Convertible Debt – Small Oversights Can Lead to Big Consequences

Convertible Debt – Small Oversights Can Lead to Big Consequences

Convertible debt is one of the most common funding instruments used by investors and startups, utilized in more than 50% of early-stage financings. It allows startups to raise money quickly and inexpensively, and allows the parties to delay agreeing on a valuation when the company is often “pre-everything.” This is debt (which provides the investor with downside protection in the event of bankruptcy or a subpar exit) that includes an interest rate, a maturity date, and most importantly for our purposes here, automatically converts into preferred stock at the company’s first major equity financing, often called a “qualified financing.” While convertible debt notes are relatively simple documents, drafting them without sufficient thought regarding possible impacts on the economics of the deal can prove costly.

Valuation Caps & the Liquidation “Bonus”

Typically, the debt will have a conversion feature allowing it to convert at a discount (15-20%) to the share price at the qualified financing, and, as an alternative incentive, founders often offer “valuation caps”. Valuation caps (which are included in a majority of seed-stage convertible notes) set a maximum valuation for the company at which the notes will convert in the next priced equity round, and they are only triggered if the pre-money valuation in that round is greater than the cap. In a world of ever-rising valuations, valuation caps can provide the needed incentive for investors to take a risk on a nascent company by providing the debt holder with a bigger piece of the pie upon conversion than their investment would otherwise have been able to purchase – this is the investors’ compensation for taking the early risk. However, in a hurry to get money into the company’s bank account, founders often overlook an important detail and inadvertently give investors an unintended benefit – a potentially huge multiple on the investors’ liquidation preference. See the following example:

  • Investor makes a $100K investment via a convertible note that has a valuation cap of $3MM.
  • A Series A investor makes an investment (in a qualified financing) at a $15MM pre-money valuation, with 3MM shares issued and outstanding, at a price per share equal to $5.
  • The investor’s convertible note converts using the $3MM valuation cap, resulting in a price per share upon conversion equal to $1.

A typical automatic conversion provision in a convertible debt note says that at the qualified financing the debt holder’s investment (including accrued but unpaid interest) will “automatically convert into Series A Shares issued in such Qualified Financing at the Issuance Price less the Discount (the “Conversion Price”); provided, that the Conversion Price shall not exceed a price per share that would result from a pre-money valuation of the Company equal to $3,000,000.”

Unintended Consequences – Double Dipping Valuation caps are intended to increase an investor’s ownership percentage, not increase their liquidation preference. In the example above, not only does the $100K convertible note convert into 100K Series A shares (80K more than the note holder’s investment would have been able to purchase at the $5/share issuance price), but the note holder’s Series A shares will have the same per-share liquidation preference as the shares issued to the new investor. The result is that the note holder is now entitled to a 5X return on its investment because its new Series A shares have a total liquidation preference of $500K instead of their $100K purchase price! Needless to say, this is usually not what founders intend. 

A Quick and Easy Solution

This problem can be solved by taking a page from the Y Combinator SAFE (an investment instrument that issues convertible equity rather than debt), which creates a specific class of preferred equity into which the instrument will convert. SAFEs use the term “SAFE Preferred Shares” but “Series A-2 Preferred Shares” also gets the job done. These shares have the same rights and obligations as the Series A shares, except for the (a) liquidation preference, (b) conversion price for purposes of price-based anti-dilution protection, and (c) dividend rights, which, in each case, are commensurate with the issuance price in the convertible note as adjusted by the valuation cap.

While this may add a column or two to the company’s cap table, if at a qualified financing the company’s valuation is as high as everyone hopes, founders will want to make sure they got this right. This adjustment should not be controversial for the investors and will allow the founders to avoid unintended consequences while making sure that the investors are treated fairly and appropriately compensated for their risk.

With the advent of the Y Combinator SAFE founders are more frequently exploring the issuance of convertible equity.  In an upcoming post we’ll discuss the pros, cons and a few intricacies of convertible equity.

For more information contact Eliot Cotton at: ecotton@velaw.com