Convertible Debt

Big Red Car here.  Well, it’s cold and raw here in the ATX.  Not convertible weather which gets me thinking about a different type of convertible — convertible debt.

The Boss received several questions as to when and how convertible debt would be used by a startup.  This explanation will give you the basics.

First, let’s make absolutely certain that nobody thinks this particular convertible — THE Big Red Car — is paying anyone’s damn debts.  I’m saving up for a new paint job.   You pay your own damn debts, convertible or otherwise.  [Haha, Big Red Car, stop playing the fool and get on with it.  Please?]

This will be a very straightforward discussion and will not make you an expert on convertible debt but it will provide a working knowledge of what you are dealing with.  When you are ready to proceed go see a good attorney and use his expertise to fashion the deal.  This information will provide a basis for the conversation.

What is convertible debt?

Money is just a commodity.  It comes in two flavors — equity or debt.

Equity is money that is invested in return for an ownership stake in an enterprise.  Equity = ownership.

Debt is money that is lent rather than invested and requires repayment subject to a prescribed agreement which encompasses the principal amount, a term or time period, an interest rate or rent on the money and a few other considerations.  Debt = loan.

Convertible debt is a loan that is initially characterized as debt — subject to a loan agreement or a promissory note — and is subsequently “converted” to equity which is ownership.  Convertible debt = loan, then ownership.

[Hell, Big Red Car, I’m confused.  Tell me that again, please.]

It starts out as a loan and is converted to ownership under circumstances prescribed in a written agreement.

When would you use convertible debt?

Convertible debt is often used for very embryonic startups which are unable to come up with a credible or agreeable “pre-money valuation”.  You remember we talked about pre-money valuations here:

Musings About Pre-money Valuation

Once More Slowly — Pre-money v Post-money Valuation With Option Pool

It may be used when the borrower (entrepreneur) wants to avail herself of lower interest rates — the rent on the money.  Convertible debt deals typically carry a bit lower rate of interest because of the attractiveness of the conversion provision.

Convertible debt is also a means of bringing family and friends — F & F funding — into a deal without the necessity to engage in strenuous or potentially contentious negotiations.

Convertible debt is very situational and may or may not be a good fit for you.  The Big Red Car is not pimping convertible debt.  Just ‘splaining it, ya’ll.

In the back of your head always remember that at some time you are going to have to “price the round” and put a valuation on your enterprise.  You can run but you cannot hide forever.  Don’t fret, just keep this in the back of your mind.

How does convertible debt work, Big Red Car?

Convertible debt is a very easy concept but like everything related to the financing of startups gets complicated quick.  Let’s review some of the basics.

1.  Principal — principal is the total amount of the debt.

2.  Term — term is the period of time before either repayment or conversion is required.

3.  Interest rate — the interest rate is the “rent” on the money and is typically a bit lower than market to compensate for the conversion feature.  It is not uncommon to accrue rather than pay current the interest.

4.  Conversion formula — the conversion formula is the arithmetic basis upon which the debt is converted to equity.  As an example, the conversion formula may be as simple as — these days nothing is simple — $2 of debt gets you one share of stock.  So if you had lent the enterprise $100,000 and converted it would result in your owning 50,000 shares of stock ($100,000/$2/sh = 50,000 shares).  Simple enough?

5.  Conversion trigger — the notion of when and under what circumstances the debt converts to equity can be very complicated and predicated on several factors including performance factors.

The conversion mechanism can be as easy as an “option”, that is the debt holders (lenders) can elect to convert to equity at their leisure during the term of the debt.

The conversion trigger can be as easy as a date certain.

The conversion trigger may be the attainment of a specific level of revenue or the attainment of subsequent financing.  In this manner, the conversion trigger is like a “put” in which the borrower can force the conversion to take place based on some other event.

The conversion trigger will be as varied as financial engineering creativity can carry it.

Those are the basic terms and will provide you with a framework to understand the idea of convertible debt.

The Devil is in the details, no?

Yes, Old Sport, like any financing the Devil is in the details and here are some considerations:

1.  Everything has to be in writing — loan agreement, promissory note — in writing, in writing, in writing.  You are creating a “security”, friend.  It has to be in writing and everyone has to be represented by competent counsel.  Convertible debt deals typically carry with them less in the way of legal expenses.

2.  A convertible debt deal may include some sweeteners such as warrants to acquire additional shares at an agreed upon price or formula.  This is the mustard on the hot dog and may become a material inducement for lenders to lend you the money.  [Pro tip:  Make damn sure that any warrants do not survive any merger as this creates a potential impact on the attractiveness of the merger deal.  Warrants have to be exercised before the merger or sale occurs and their impact on the arithmetic has to be baked into the transaction itself.  No exceptions.]

3.  If subsequent to the convertible debt a further round of financing is raised — a generally desirable development and a highly likely outcome — then this may trigger the automatic conversion of the convertible debt to equity with a formula based upon the pricing of that subsequent round of financing.

It is not uncommon for the convertible debt holders (lenders) to receive a discount when making such a conversion.  The discount is applied to the pricing of the new money and is typically approximately 20%.  Like everything this is negotiable and must be agreed to in the original documentation.  In its application, you will be tempted to describe it as a “premium” as it will likely result in the convertible debt holders (lenders) receiving more shares than the pricing of the subsequent financing would suggest.  We are in the weeds a bit here, Old Sport.

4.  The Big Red Car is a purist on the notion that warrants and a discount are almost always mutually exclusive.  You get one or the other but not both.  Having said that, it is your deal, Old Sport.  Make it the way you want.

5.  It is not uncommon for convertible debt holders (lenders) to negotiate a “cap” on the valuation of the conversion arithmetic.  This is a fairly complicated feature and should be explored carefully with your attorney.  It is an important consideration.

6.  There will be special provisions related to what happens if the company is sold for a profit prior to the maturity of the convertible debt and before any conversion takes place.  Convertible debt holders (lenders) will typically benefit from some higher return than just the return of principal and the payment of accrued but unpaid interest.  It is often expressed as a multiple of their original investment.

7.  Remember you are dealing with debt and, as such, debt is first in line — behind secured debt — should any formal liquidation of a company occur.  Convertible debt holders (lenders) may insist on some multiple of their investment as a liquidation preference.  Again, a negotiable term but one that should not catch you completely by surprise.

8.  Never, ever, ever even consider any form of personal guaranty or personal responsibility on the convertible debt.  This is venture financing and has huge potential upside.  It is not personal debt.  It is business or company debt.  Do not undertake any guaranty of any kind, CEO or founder or entrepreneur.  [If the Big Red Car ever findw out you undertook any personal obligation, he will come to your house and spin donuts at high speed on your front yard churning up the grass and generally making a mess. He will also much up the flower beds.  Haha, STFU, Big Red Car.]

9.  Do not offer collateral of any kind to secure the convertible debt.  Again, this is risk capital which has many of the risk elements of equity.

So, my friend, there you have it.  I hope this is helpful.  The Boss has had several questions as to how to get started on thinking about convertible debt.  Again, the Big Red Car is not touting convertible debt and it was likely used a bit more frequently a couple of years ago but in the form of “bridge” loans rather than pure startup or seed funding.  Today it continues to be a viable method of getting an enterprise out of the garage.

If you need a bit of a chat about it all, please call The Boss at 512-656-1383 or email him at [email protected].  He will be glad to help.

Have a damn safe New Years Eve, please.  Take care of your sweet selves because 2014 is going to be YOUR year, Old Sport.  Your year indeed.

But, hey, what the Hell do I really know anyway?  I’m just a Big Red Car.  And now you know a bit about convertible debt.