Convertible debt is a structure with debt-like features, and converts into the issuer’s equity in certain circumstances. Many early stage companies use convertible debt for their initial fundraising. This article identifies and explains the basic terms of convertible debt. A few variations on the “classic” convertible debt structure have recently been introduced, including Y Combinator’s “Safe”, the Founder Institute’s “convertible equity” and and 500 Startups’ “KISS”, but the vast majority of convertible debt transactions are using the “classic” structure that is the focus of this article.
Primary features of convertible debt:
- Principal amount. The principal amount (or “face amount”) of an investor’s note will equal the amount invested by the investor.
- Interest rate. This is the annual rate at which interest accrues on the note, as long as it is outstanding. Interest may be either compounding (meaning the interest is turned into principal on a regular basis and accrues its own interest) or “simple” (meaning, not compounded). Your notes may specify that accrued interest can either be repaid in connection with a conversion event, or can be converted into additional shares on the same terms as the principal is converting. It used to be typical for the interest rate to be set at 6-10%. It is now increasingly common to see nominal interest rate in the 1-2% range – this is a reflection of the low interest rate environment and because the accrued interest acts like additional discount in connection with a conversion (see “Conversion” below). If your note specifies that no interest is accruing, there may be adverse accounting and tax consequences. Ultimately, the interest rate is one factor in the investor’s return model and should be negotiated as part of the overall economics.
- Maturity date. This is the date on which the obligation to repay the debt “comes due” – but many issuer-favorable notes have flexible repayment language that would require the holders of a majority of the outstanding principal amount of notes to request repayment before the payment is actually due, or that allows the majority holders to elect to receive stock in lieu of repayment. Setting the maturity date is a way to set expectations for investors as to the likely outside date for closing an equity round – and in general a later maturity date is better for the company. Note that due to a previous technical issue under California finance lenders law, some investors may insist on a maturity date that is no more than 12-months after the date on which the notes are issued; however, the law was amended such that the technicality does not apply to maturity dates less than three years from note issuance.
- Conversion. The conversion terms of convertible notes typically garner the most attention. The baseline mechanic is that the principal amount of the notes will automatically convert into shares of the issuer’s capital stock in connection with the issuer’s next financing. This mechanic is customarily further defined in three main ways:
- Qualified Financing. In most cases an equity financing will not trigger an automatic conversion unless a minimum amount of new cash is raised in the financing. This amount is typically something like 1x-2x the principal amount of notes outstanding, but can vary substantially. The reason for this “floor” amount is that many noteholders want to make sure that they only give up their debt instrument (and the additional protection it may afford the holder as compared to a holder of equity) at a time in which the company has demonstrated that it is more healthy and sustainable. As a result, the goal of setting a “floor” is to protect the note holders from having their notes converted to equity in a financing that leaves the issuer inadequately capitalized. The floor also ensures that the equity financing causing conversion is a “true” financing and not a sham financing designed to force the notes to convert into terms that are not favorable. On the other hand, the floor shouldn’t be set so high that you risk having the notes not convert in the round.
- Conversion discount. In many cases convertible notes provide for a discounted conversion into the issuer’s equity, on the theory that the noteholder should receive a benefit relative to the subsequent equity investors in recognition of the added risk taken by the noteholder by investing earlier in the issuer. A typical discount off of the price paid by the subsequent equity holders would be 15-25%. Conversion discounts may be higher in investments with more perceived risk, either because the note may have a longer maturity or because of the specific circumstances of the issuer. Note that with the increased use of caps (see below), the variability of conversion discounts has been greatly reduced.
- Conversion Cap. Over time it became clear that in certain circumstances a conversion discount structure by itself was inadequate to fairly compensate note investors. The best example of this “fairness” issue is when outstanding notes convert into an equity round priced at a very high valuation (see example below). This “fairness” issue has led to a common feature of convertible debt, referred to as a conversion cap. Typically the cap and discount operate “in the alternative,” with the effective conversion price being determined by operation of one or the other based on which results in the lowest price. The conversion cap is the maximum value at which the convertible debt would convert into the next financing, regardless of the value agreed to by the issuer and the new equity investors. While a cap is not a “valuation”, many investors and companies do tend to look at the cap amount as a proxy for valuation. It is very important to note that the size of the round and the conversion cap are two variables that each can have a significant impact on the ownership position of investors following the conversion of the notes, and the two variables together have a magnifying effect. It is critically important that founders run through a sensitivity analysis when trying to determine how much to raise and where to set the cap.
- For example, following conversion of a $1,000,000 note made by an issuer shortly after the issuer’s incorporation, in an equity financing at which the issuer is valued at $100 million, the noteholder would own 1% of the company; but if the noteholder had invested the same $1,000,000 in an equity financing at the time in which it made its investment in the issuer’s convertible note it would have likely acquired no less than 20% of the company.
- Bonus material: The “Liquidation Windfall” problem. If notes convert into preferred stock at a subsequent financing at a steep discount, an unintended consequence may be that the holder receives a liquidation preference that is “outsized” in relation to its initial investment. This topic is addressed in more detail in our article The (Troublesome) Convertible Note Cap .
- Repayment terms. The traditional repayment term would require repayment of principal and accrued interest by the issuer at the maturity date. But the reality for the issuer is that in most cases if the note hasn’t converted by the maturity date, the company probably doesn’t have the money to cover the repayment obligation. And the reality for the investor is that in most cases it is not interested in the prospect of making its money back, with interest. This has increasingly led to parties taking a more flexible approach, in which at maturity investors can elect repayment or conversion into equity. The conversion price should be agreed to in advance – some companies use the conversion cap but there are no rules here. Also, the parties need to agree in advance what kind of stock the notes convert into at maturity – common stock or preferred stock. Finally, in many cases in which the maturity date is reached, the issuer and the investors may agree to extend maturity, or to keep the notes outstanding and “due” but not otherwise take any action to collect or convert.
- Amendment provisions. To avoid administrative challenges and “holdout” problems associated with trying to amend outstanding notes (to extend their maturity date or otherwise), notes usually require a “majority rules” provision through which the holders of a majority of the principal amount of all outstanding notes may agree to amendments that would be binding on all notes. In some cases investors may require carveouts to the “majority rules” rule for fundamental changes (to principal, conversion cap, interest rate) or for amendments that do not treat all noteholders similarly.
These are the terms common to most convertible debt instruments. Many variations exist, many other terms find their way into convertible debt deals, and there are many relevant design considerations.