Convertible debt is a type of financing companies frequently seek as a prelude to their first significant preferred equity financing, or as a bridge round between equity financings. A convertible debt round will typically involve promissory notes that the company hopes will convert into preferred equity when the company closes on a good sized equity financing at a later date.

Investors like convertible debt because it offers the benefits of debt (repayment of the invested money, plus interest, at some point in the future) plus the possibility to convert the debt into preferred equity under terms negotiated later by an equity investor with significant leverage and experience.

Where does the term sheet come into play in all of this?

As discussed in my March post, the term sheet is frequently the first step in a financing transaction.  The term sheet outlines the key terms of the investment and allows the parties to reach agreement on these points before signing up to the investment.  Typically convertible debt term sheets are not binding, and often the company runs the entire transaction, from drafting the transaction documents to closing the deal. (convertible debt deals are also often done on a rolling basis with multiple closings).  .

Documents.  .  A note deal includes two primary components: (1) the note that creates the legal obligation to repay the loan and (2) the note purchase agreement.  Convertible note deals are usually designed to be fairly simple and the provisions of the note purchase agreement can be incorporated in the note itself. Some investors look for extensive company representations and warranties and legal rights and in these situations, a separate note purchase agreement is more common.  In general, the more formal the note round, the more investors may require formal deal documents, that may also include a noteholder agreement other provisions such as information rights and debt covenants.

Conversion Thresholds and Mechanics. The terms that dictate when the note converts into equity is one of the most important terms in a convertible debt round.

Automatic/Optional – Most convertible debt will automatically convert upon a qualified preferred equity financing completed by the company in the future, as long as that future financing meets certain terms.  Assuming that the company can get to such a qualified equity financing closed, the fact that the notes will automatically convert is a great benefit to the company because it avoids having to negotiate the conversion with the noteholders.  Some convertible debt only converts if the noteholder consents, which is worse for the company.

Occasionally, the notes will also lay out what optional conversion rights there are if the qualified financing doesn’t emerge before the notes mature, and may give the noteholder the option to convert into equity (usually into common or some other existing class of stock, frequently at a significant discount).

Qualified Financing – The most common terms that are required by investors for automatic conversion are that the future equity round must be of preferred stock that is senior (in terms of liquidation preference; certainly senior to the common stock and probably senior to any existing preferred the company already has) and that such equity round must happen before the note matures and becomes repayable, if not earlier.  The company obviously will want the automatic conversion term to be as long as possible, to provide maximum flexibility and the ability to leave the notes outstanding as long as possible.  However, typically investors will require that the company complete the qualified financing within a shorter time frame (somewhere between six months and one year) to allow for automatic conversion of the notes; otherwise the notes will mature and the investors will be free to demand repayment.

Threshold of Dollars Raised – Additionally, there is always a minimum threshold amount that has to be raised in that equity round for it to be qualified (and it usually must be “new money”, with the notes specifically excluded from the threshold).  This is inexpensive insurance for the investor that the company is not staging an insignificant equity round just to convert the notes.  If the company can’t close a round that meets this threshold, the notes will not automatically convert and will instead either mature and become due and payable, be extended by amendment to a later maturity date or be converted on a negotiated basis (for instance, if the company has an interested equity investor, if the prospective round is too small to trigger the conversion, the investor will still likely want the notes converted as a condition to investment, otherwise the new investor’s funds are essentially going to be paid out by the company to pay off the notes)  Therefore, it is important that the entrepreneur negotiate for a threshold amount that is reasonable, based on perceived investor interest in the company, and the amount of time the company has to raise the funds.

Discount to Conversion. A convertible debt investor doesn’t purchase equity in the company when they buy the note. Rather, the note converts to equity when the company closes on an equity financing and .  because the note investor put their investment at risk earlier than the investors in the equity financing, the notes will often convert based on a specified discount to the per share price at which the later equity financing happens. This discount will usually range between 10-30%, with 20% being the most common discount rate.  Occasionally, the discount will increase (meaning, the effective price the note investor “pays” for the equity that the note converts into decreases) over time; for example, the note might convert at 10% if the future financing round happens fairly quickly (for instance, within 90 days ), but increases to 20% if the round closes later.

The discount effect can also be created by issuing warrants to buy shares (assuming a de minimis exercise price for the warrant); for instance, a note could be accompanied by a warrant that would become exerciseable upon conversion of the note into common stock equal to 25% of the number of shares into which the note converted (which is effectively a 20% discount on the as-converted value of a single share of the company’s equity).

Prepayment.  The term sheet will also often address whether the note can be pre-paid by the company without the investor’s consent (or the converse, that prepayment is not allowed, because unless it is prohibited, prepayment is usually allowed under law).

Effect of a Sale of the Company. It is also not uncommon for a company to be acquired before the convertible debt is able to convert into equity.  As a result, convertible notes should, and often do, have provisions that address what would happen in this scenario.  This provision typically takes one of two forms: (1) the note accelerates and the investor will be repaid the entire amount of the note plus interest at the closing of the sale; or (2) the investor will be repaid the entire amount of the note, plus interest, plus a multiple of the original amount (this can be addressed in tandem with a hypothetical liquidation preference, discussed below).  Scenario (1) above is most frequent, and is less than ideal for the investors, as they don’t see any upside as a result of the acquisition.  Scenario (2) is negotiated by investors, and typically includes a multiple on the original investment of 2-3x in early stage companies.  This type of provision ensures that a noteholder will receive a return of some kind on its investment above the interest rate, even if the company is sold before a qualified financing or before the note’s maturity date.

Interest Rate. Since convertible notes are as much as anything a mechanism by which early investors can potentially receive preferred equity in a Company on terms that are negotiated later by another investor in a strong bargaining position, interest rates on convertible debt can be lower than what such a company would get on traditional bank debt (assuming the company could get bank debt).  Typical interest rates on convertible notes range between 7-10%, but obviously that can vary based on the discount rate and other terms of the note as well as the riskiness of the investment overall.

Liquidation Preference. Though not particularly common in an average convertible note round, liquidation preferences can be found in convertible debt deals from time to time.  This concept works the same way as it does in a preferred equity financing, which I discussed in detail in my March post.  Upon the occurrence of a sale of the company before the note is converted, noteholders would receive their investment back, or a specified multiple of their investment back by way of giving them some equity-like return since their note was never converted into preferred stock (which would have had a liquidation preference with some built in gain).  This presents investors with the advantage of holding debt, while maintaining same upside they would have if they held preferred stock upon the occurrence of a liquidation event.