytime for 5 years. </li></ul></ul></ul><ul><ul><ul><li>Thus, investor sits back and waits to see if warrant is in money. </li></ul></ul></ul><ul><li>Discounts. </li></ul><ul><li>Interest and Convertibility of Interest. </li></ul><ul><li>Conversion into Previous Round. </li></ul><ul><li>Prepayment Premiums if Company Gets Acquired Before Next Equity Financing. </li></ul>
  8. 8. When is Convertible Debt Appropriate? <ul><li>Right at Beginning– True Friends and Family Round. </li></ul><ul><ul><li>Friend and family are betting on founders primarily and on Company’s idea second. </li></ul></ul><ul><ul><li>Not arms’-length, flinty nosed third party investor driving hardest bargain. </li></ul></ul><ul><li>A True “Bridge” Situation (as opposed to a “Pier” Situation). </li></ul><ul><ul><li>When Company is just covering a relatively short funding gap to a discreet, identifiable, and visible valuation-raising event – e.g., signing of a key customer deal, product release, financing event, etc. </li></ul></ul><ul><li>When Company is a “hot deal.” </li></ul><ul><ul><li>When investors are clamoring to get into your deal. </li></ul></ul>
  9. 9. When is Convertible Debt Appropriate? (Cont’d) <ul><li>Punchline: convertible debt is favorable to the Company … but: </li></ul><ul><ul><li>You have to convince investors it’s a good enough deal to say yes to. </li></ul></ul><ul><ul><ul><li>This is not as easy as it sounds in every situation. </li></ul></ul></ul><ul><ul><li>Don’t give away so many dilutive kickers that you make your true cost of capital prohibitively expensive. </li></ul></ul><ul><ul><li>Don’t let the aggregate amount of convertible debt “overhang” become too large a % of Next Equity Financing as this can scare off new money. </li></ul></ul>
  10. 10. When is Convertible Debt Not Appropriate? <ul><li>A True “Pier” Situation– i.e., when Company is financing out into fog (no land in sight); no clearly articulable valuation-increasing milestones or events. </li></ul><ul><li>When aggregate effect of kickers becomes very dilutive making true cost of capital prohibitively expensive. </li></ul><ul><li>When the aggregate amount of convertible debt “overhang” becomes too large a % of Next Equity Financing as this can scare off new money. </li></ul>
  11. 11. Avoid Mistakes <ul><li>Follow securities laws </li></ul><ul><ul><li>Make sure you have exemptions </li></ul></ul><ul><ul><li>Try to limit to accredited investors if possible unless you have an alternative exemption </li></ul></ul><ul><li>It is easier to start giving warrants than to stop. </li></ul><ul><li>Avoid setting all kinds of valuation constraints that will interfere with free market setting valuation in Next Equity Financing. </li></ul><ul><li>Make maturity date far out enough that you have a realistic shot of closing Next Equity Financing. </li></ul><ul><li>Be very cautious of optional conversion and no mandatory conversion. </li></ul><ul><li>Be wary of giving any single note holder a veto right– consider a clause whereby a majority in interest of noteholders can agree to a change binding on all noteholders. </li></ul>

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