This document summarizes a discussion on convertible debt. Convertible debt is used as an alternative to equity financing for seed stage companies. It allows investors and entrepreneurs to avoid agreeing on a pre-money valuation up front. Convertible debt functions as a loan that converts to equity at a discount in a future financing round. While simpler than equity deals, convertible debt structures can be complicated and potentially worse than traditional equity in some scenarios if not structured properly. Common issues include multiple liquidation preferences, anti-dilution provisions, and preference overhang for later investors. Convertible debt is typically used as a bridge to another financing round or company sale.

1. On Air
Convertible Debt
November 19, 2014

2. Today’s Expert
• Robert Bishop
– Partner Goodwin Procter LLP
– Over 18 years experience representing venture capital firms and high growth
companies
– Founding team member of the Founders Workbench

3. Convertible Debt
Robert Bishop
rbishop@goodwinprocter.com

4. Structure of an Equity Deal
• Company and Investors agree on a “pre-money
valuation” (PM) which leads to a price per share
• Investors put in $X
• Investors then own: X / (X + PM) of the company
Example:
PM = $1M
X = $0.5M
Investors own 0.5/1.5 = 33%
Remember: New issuance NOT a transfer

5. What about Convertible Debt?
• Many seed-stage companies use an instrument
called Convertible Debt.
• Convertible Debt is not traditional bank debt
• Converts are principally used in seed deals for
two reasons:
– Investors and Entrepreneurs find it hard to agree on a
PM valuation
– Usually quicker and cheaper to document than equity
deals

6. Convertible Debt provides
Optionality
• Convertible Debt = (Usually) unsecured debt obligation of the Company
that may be converted into equity of the Company.
• Conversion Trigger = Qualified Financing usually at some minimum
amount of funds (ex. $500,000)
• If Notes Don’t Covert = (In theory,) the investors get back their principal
and interest ahead of equity on maturity
• If Notes Convert = Convert amount of debt and interest into equity at
the valuation in the next round
• after application of a Discount (often 15 – 25%)
• often, subject to a maximum valuation amount (a “Cap”)

7. Basic Structure of Convertible Debt
• Investor loans $ to Company anticipating another round of funding
• Investment accrues small interest (6-8% typical)
• When the funding occurs, investment + interest convert to equity,
usually at a discount (15-25% typical)
Example:
• Investors loan $200K to Company
• 20% discount
• As of conversion, interest of $10k has accrued
• Next Round PM = $2m; 1M shares before financing
• New Shares offered at $2/each
At Conversion, Note holders receive 210K / 1.60 shares = 131,250 shares

8. Converts – Complications!
• What if only a little money comes in?
• When does the debt convert?
• What happens if PM of next round is huge?
• Does the investor have any say in things?
• What if there is an equity investment that doesn’t
trigger conversion?
• What happens if it never converts?
• What happens if Company is sold?

9. Converts – “Solutions”
• Caps (and sometimes) Floors
• Default conversion price and security at maturity
• Open round, minimum close
• Quick sale preferences (ex. 2x) or hardwired
conversion on a sale
• Governance provisions

10. Converts: Worse Than Equity?
• Multiple liquidation preference
– Ex. $500k of Notes with cap at $2m PM
– Next Round at $6m PM
– Issue Note holders 3x number of shares
– 3x shares equals 3x liquidation preference!
• Without a floor, effectively Full Ratchet Anti-dilution
• Preference Overhang
– In prior example, Note holders bought $262,500 of
preference for $200,000.
– All other Series A Holders bought 1:1 preference
• Not Just a Price Adjustment

11. Converts: When Are They Used?
• “Bridge” financing in anticipation of an “event”
– Another financing
– Company sale
• Seed stage investment
– Valuation not understood
– Small amount raised; does not justify the cost of an
equity round
– Rolling closes (some with ratcheting caps)

12. What is a “SAFE”?
• New security that acts like Convertible Debt
• But it is not debt – no maturity date, no
creditor rights
• Right to buy equity at a price to be
determined in the next round, subject to a
discount, cap and/or floor.

13. On Air
Convertible Debt
November 19, 2014