When a start-up company is ready to raise its initial capital after its formation, it commonly raises seed capital from founders and friends/family by selling them common stock. This seed capital can be followed by subsequent rounds of common stock and/or preferred stock. But sometimes during the early stages of an emerging company’s life, investors and founders may find it difficult to agree on a valuation for the financing round. In those instances, convertible notes are often the structure chosen to “bridge the valuation gap” and allow the financing to proceed.
Why Use Convertible Notes?
Convertible notes permit the company to be funded now, but to postpone the valuation discussion until a time when more facts are known and there is less uncertainty about valuation. This valuation happens when the company issues equity securities in a priced round of sufficient size (a “Qualified Financing”). Typically, the notes’ conversion price is determined by reference to the price established in the Qualified Financing. The next-round notes then convert into the same type of equity securities issued in the priced round, at a pre-determined discount to the price paid by the new investors. A next-round convertible note financing benefits the company and investors. The company gets badly needed funding immediately in order to build enterprise value, and investors are rewarded for being early risk takers.
Features of Convertible Notes
Convertible notes typically contain provisions regarding the following key terms:
- principal amount
- interest rate and method of compounding
- maturity date
- events of default
- rights of prepayment
- voluntary conversion
- mandatory conversion.
Depending on the facts, they might also contain terms regarding subordination (rank); amendments and extensions; status of being secured or unsecured; and covenants.
To savvy investors, the conversion features are often the most important terms in the instrument. The types of conversion provisions may vary based on the circumstances. Some or all of the following conversion mechanisms may be present:
- next equity financing conversion – closing of a subsequent equity financing of a certain minimum size
- corporate transaction conversion – a sale of the company or substantially all of its assets
- maturity conversion – reaching maturity date before closing a subsequent equity financing or sale of the company
- voluntary conversion.
Qualified Financing Conversion
When the company closes a subsequent round of priced equity raising proceeds that exceed a certain dollar amount threshold (a “Qualified Financing” as noted above), the principal and accrued interest of the notes automatically converts into the same class of equity securities that new investors purchase in the qualifying round, but at a conversion price lower than the price paid by the new investors. The rationale for this discount is that the company is considered less risky as compared with the time when the noteholders invested; and the noteholders should be rewarded for accepting risk earlier than the investors in the Qualified Financing. Conversion discounts in these circumstances are negotiated into the terms of the notes, but typically range from between 10 percent to 30 percent.
In addition to discounting the conversion price, many convertible notes include a cap on the pre-money valuation at which the notes will convert in a Qualifying Financing. The rationale for including a conversion cap is to protect the noteholders in a scenario where the company achieves an unusually high valuation in its Qualifying Financing. The conversion cap acts as a risk allocation mechanism to reward noteholders for accepting considerable early-stage risk at a time of valuation uncertainty. This cap is negotiated at the time of the note financing.
Corporate Transaction Conversion
If prior to the time a Qualifying Financing happens, the company is sold (i.e., consummates a business combination, asset sale, or merger transaction (a “Corporate Transaction Conversion”)) while the notes are still outstanding, noteholders are typically offered two options they can elect from: (i) receiving the principal and accrued interest of their notes; or (ii) converting the notes into the merger consideration (often preferred or common stock of the acquirer) at a discount to the price offered by the acquirer in the transaction. Noteholders want this election because it gives them the flexibility to exit the investment in situations where they don’t believe that retaining an equity stake in the new company will be favorable; or to do the converse if they like the prospects of the combined entity.
Options at Maturity
If the note maturity date is reached without the occurrence of a Qualifying Financing Conversion or a Corporate Transaction Conversion, noteholders typically have the choices to: (i) demand repayment; (ii) extend the maturity date; or (iii) convert their notes into common stock.
Repayment. This may not be an exciting option, where the company has little cash, and liquidating its assets will not be easy or provide a meaningful recovery for noteholders. It may however, provide leverage to noteholders to demand a change in company strategy, direction or management.
Extension. This is a popular choice – it “kicks the can down the road” and may be accompanied by a further increase in the conversion discount or an adjustment to the conversion cap, if one is present. The hope is that permitting extension will increase the chances of a Qualifying Financing ultimately taking place. Sometimes an extension is given or required at the time of an additional convertible note financing round.
Conversion. If the company has enough capital to survive and grow, and if the noteholders believe the upside justifies the risk of giving up noteholder status, they may elect to convert into common stock. This conversion is often at a predetermined price. If the note contains a conversion cap, that may be the price at which the conversion takes place.
Amendments to Terms
The provisions governing how note amendments are approved is often overlooked. Does each noteholder have the individual right to consent to amend its note, or can a majority in interest of the notes decide the issue for all noteholders in a class? This is an important issue that also needs to be addressed when entering into convertible note transactions.