I get questions all the time from clients who haven’t raised convertible debt before. If my clients frequently ask these questions, no doubt there are scores of others who have the same ones. Send me an email at firstname.lastname@example.org, or send me a tweet at @phwerner if you have a FAQ that you think should be added to the list!
Here are other Cooley GO articles that dive into the topic of convertible debt:
- Primer on Convertible Debt
- Calculating Share Price With Outstanding Convertible Notes
- The (Troublesome) Convertible Note Cap
You can also generate your own Convertible Note Documents on Cooley GO Docs.
How do I show convertible debt on my cap table?
Because in most cases you won’t know how many shares your convertible debt will convert into, most companies don’t include convertible debt on their cap table. You should keep a ledger of issued notes (listing the holder of each note, the principal amount and the date of issuance). I would recommend that you keep the ledger in Excel so that you can easily calculate accrued interest. Keep your cap table on one tab and your notes ledger on the next tab – so that when it comes time to compile your Series A cap table (download our Sample Pro-forma Cap Table), which will reflect the conversion of your notes into equity, you have all of the information in one workbook. Many law firms (including Cooley) have also licensed software to track cap tables (including promissory notes), and there are third party providers such as Carta that will do it as well.
What is a typical size of a convertible debt financing?
Convertible debt rounds come in all shapes and sizes. At the low end, I’ve seen small “friends and family” rounds in which less than $100k was raised, and I’ve seen rounds over $5,000,000. But a typical range for a healthy initial convertible debt round being done as an initial round of financing for a startup that is eventually likely going to raise venture capital is $500,000 to $2,500,000. As the size of the raise gets larger, investors start to care more about control provisions and precise ownership calculations, which tends to lead them toward requiring priced rounds in which it is more customary to hash out control and ownership details.
Why should I do a convertible debt financing and not an equity financing?
Much has been written about the pros and cons of debt vs. equity. See classic pieces by Seth Levine (“Has convertible debt won? And if it has, is that a good thing?”) and Jon Callahan (“Why we (still) don’t invest in convertible debt”). The major benefit of a convertible debt round over an equity financing is speed. We see equity rounds being done faster and more efficiently than ever, but a convertible debt round can still be done faster and more inexpensively. The best piece of advice, however, is to not automatically turn away a great investor because you want to do a debt round and they want to do an equity round.
I’m trying to raise a convertible debt round. Can I bring in investors at different times?
An important feature of typical convertible debt documents is the ability to conduct multiple closings without significant marginal cost. If you’re targeting a $1,000,000 raise and have commitments from investors to invest $100,000, you can collect money from those investors and issue them notes. You’ll want to manage investors’ expectations – if the investor has committed $100,000 because he thinks you’re raising $1,000,000 and you don’t end up raising anything more than the initial $100,000, you may be creating a problem for yourself. I like to tell my companies that are raising a debt round to clump investors into closings, so that you can use a future closing date as a forcing function to get people to make decisions. Telling people that you’re rounding up final commitments for a Friday closing can be an excuse to reach back out to an investor prospect, and can get them to make a decision.
What happens if we get to the maturity date, there hasn’t been a conversion event, and I can’t repay my investors?
The answer depends in part on the terms of your notes. Some notes provide that a cash repayment obligation is triggered at the maturity date; others say that the notes are repayable at the option of the holders, or that the notes are either repayable or convertible into equity at the option of the holders; and sometimes that the notes automatically convert into equity.
Regardless, it is commonplace for the company to reach out to the holders prior to maturity and get the holders to agree to an extension of the maturity date – with the logic being that the company is unlikely to have sufficient funds to repay the debt, and the debt holders aren’t that excited about being repaid anyway. Note that having a “majority rules” amendment provision that allows the holders of a majority of the principal amount of notes to take action on behalf of all noteholders can be really helpful in cases like this. And most investors in convertible notes aren’t investing to get their money back in a year or two; they want to eventually own equity in the company. As a result, it’s pretty rare for an investor group to aggressively seek repayment at maturity.
What happens if I’m being “acquihired” and the acquirer isn’t offering me enough cash to pay off my noteholders?
We fairly regularly see small companies get acquired by larger ones in a transaction many refer to as an “acqui-hire” transaction, called that because a primary motivation for the acquisition is to bring on the employees of the target company. The acquiring company’s desire to pay as little as possible to acquire these employees (and whatever other assets they may want), and to funnel as much of the consideration as possible to the employees.
In many cases the target companies have outstanding convertible notes, which provide that in connection with a sale of the company the notes must be repaid (sometimes with a premium cash payment). So the target company has a couple of options: (1) convince the acquiring company to include sufficient cash in the deal consideration to pay off the notes, or (2) convince the noteholders to take less cash in satisfaction of the amounts owed to them (and convince the acquiring company to include sufficient cash to pay off the lowered amounts). Regardless, this is an issue to surface early on with the potential acquirer, and in many cases with your noteholders, to determine whether this might be an impediment to doing a deal.
A potential note investor wants warrant coverage. What is that?
