Convertible debt financing involves providing a company with a loan that can later be converted to equity shares in the company. It is commonly used as a "bridge" between equity funding rounds. Key aspects of convertible debt include interest rates of 6-10%, conversion discounts of 15-25% off the price of future rounds, and automatic or optional conversion upon certain triggers like new funding rounds or maturity of the debt. While simpler than equity deals in some ways, convertible debt agreements can also become complex with additional terms governing stock rights, board seats, and valuation caps. Both entrepreneurs and investors face pros and cons from using convertible debt versus traditional equity.

1. Convertible Debt Financing How it Works 11.2.11 Benjamin M. Hron [email_address] 617.449.6584 @HronEsq Rick M. Lucash [email_address] 617.449.6568 @RickLucash

2. Convertible Debt Essentials A loan that can be converted to stock Originally primarily used as a “bridge” between equity rounds Has become a typical way to do seed stage deals

3. Cost - Benefit Puts off discussion of valuation Tends towards smaller deals CAN be simpler, and cheaper to document, than equity BUT can become complex; while seed equity getting simpler

4. Cycles and Styles East Coast angel groups have evolved towards Preferred Stock deals Tends to be used by friends, family, and solo angels Use by superangels Good or bad for entrepreneurs? Will discuss later

5. How it Works Loan to ( Debt of ) the Company Principal and interest repayable at future date/circumstances May convert to equity By whom (investor or company) Under what conditions Conversion typically comes with a benefit – most commonly a discount off next round

6. Basic terms and Norms Term/due date: 1 – 2 years Cash payment of principal and interest is likely a “fail” scenario Interest rate: 6-10% Accrues till maturity Conversion discount: 15-25% Increases every 3 – 6 months

7. Cap on Conversion Value Protects investor against big increase in value between debt round and preferred round Arguably more fair to activist investor who helps drive up value

8. Conversion – When and How Automatic upon a new round of at least $X ($1M) – same equity as new investors Discount [Investor option to convert on smaller round] Automatic immediately before change of control – to common stock Discount to acquiror’s price Investor option: At maturity or default At discount from FMV or pre-agreed value [Company option to force conversion at maturity ]

9. Complexities Note-holder agreement Board seat Protective provisions Discount may be implemented in common shares warrants Harder for next round to negotiate away

10. Subtleties Better for entrepreneurs? For Investors? Cheaper and faster than equity – maybe Avoids valuing company Investors may be unhappy if equity round is high valuation Entrepreneur may also be unhappy –converting into a big valuation at a discount If cap, effectively values company (CEILING) - why not lock that in as FLOOR?

11. Subtleties – continued Liquidation overhang: Convertible debt investors get preference of $X for Y% of $X. Special investor cases Risk of discount being negotiated away by next round Incubators – get founders stock; so aligned with entrepreneurs vs. debt investors Superangels – quick; just an option on future rounds; small $ for them so valuation not a concern vs. home run return

12. McCarter & English LLP Benjamin M. Hron [email_address] 617.449.6584 @HronEsq Rick M. Lucash [email_address] 617.449.6568 @RickLucash Questions?