Primer on Convertible Debt

Convertible debt is a structure with debt-like features, and converts into the issuer’s equity in certain circumstances. Our forms of Series Seed debt documents are available on Cooley GO Docs (US forms can be found here, Singapore forms can be found here). Many early stage companies use convertible debt for their initial fundraising and bridge financings.  This article identifies and explains the basic terms of convertible debt.

Please note that this article focuses on the “classic” convertible debt structure. A few variations on the “classic” convertible debt structure have emerged over the years, including Y Combinator’s “Safe”, and 500 Startups’ “KISS”, which are beyond the scope of this article.

Primary features of convertible debt:

• Principal amount.  The principal amount (or “face amount”) of an investor’s note will equal the amount invested by the investor.

• Interest rate.  This is the annual rate at which interest accrues on the note, as long as it is outstanding.  Interest may be either compounding (meaning the interest is turned into principal on a regular basis and accrues its own interest) or “simple” (meaning, not compounded).  Your notes may specify that accrued interest can either be repaid in connection with a conversion event, or can be converted into additional shares on the same terms as the principal is converting.  It used to be typical for the interest rate to be set at 6-10%.  It has become more common to see nominal interest rate in the 1-2% range – this is a reflection of the low interest rate environment and an acknowledgment that the accrued interest acts like additional discount in connection with a conversion (see “Conversion” below).  If your note specifies that no interest is accruing, there may be adverse accounting and tax consequences. Ultimately, the interest rate is one factor in the investor’s return model and should be negotiated as part of the overall economics.

• Maturity date. This is the date on which the obligation to repay the debt “comes due” – but many notes have flexible repayment language that would require the holders of a majority of the outstanding principal amount of notes to request repayment before the payment is actually due, or that allows the majority holders to elect to receive stock in lieu of repayment. Setting the maturity date is a way to set expectations for investors as to the likely outside date for closing an equity round – and in general a later maturity date is better for the company.

• Conversion.  The conversion terms of convertible notes typically garner the most attention.  The baseline mechanic is that the principal amount of the notes will automatically convert into shares of the issuer’s capital stock in connection with the  issuer’s next financing.  This mechanic is customarily further defined in three main ways:
  • Qualified Financing.  In most cases an equity financing will not trigger an automatic conversion unless a minimum amount of new cash is raised in the financing.  This amount is typically something like 1x-2x the principal amount of notes outstanding, but can vary substantially.  The reason for this “floor” amount is that many noteholders want to make sure that they only give up their debt instrument (and the additional protection it may afford the holder as compared to a holder of equity) at a time in which the company has demonstrated that it is more healthy and sustainable.  As a result, the goal of setting a “floor” is to protect the note holders from having their notes converted to equity in a financing that leaves the issuer inadequately capitalized.  The floor also ensures that the equity financing causing conversion is a “true” financing and not a sham financing designed to force the notes to convert into terms that are not favorable.  On the other hand, the floor shouldn’t be set so high that you risk having the notes not convert in the round.
  • Conversion discount.  In many cases convertible notes provide for a discounted conversion into the issuer’s equity, on the theory that the noteholder should receive a benefit relative to the subsequent equity investors in recognition of the added risk taken by the noteholder by investing earlier in the issuer.  A typical discount off of the price paid by the subsequent equity holders would be 15-25%.  Conversion discounts may be higher in investments with more perceived risk, either because the note may have a longer maturity or because of the specific circumstances of the issuer.
  • Conversion Cap.  As Series A valuations have climbed in recent years, it has become more common to include a conversion cap in order to protect investors’ interests when outstanding notes convert into an equity round priced at a very high valuation (see example below). Typically the cap and discount operate “in the alternative,” with the effective conversion price being determined by operation of one or the other based on which results in the lowest conversion price.  The conversion cap is the maximum value at which the convertible debt would convert into the next financing, regardless of the value agreed to by the issuer and the new equity investors.  While a cap is not a “valuation”, many investors and companies do tend to look at the cap amount as a proxy for valuation.  It is very important to note that the size of the round and the conversion cap are two variables that each can have a significant impact on the ownership position of investors following the conversion of the notes, and the two variables together have a magnifying effect.  It is critically important that founders run through a sensitivity analysis when trying to determine how much to raise and where to set the cap.
    • For example, following conversion of a $1,000,000 note made by an issuer shortly after the issuer’s incorporation, in an equity financing at which the issuer is valued at $100 million, the noteholder would own 1% of the company; but if the noteholder had invested the same $1,000,000 in an equity financing at the time in which it made its investment in the issuer’s convertible note it would have likely settled on a valuation that was substantially lower than $100 million, and ending up owning significantly more of the company’s equity.
    • Bonus material: The “Liquidation Windfall” problem.  If notes convert into preferred stock at a subsequent financing at a steep discount, an unintended consequence may be that the holder receives a liquidation preference that is “outsized” in relation to its initial investment. This topic is addressed in more detail in our article Understanding the Valuation Cap.

• Repayment terms.  The traditional repayment term would require repayment of principal and accrued interest by the issuer at the maturity date.  But the reality for the issuer is that in most cases if the note hasn’t converted by the maturity date, the company probably doesn’t have the money to cover the repayment obligation.  And the reality for the investor is that in most cases it is not interested in the prospect of making its money back, with interest.  This has increasingly led to parties taking a more flexible approach, in which at maturity investors can elect repayment or conversion into equity.  The conversion price should be agreed to in advance – some companies use the conversion cap but there are no rules here.  Also, the parties need to agree in advance what kind of stock the notes convert into at maturity – common stock or preferred stock.  Finally, in many cases in which the maturity date is reached, the issuer and the investors may agree to extend maturity, or to keep the notes outstanding and “due” but not otherwise take any action to collect or convert.

• Amendment provisions.  To avoid administrative challenges and “holdout” problems associated with trying to amend outstanding notes (to extend their maturity date or otherwise), notes usually require a “majority rules” provision through which the holders of a majority of the principal amount of all outstanding notes may agree to amendments that would be binding on all notes.  In some cases investors may require carveouts to the “majority rules” rule for fundamental changes (to principal, conversion cap, interest rate) or for amendments that do not treat all noteholders similarly.

These are the terms common to most convertible debt instruments.  Many variations exist, many other terms find their way into convertible debt deals, and there are many relevant design considerations.

Learn more about convertible debt in my other post, Frequently Asked Questions: Convertible Debt. You can also generate your own Convertible Note Documents now on Cooley GO Docs (please click here for the US version and here for the Singapore version).