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Early stage high growth startups face a key early financing challenge: to fund growth operations, they need to raise a lot of cash, yet they have little, if any, market value. They typically have not fully developed intellectual property, produced a product, proven the market or de-risked the venture in any meaningful way. If a startup raised all of the cash it would need to fund even 6–12 months of operations at such a low “intrinsic” valuation, the founders would experience massive dilution. This would likely demotivate the team and limit the potential value of the company.

The seed capital market, therefore, adopted the idea of raising funds with a floating rather than a fixed valuation. By “kicking the valuation can down the road” and pegging the seed round valuation to the price paid by subsequent investors, founders avoid over-dilution while still providing seed investors with preferential pricing to reflect early risk. The most common instrument used in these friends and family, early angel, and incubator type deals has become convertible debt.

Structure
Convertible debt has two central components. On the debt side, investors lend cash to a company in exchange for a promise to repay the debt, plus interest. As might be expected, high growth companies almost never have sufficient cash to repay such amounts—which leads to the second component.

On the equity side, the company can avoid repayment at maturity by forcibly converting the principal and interest into equity at a rate determined by the next round of professional investors.

During the time such an investment remains debt, the holders of the debt act like unsecured noteholders, having few control rights over the company. Once converted, however, these holders become owners of equity, and have all the usual rights of angel or venture investors.

Bridge Not a Pier
Convertible debt, therefore, relies upon the premise that the issuing company will, in fact, successfully raise follow-on financing. In fact, this mechanism is only worth the trouble if such subsequent round is (i) likely to occur before note maturity, and (ii) priced at a substantially higher valuation that the company would have received at the time of issuing the notes. At a minimum, for the note mechanism to be of any value to the company and the preexisting shareholders, the company needs to grow faster than the rate at which the notes’ interest and discounts are creating additional dilution. If a company issues convertible debt and then doesn’t build value, the founders will experience even worse dilution than that which they sought to avoid in the first place. As they say, convertible debt is a good “bridge” mechanism but makes an awful “pier.”

Key terms
Maturity—Maturity is the date on which the convertible debt must be repaid. As seed cash typically is intended to last the company 12–18 months, convertible note maturities tend towards 18–24 months to allow for the inevitable bumps in the road. If the company reaches the maturity date without having triggered a conversion of the debt, the company is likely to then be insolvent, with the holder of the notes owning a claim to all of the assets of the company. While noteholders rarely foreclose, if there is upside potential in the company, the noteholders will typically renegotiate to obtain a larger share of the value in exchange for their agreement to convert or extend the maturity date. A side effect of insolvency may be that it creates additional obligations and restrictions on how the company may operate until cured.

Mandatory conversion and Qualified Financing—The parties typically agree that only a financing of a certain size and type will be usable as the reference valuation. This “Qualified Financing” triggers a mandatory conversion of the principal and interest into the type of equity securities issued in the Qualified Financing, which is in almost all cases, preferred equity. Shares of this preferred equity will have a liquidation preference equal to the per share price paid by the subsequent investors.

Optional Conversion—In certain deals, noteholders will contract for the right (typically at maturity) to convert principal and inter est into shares of common equity, usually because no Qualifying Financing will have occurred. In other deals, the company can force the conversion into common equity as a way to stave off the insolvency created upon note maturity. In both cases, the conversion is effected at punishingly low valuations as an incentive on founders to build value and raise a Qualifying Financing.

Interest—Interest is typically simple interest in the range of 5%–10%, which compensates the noteholders for the time value of money. Interest will accrue but not be payable until maturity or conversion. As the interest will also convert into shares of preferred stock, converting noteholders will obtain more than $1 of liquidation preference for each $1 actually invested.

Discount—A discount is the reduction in price per share paid by the converting noteholders relative to subsequent investors. Typically 5%–25%, this discount is intended to compensate the earlier noteholder investors for the additional risk they undertook. Subsequent investors will resist permitting the company to convert noteholders at excessive discounts, particularly if substantial additional risk was not absorbed by the earlier noteholders.

As is the case with accrued interest, the discount will provide converting noteholders with more than $1 of liquidation preference for each $1 actually invested. By way of example, if the new investors would pay $1.00 per share and the noteholders were entitled to a discount of 20%, the new investors would convert all principal and interest at $0.80 per share, but will be entitled to a liquidation preference of $1.00 per share.

