Prepared by Andrew B. Coburn
As seen in Business Black Box
Q4 2014 Edition

A startup company can use a variety of forms of debt or equity to raise its initial funding. Sorting out the options is complicated by the numerous model documents now available for venture capital financing, from the National Venture Capital Association’s Series A documents to Fenwick & West’s Series Seed documentation. One way to dive into this issue is to start with a basic review of one of the most common forms of seed financing, convertible debt.

What is convertible debt? Convertible debt, like any form of debt, creates an obligation to repay, with interest, the money provided by the lender/investor at a specified maturity date. Upon the occurrence of a Series A preferred stock financing, however, the debt, plus accrued interest, will convert into Series A preferred stock. In order to compensate investors for the risk of investing early in the company’s history, the debt converts at a discount. For example, if the Series A investors pay $1.00 per share, the convertible debt might convert at $0.80 per share. Typically, investors also insist on a valuation cap, which is too complicated to explain here in detail. The end result is that investors generally will convert based whichever is more favorable – conversion based on the discount or conversion based on the value of the company at the time of the Series A offering, subject to a maximum value cap.

Why is convertible debt used? Issuing common stock creates issues for a startup company even if it can find investors willing to invest in common stock. Accordingly, startups typically issued Series A preferred stock to investors. Convertible debt was developed as an alternative to Series A preferred stock. Convertible debt documents are much less extensive and complicated than traditional Series A preferred stock documents, making a convertible debt financing significantly less complicated, time consuming and expensive than a traditional Series A offering. In addition, both the company and investors can postpone trying to set a value for the company until the Series A offering, when the company will have more of a track record on which to base a valuation. Convertible debt also leaves company founders and management with greater control because it does not provide investors with stockholder voting rights or, in many cases, with restrictions on the actions the company can take without investor approval.

Issues to consider. Convertible debt usually must be repaid after a short term of around one year. If a Series A offering does not occur before the maturity date and the company does not have the money to pay the debt, the convertible debt holders can have tremendous leverage over the company if they refuse to renegotiate the debt. The convertible debt also needs to address what will happen to the debt if the company is sold prior to a Series A financing. Finally, under the wrong circumstances, the conversion valuation cap can have a very serious, adverse effect on the economic interests of the company founders. There generally are methods to address the foregoing issues or limit the associated risks, but convertible debt should not be used without careful thought. In some cases, a startup company may find that other alternatives, such as Series Seed stock or “convertible equity” may be preferable, but that is a topic for another day.