This document discusses convertible debt financing, which is a loan that can be converted to equity. Convertible debt is commonly used as a "bridge" between equity rounds, and has become a typical way to do seed stage deals. While it puts off discussions of valuation and can be simpler than equity deals, convertible debt financing can also become complex. The document outlines basic terms like interest rates, conversion discounts, caps on conversion value, and conditions for conversion. It also notes potential complexities and subtleties to consider from the perspectives of both entrepreneurs and investors.

1. ♦Convertible Debt Financing
How it Works
Benjamin M. Hron
bhron@mccarter.com
617.449.6584
@HronEsq

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?

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
Questions?
Benjamin M. Hron
bhron@mccarter.com
617.449.6584
@HronEsq