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So we just talked a little bit about why start-up companies might find a convertible note financing to be a better approach than priced equity round. Let’s talk a little bit about the typical terms that we see a convertible note financing.
The amount of financing in a convertible note brown usually tend to be smaller than a priced equity round if you think about it convertible note round is supposed to be in some ways a bridge for the company to get some early investment capital, prove the concept, get a beta product up and running, perhaps get some initial traction with customers and users, such that again in 12 to 24 months they need to raise more money and can have a more substance valuation discussion with investors that at that point in time.
We typically see not convertible debt rounds being anywhere from $250,000 to $1,000,000 in terms of the size of the check that a convertible debt investor tends to write could be as low as $25,000 up to $100,000. convertible debt, it’s debt . today and as many of you know if you have a mortgage or a home loan debt usually comes with. with interest. So a convertible note will accrue interest over time the interest rate that no we typically see is 4-8%,
We keep calling this ‘convertible debt.’ What do we mean by convertible? This debt is going to have a maturity date like most debt has. You lend someone money at some point in time that debt is going to come due and you have to repay the investor that extended the credit to you.
Really convertible debt holders are not looking to receive their money back with modest 6% interest. Really what they’re hoping is that the company is going to use the money that was invested in early stage, and they’re going to leverage that money and grow a business that is now financeable. at a higher valuation in the future. and so we say convertible debt what we mean by that the debt can not only could be repaid on the maturity date but it can also convert into equity of the company if the company does another financing this time in equity financing after the convertible debt is come in the door.
So a scenario would be a company raises a half million dollars of convertible debt, it hires a couple of engineers, grows a product, it has some initial user customers and in 18 months, it goes out and tries to raise money from new investors at a pretty decent valuation. What would happen again, just use a hypothetical, if the company was able to do what I just suggested, and leverage the early money and grow the business and maybe 18 months after they raises the convertible debt, they are now raising money on a $5 million valuation so the companies being valued at $5 million by investors.
The convertible debt would convert into the equities that’s issued to investors in that financing, but what would happen is to give the victim the convertible debt holders the benefit of having invested in earlier stage when there was more risk involved, their debt would essentially be a prepayment, if you will, of shares of equity and equity financing. And they’d be buying shares at a slight discount to the prevailing valuation of shares in equity financing.
So in the situation I just described, if the investors are investing in a $5 million valuation and say shares are being issued for a dollar a share, perhaps the convertible debt holders’ debt would convert and pay for equity in that financing, and they’d be buying shares of $.80 a share $.90 a share so there’s a discount from the prevailing preferred stock price not valuation for the for the convertible debt investors by virtue of having invested earlier in the process and taking more risks earlier om
One other important component of convertible debt that will want to bear in mind in addition to the conversion discount that we just talked about oftentimes convertible debt will also have what’s called a valuation cap attributed to their convertible debt would evaluation Is it is essentially an upper-level mechanism to govern the rate at which the debt is going to convert into equity for the company.
So the scenario that convertible debt investors want to avoid is one where entrepreneurs have been more successful than was anticipated in leveraging that early cash that convertible debt holders put into the company, and now they’ve grown the business with really a modest amount of investment capital to a really impressive business with a high valuation.
I have seen situations where companies have raised half a million dollars of convertible debt and did such a good job of leveraging that money that they’re now raising money in their first equity financing round at a 10 or 20-million-dollar valuation. In that situation, if you have $500,000 of convertible debt, that’s going to convert into a small, meager amount of equity in the company.
To combat against that, what convertible debt holders will do sometimes is they’ll put a valuation cap in their convertible debt conversion. So for example, in the situation I just described, if a note had a valuation cap of $5,000,000 or $6,000,000, not withstanding the fact that the company would be raising money at a $10,000,000 valuation or a $20,000,000 valuation. What that valuation cap will do is essentially put the breaks on the conversion, and convert at that valuation cap as oppose to that much higher negotiated valuation.
So again, the convertible debt would convert at an artificial lower valuation as oppose to the negotiated higher valuation, so convertible debt are not unduly deluded by the entrepreneurs doing such a good job of leveraging that early money and growing that business to a high valuation.
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.