Cap—The valuation cap is the maximum value at which the noteholders will convert their principal and interest, regardless of the valuation used in the Qualified Financing. Investors often require that they receive the lower of (i) the discount times the new price, and (ii) the cap. This means that if, in the prior example, the company caps the conversion at $3,000,000, and then issues shares at a $3,000,000 price, the noteholders will convert at $2,400,000 because of the 20% discount.

Prepayment—In many cases investors prohibit the company from prepaying the debt, as they are not really investing for the interest payments and do not want to absorb equity risks for debt returns.

Unsecured—In almost all cases the convertible notes will be unsecured by the company’s assets. This both helps the company raise other standard credits from lenders, vendors etc., but also avoids the substantial costs of negotiating security and collateral agreements.

Liquidity—Recently, as many companies went from seed financing directly to acquisition, investors have negotiated for the right, upon an acquisition to get either (i) a multiple of their investment back, typically 1.5–3x (in some cases plus interest), or (ii) the right to convert at a default valuation as of immediately prior to the transaction, enabling them to participate as equity holders. In negotiations, many companies resist any requirement to pay a multiple of capital upon an exit, as the investors have not fully absorbed equity risk at the time of acquisition.

Positives
Convertible notes structures have many advantages over equity deals. They are typically cheaper to document and can be sold to investors much quicker and on a rolling basis. Convertible debt also allows the company to offer larger discounts to earlier investors to incentivize early closings. Convertible debt deals also avoid the possibility of a “down round” in which the company raises money in the second round at a lower valuation than in the seed deal, triggering various investor rights and sending terrible signals to the marketplace. Lastly, convertible notes often do not require companies to give board seats or extensive control rights to their seed investors.

Negatives
However, these advantages must be weighed against certain real downsides. Most critically, the combination of the maturity, the cap, the interest and the discount place a huge burden on the company to build value very quickly. Unlike an equity deal in which investors and founders are in the same boat if the company grows slower than expected, in a convertible debt deal there is strong disalignment of both incentives and outcomes if the company does not meet expectations. Investors will end up with a much larger share of the company than anticipated if the company does not meet its goals.

As noted above, the existence of a drop dead maturity date may also lead the company to a position of insolvency, or, at a minimum, to a very painful renegotiation with the noteholders.

The effect of the discount rate and the interest on the note also means that investors will receive a significantly larger liquidation preference than the amount of cash actually contributed. This “multiple liquidation preference” would be a red flag in a standard 1x equity deal, in which $1 of contributed cash nets an investor $1 of preference. Similarly, in an equity deal, investors have proportionate “weighted average” anti dilution protection upon a subsequent downround, whereas in a convertible debt deal they are offered the equivalent of “full ratchet” price protection to reset their investment at a lower price.

Equally important is that the price cap often works as an unintended bellweather to next round investors about where to begin negotiations. This critically reduces the opportunity of the founders to use convertible debt to avoid over-dilution—the whole point of the convertible debt transaction. If the next deal will happen at the cap price, founders would be better off pricing the existing round at that valuation and avoiding the extra dilution resulting from the discounts and interest.

Taxation
It is generally the case that shares issued upon the conversion of the debt are eligible for capital gains treatment. Investors who want to start the clock on the one year holding requirement permitting the most favorable tax treatment need to consider the possibility of an exit transaction occurring within a year from the conversion date, as opposed to the date on which the convertible notes were issued.

It is also likely that the original convertible debt mechanism does not deprive investors of the ability to treat shares issued upon conversion as qualified small business stock. These very favorable provisions allow stockholders to shield all or a portion of the gains from taxes.

More significantly, convertible debt can create interest reporting obligations as well as change the taxable character of the investment. First, even where interest on convertible notes is accruing and will not be paid until maturity or conversion (if ever), companies and investors are required, for tax purposes, to treat the interest accruals as if cash has been paid. This means investors will have presently taxable income without having received any cash, a situation many find unpalatable.

Second, and more troubling, is that the payments due to investors upon an acquisition prior to conversion (usually calculated as a multiple of principal and interest), are likely taxed as ordinary income rather than capital gains. Such treatment massively reduces the net return on investment for investors.

Conclusion
While convertible debt deals offer some useful features for early seed deals, principally delaying the valuation negotiation, their use by sophisticated investors and entrepreneurs is declining. Recently many startups and early stage investors have begun to adopt convertible equity documents to achieve the valuation deferral objective, without subjecting the parties to the risks and problems of the convertible note mechanism.


This article was prepared by Jeremy Halpern, a member of the Emerging Companies Group at Nutter McClennen & Fish LLP. For more information, please contact Jeremy or your Nutter attorney at 617.439.2000.

This article is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.