Why Convertible Debt is a Good Alternative

  It's hard to know your company's value at an early stage. Learn why convertible debt can be a good alternative to pricing equity.


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So we talked a little bit about some of the rationale behind why venture capital testers choose to invest someone started a company as opposed to others, and we talked a little bit about what the data suggest in terms of the number of companies that are receiving venture capital financing in the United States. Let’s talk now at a high level about the different types of approaches that venture capitalists will take when they’re investing in start-up. companies

So let’s start first about talking about convertible debt, convertible debt is a alternative to traditional priced equity round where a company would negotiate with the venture capital investor as to what the valuation for the company is, and as a result based on the amount of money the company is choosing to invest in that business, what percentage of the company is given to that investor.

One of the reasons that convertible debt has become a fairly typical ways were early-stage companies to raise money is because early-stage companies really have a hard time getting their heads around what their valuations should be, especially if you’re right out of the blocks, you don’t have any customers really, you don’t even have a beta product, you just have an idea in mind it’s very hard to attribute a valuation of that company in a meaningful and thoughtful way.

Often times in order to avoid the valuation discussion with investors, what startup companies will do is rather than pricing there around and saying I am issuing shares of stock to an investor for a dollar a share of $.50 a share. which again attributes evaluation to the company.

Instead what they’ll do is issue a debt security to the company. The way that security will be structured is that it converts into equity of the company down the road when the company hopefully has more of a track record, maybe now they have products and customers in the door looking to raise additional investment capital in a way where they can more meaningfully ascribe evaluation to the company. What will happen with that convertible debt is that in later that financing event, when a valuation is more appropriately determined with a new set of investors the debt will convert into equity that is issued in connection with that financing.

With the way that conversion will typically work is that the conversion will occur at a discount to the prevailing of valuation and that financing round. So for example, if 18 months after convertible debt is issued to the to to investors the company goes and raises more money for a dollar a share by virtue of having essentially taking a chance on the company in an earlier stage, their debt is almost looked at as a pre-payment of equity for the later financing round will converted to equity at a discount to the prevailing valuation in the financing round.

So again, using my example, if you’re selling shares of stock for a dollar a share maybe your debt will convert and buy shares for $.80 a share so if I invested $100,000 18 months ago, and now you’re selling a stock for a dollar a share, rather my hundred thousand dollars buying hundred thousand shares of stock, my $100,000 dollars that I invested 18 months ago would convert by hundred 20,000 shares of stock because I’m converting at a 20 percent discount to the prevailing valuation of that equity financing.

So certainly one of the reasons that some startup companies choose to raise money by issuing convertible debt to investors as opposed to actually pricing their equity doing priced equity round as I just said is to avoid the valuation discussion, kick the can down the road if you will until the company has customers, products, and can have a more thoughtful meaningful negotiation around what the value of their company is.

Another reason that convertible debt has become a favorite form of investment is because of speed and simplicity. Typically, if the funding documents can be fairly voluminous that can take a while to negotiate, it’s not atypical for a priced equity round from term sheet to closing to take 60 to 90 days, believe or not. they can be quicker but they can take a long period of time and often times that’s just the amount of time to start companies don’t want to waste on negotiation documentation process.

So convertible debt, especially larger convertible debt financing rounds, can become complex and document-heavy in their own right, but generally speaking you can close a convertible debt financing round more quickly with a more simplistic form of documentation than you can in the priced equity round.

Last but not least, the reason the convertible debt financings have really curried a favor with start up companies, convertible debt financings tend to be cheaper from a legal cost standpoint for start up companies because you don’t have the volume of documentation, the rounds of negotiation back and forth with investors. You usually have more modest legal fees, which of course much to my chagrin as a lawyer, but much to the benefit of start up companies, is always a nice thing that you are limiting your exposure to legal fees.

Now again that’s not always the case. There can be convertible debt rounds that are larger debt rounds with multiple investors that can become complex again in their own right, in which case your legal fees can be higher, but again another reason the convertible debt is often favored by early-stage start companies that are looking to raise money.

About Scott Bleier

Scott’s practice is focused on the representation of entrepreneurs, emerging technology companies and venture capital investors. Scott specializes in corporate and securities law; private financings; and mergers and acquisitions.

Scott has worked with technology companies and their founders in a wide array of industries, including software, e-commerce and internet, life sciences, biotechnology, retail, consumer products, manufacturing, and healthcare information and management. Scott serves as outside general counsel to his company clients, advising their boards of directors and senior management on a broad range of corporate matters, including company formation, founder equity structures, financing transactions, corporate governance responsibilities, equity-based compensation strategies, employment issues, intellectual property, and commercial transactions. Scott also regularly represents these clients in mergers and acquisitions, including a significant number of sales transactions with large, public companies.

In addition, Scott devotes a significant portion of his practice to the representation of venture capital investors, negotiating and structuring portfolio company investments on behalf of these clients.

Scott also represents established foreign companies seeking to expand their operations to the United States.

Scott speaks regularly on entrepreneurship, start-up companies and financings, delivering presentations to entrepreneurs, investors and lawyers at the Cambridge Innovation Center, Swissnex Boston, the American Bar Association and the MIT Enterprise Forum. Scott currently chairs the Venture Capital Transactional Issues sub-committee of the Business Law Section of the American Bar Association.

Scott is a frequent writer on topics involving start-up companies and corporate law. You can follow Scott on Twitter at @bleierlaw.

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