A warrant is like an option – it is a contract that gives the holder the right to purchase a company’s stock in the future at a per share price that is typically set at the time the warrant is issued. We don’t see warrants issued particularly frequently in connection with convertible debt rounds, but it happens in two principal circumstances: (1) as a benefit to all investors, along the lines of a discount, to sweeten a deal for potential investors by giving them greater potential upside in the company, and (2) as a “kicker” for a lead investor to incentive the investor to commit before other investors and to set the terms of the financing. While we don’t see this frequently, it can be helpful. Note that the inclusion of warrants in a convertible note financing could have tax issues, and you should talk to your tax counsel about them before implementation. Note, however, that while discounts are often used instead of warrants these days, warrants have the advantage of requiring additional investment by the investor (the exercise price). So in larger deals, this may be worthwhile.
My investor wants a security interest. What is that?
Convertible notes are a form of debt. Some debt is “secured” by the Company’s assets (meaning that the holders of the debt may have a priority claim on some or all of the issuing company’s assets) and some debt is “unsecured” (meaning the holders of the debt have no particular priority relative to other debt holders in the company’s assets. Secured debt comes with a “security interest” in identified assets. It is nearly unheard of for a company to issue secured debt in an early-stage financing. You will occasionally see distressed companies issuing secured debt in connection with a bridge financing conducted in a situation perceived by investors as particularly risky. Before agreeing to grant a security interest to investors in a convertible note financing you should consult with counsel to make sure you understand the full ramifications of doing so.
My investor wants pro rata rights. What are those?
Pro rata rights (also referred to as “participation rights” or “rights of first refusal”) allow the holder of the rights to participate in the company’s future financings. We’re seeing this term included in a minority of note financings, but with increasing frequency – particularly in financings in which the lead investor is an institutional investor (like a venture fund). Calculation of the amount a holder of these investment rights may invest in a future financing is typically done in one of two ways: (1) through calculating the investor’s “pro rata” share of the company’s cap table prior to the financing (and after giving effect to the conversion of the notes) – meaning the percentage of the cap table represented by the shares held by the investor or (2) by agreeing in advance to a flat maximum amount that the investor can invest in the future financing. In certain limited cases the company may agree that the investor’s pro rata rights would continue beyond the immediate next financing, but in most cases the right would apply only to the immediate next financing, and any future rights would be provided by virtue of the rights the investor would have through owning the preferred stock acquired in the financing in which the investor’s note converted.
I raised a debt round a year ago and I need to raise more money, but not enough to merit doing a priced round. What should I be thinking about if I want to issue more convertible notes to new investors?
Most companies would do one of two things in this circumstance: (1) extend the initial note financing and sell more notes on the same terms – this would likely require an approval from the existing noteholders to extend the existing round, which in many cases is not a controversial request; or (2) conduct a new, second note financing, which could be on identical terms or different terms from the initial round. If you’ve seen progress in building your business or if other beneficial factors exist that didn’t exist at the time of the first financing, you should consider going this second route and improving the terms (from the company’s perspective) to take advantage of the progress or beneficial factors. With most convertible debt structures, you probably don’t need to get approval from the investors in the initial round, and probably don’t need to offer participation rights to the initial investors – but absent extenuating circumstances you should let the initial investors know what you’re doing, for investor relations purposes if nothing else.
I’ve done a debt round and now I’m raising an equity round that won’t meet the “qualified financing” threshold. What should I do?
A normal feature of convertible debt is an automatic conversion of the debt to equity when the company closes an equity financing in which it raises cash above an identified threshold. This threshold is typically set in the $1-2 million range. A financing above that threshold is typically called a “qualified financing.” The purpose of the threshold is to protect the noteholders from having their notes converted prematurely, via a “manufactured” equity financing in which the company raises just a few dollars. If you’re raising a real round of financing but not one that meets the qualified financing threshold, the new investors are unlikely to be comfortable allowing the debt to remain unconverted – both because of the uncertainty in terms of cap table ownership resulting from not knowing how the notes will eventually convert, and because of the perception that the unconverted notes would be “senior” to the new preferred equity in right of repayment. So as a condition to closing your equity round you’ll likely need to go to the noteholders and get their agreement to convert in the financing.
I have bank debt and convertible notes outstanding. Who has priority if I go out of business?
In almost all cases, your bank debt will be secured (see the Q&A above regarding security interests) and your convertible notes will be unsecured. So assuming the bank has made the proper security filings and taken other required actions, the bank will have priority over the convertible notes – both in right of repayment (if there is any cash to be distributed) and in the right to take non-cash assets in satisfaction of the debt. Absent a security interest, all debt is likely “equal priority.”
If I can’t pay back my convertible debt, can my noteholders foreclose on the company and take my IP?
This is a complicated question, but the answer is something like “they theoretically could but probably won’t.” If your convertible notes are past maturity and have become due and payable, if the holders have the right to demand repayment and have demanded repayment, and if you don’t have the cash to pay them, they in theory could (alone or together with other creditors) seek to force the company into a proceeding that may end up with the company’s assets being sold or distributed to satisfy creditors. The reality is that these types of proceedings are typically costly and have uncertain outcomes, and we rarely if ever see investors in early stage companies take aggressive action along these lines. Early stage investors understand the real possibility of their investment being lost, and are typically fairly flexible and cooperative identifying and supporting alternatives that may have a better chance of preserving value and relationships.