Convertible notes have become a common way of raising capital among entrepreneurs. The use of convertible notes offers a number of benefits over more traditional fundraising options for both entrepreneurs and investors. However, convertible notes can prove confusing and complicated.
Furthermore, some parties have taken advantage of the complications involved with convertible debt to place some very unfavorable terms under the radar. For this reason, it is critical that entrepreneurs not only have a strong understanding of what exactly convertible notes are, but also the questions to ask and the things to consider before structuring an offer. Following is a look at the key aspects of convertible notes if you are considering this type of fund-raising.
- Liquidation preferences: When a liquidation event such as a sale occurs, the preferences set for the structure of the convertible note dictate which parties will get paid first and how much compensation they will ultimately receive. Often, the language of a convertible note, especially that surrounding the valuation cap, provides a much higher liquidation preference to investors than the initial investment that they made. A talented investment lawyer can help find a more agreeable structure that protects the company and its founders in the event of a liquidation event.
- Interest rates and payment expectations: The idea behind convertible debt is that a loan turns into equity over time. However, this does not always happen. If the conditions for a conversion are not met before the note becomes due, then entrepreneurs may be obligated to repay the loan. Furthermore, some notes must be converted when conditions are met, while others provide investors with the option to convert. In some cases, an investor may want repayment instead of conversion, so it is important to take a close look at the structure created for repaying the debt if the conversion does not happen. General interest rates for convertible debt range from 4% to 8%. This low rate is due to the fact that convertible debt is not expected to be high-yield and is instead intended as a stand-in for equity. In addition, investors expect to see a substantial gain if the note converts, so the potential reward is worth the risk of very low return.
- Discount at conversion: When convertible debt qualifies for conversion to equity, that equity should be priced at a discount. The discount provides an incentive for investors to get in on the company early. In general, the discount ranges from 20% to 30%. Another option is to provide warrant coverage. However, this second option accomplishes basically the same thing as a discount, but it adds in additional complications. An investment lawyer can help individuals to figure out what is best for their individual circumstances, but a discount is almost always the simpler solution.
- Full-ratchet and anti-dilutions rights: A common trend in recent years has been to add full-ratchet and anti-dilutions rights for investors into convertible notes. The terms can seriously injure a company in any subsequent financing round that is not very successful. With full-ratchet rights, an investor who paid $10 per share of stock can convert all holdings to any lower price for which this stock is sold in subsequent rounds. Therefore, if a company can only find investors at a price of $5 per share, the previous investor now essentially doubles his or her share of the company. Suddenly, someone who owned 10 percent of a company now owns 20 percent without investing any additional money. A better option is a weighted-average ratchet, which allows only a portion of the original stock to convert to the new, lower price.
- Note maturity: The assumption going into a convertible note made by both an entrepreneur and investor is that the investment will eventually turn into equity. However, if the note matures and the conditions for conversion have not been met, then companies are liable for the balance and interest. While it is important to look at interest and repayment terms, it is also crucial to consider the maturity date. The majority of companies issue convertible debt that matures in a year, but owners who do not foresee the conversion happening in that time frame can structure a deal with longer terms. Sometimes investors will agree to extend the maturity date, but it is better to push the date out from the very beginning in order to ensure conversion.
- Valuation cap: One of the most important parts of a convertible note is the valuation cap, the maximum valuation that allows notes to become equity. In other words, if a company is valued at more than the valuation cap, early investors with convertible debt can purchase shares of equity based on a lower valuation. The cap is essentially a reward for individuals who invest in the company early, and it has no benefit for the entrepreneur other than attracting investment. Without a favorable valuation cap, angel investors will not have a lot of interest in the company. At the same time, entrepreneurs need to protect themselves from being sold short in the future.