Startup Lawyer | How Convertible Debt Works
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How Convertible Debt Works

Posted 17 Dec 2009

Convertible debt is a type of security frequently issued by startups when raising seed capital. With convertible debt, the startup issues the seed investor a promissory note, for the investment amount, that contains a conversion feature. The conversion feature is the mechanism by which the debt (the promissory note) will convert to equity (new shares for the investor) upon a future event.

The Qualified Financing

Most (if not all) convertible promissory notes contain an Automatic Conversion clause that dictates the automatic conversion of the convertible debt upon a “Qualified Financing.” The Qualified Financing is typically defined as an equity financing by the startup, for the purpose of raising capital, in which the aggregate of $1,000,000 (this amount can vary per deal) is purchased by investors. Thus, the Qualified Financing event is the trigger by which the convertible debt will automatically convert to equity. The conversion is considered “automatic” because it does not require the vote of either the startup or the investor.

The Qualified Securities

The equity raised in the Qualified Financing (the $1,000,000 above) is typically termed “Qualified Securities.” Think of this as the Series A round. The convertible debt held by the investor will convert to the Qualified Securities. The amount of shares of the Qualified Securities issued to the convertible debt investor is dependent on the conversion discount per the terms of the convertible promissory note.

The Conversion Discount

As a sweetener to the convertible debt investor, convertible promissory notes have a conversion discount feature by which the convertible debt holder will exchange the debt for Qualified Securities at a price per share equal to 80% (this amount can very per deal) of the price per share paid by the Qualified Financing investors (the investors with the new $1,000,000 above).

Example

Here’s the basic outline of how convertible debt works:

(1) Joe Angel invests $100,000 in Startup.

(2) Startup issues Joe Angel a convertible promissory note for $100,000. The convertible promissory note has an automatic conversion feature at $1,000,000 (the “Qualified Financing”) with a conversion discount equal to 20%.

(3) Startup closes $1,000,000 Series A Preferred Stock round (the “Qualified Securities”) by a VC at a Series A Preferred Stock price of $1.00 per share.

(4) Since the Automatic Conversion feature in Joe Angel’s convertible promissory note is triggered by the Series A round, Joe Angel’s convertible debt will be converted to Series A shares at a per share price of $0.80.

(5) The Startup issues Joe Angel 125,000 shares ($100,000/$0.80 per share) of its Series A Preferred Stock. The convertible promissory note is cancelled.

31 Comments
  • Derek Carroll
    Posted at 08:22h, 06 January Reply

    So the start-up does not service the debt to the angel investor? Is interest typically accrued? Example, if the convertible note is at 7% and the qualified financing is one year later, would the angel investor get shares = 107,000/.8?

  • Ryan Roberts
    Posted at 12:11h, 06 January Reply

    Derek – The startup does not service the debt. Interest is typically included in the note, but it's not the main feature. The accrued interest is factored in the conversion.

  • Kevin Vogelsang
    Posted at 03:23h, 10 March Reply

    What are the specific advantages of convertible debt as a financing instrument? Is it about preserving control early on?

    And, generally speaking, is an acquisition a conversion trigger?

  • Ryan Roberts
    Posted at 11:00h, 10 March Reply

    Kevin – It's not so much about control as it is not having to agree on a set valuation.

    An Acquisition can be a "trigger" but normally to a liquidation preference. I.e., the investment may get 2X the return upon a sale (prior to a series A round).

  • Alex Neth
    Posted at 09:11h, 17 March Reply

    I've always looked at these contracts and wondered what happens if no qualified financing takes place. What happens if a successful business is built off of $500K?

    The last time I signed one of these I changed the language to include other triggers, such as a time window or a revenue level. Otherwise as the investing company, I saw us being in purgatory if they never raised significant capital, but built a nice business.

    Granted, it's unlikely they would go public providing an exit for our shares in this case, but it still seems reasonable to expect a conversion.

  • Ryan Roberts
    Posted at 11:29h, 17 March Reply

    Alex – Assuming the maturity date of the note is reached (and the investors will not extend the maturity date) without a qualified financing, the startup can either (a) pay the outstanding principal plus any accrued interest on the note, or (b) convert the note into the startup's common stock.

    (a) is probably unlikely, and (b) is a difficult negotiation, especially up front because then you have the valuation issue (which is probably why you avoided an equity financing to begin with). But if the startup can't agree to a conversion and repay the note, the investors could essentially call the note and force the startup into bankruptcy.

    Extending the note for consideration (higher interest, additional security) may be an option. You could also modify the note to include a paydown schedule.

  • Sean Stoner
    Posted at 01:13h, 22 April Reply

    Ryan,

    I have lots of experience using convertible notes to raise capital in past startups. However, my current situation is a little different. I would like to actually service the debt as a regularly amortized payment as an option should the investor choose to never convert or if the other trigger events never take place. For the sake of example, let’s say the note is for $25k at 10% per annum, payable monthly with a 24 month term/maturity. It has regular tag-along/drag-along provisions customary with such notes (e.g., http://blog.lookery.com/wp-content/uploads/2008/08/generic-convertible-note.doc). In my case, rather than a discount conversion with a cap, I would like to issue warrant coverage and/or a warrant kicker as a sweetener that the investor can hang on to even if there is no future round and the note is paid in full and canceled as a result. How would you most simply address these points using a template like I’ve provided in the link above?

    Keep up the great work!

    Sean

  • Ryan Roberts
    Posted at 08:36h, 23 April Reply

    Not really a simple way to do that. At a minimum, you’ll have to contract for the warrant coverage/kicker in a note & warrant purchase agreement, the terms of note payment in the note, and then provide a form of warrant. Of course, you’ll have to mind the potential tax implications of the warrants as well.

  • Steven Wolf
    Posted at 17:04h, 26 July Reply

    Hey Ryan,

    Great article. I have an interesting situation where a guy wants to invest in my company with convertiple debt that converts at a fixed multiple of earnings in the future. Hes willing to wait for the third years earnings to convert based on. The company is an internet company that we are just taking out of the test marketing stage and starting to do a real big expansion. We could be very profitable but some of the issues that I'm worrying about is what happens if we reinvest all our money in the company and don't show any earnings and also am I entering into a deal where I may lose my shirt.

    I know that I'm probably not giving enough information but I have never heard of this kind of a deal and I need some guidance.

    Thanks,

    Steven Wolf

  • Mick Grant
    Posted at 03:08h, 03 August Reply

    Ryan,

    thanks for all your comments. very informative..

    I am interested to understand the risk in convertible note purchase agreements… If company A is looking for $10m series A investment but needs $300k (convertible note) angel investment to get through the early stages what guarantees are there that the series A will in fact happen? In other words, if i was the Angel investor i would want to be pretty certain that the series A would be going ahead once i had committed my $300k. The reason I ask is that I have unwittingly found myself as the middle man in such a deal and expect to profit from a finder's fee. I need to persuade would be Angel's that it is a good investment (the series A investment does indeed look 'likely' as far as the team putting together the proposal are concerned, but i guess as an outsider I would appreciate some advice on what to do to make the case as compelling as possible for the Angel Investor. I am sure Company A who are seeking the investment will pitch well when i connect them with possibles Angel's but i would like to understand the risk a little better and what i can do as the middle man to persuade would-be Angels that the risk is as low as possible..

  • J Adams
    Posted at 10:50h, 10 August Reply

    Ryan,

    What if I wanted to use this security as additional funding. Say the comapy secures $300k, which is delived in 2 stages. But when the time comes Investor in this case an institution fails to pay. Now 50% of the way is a really bad place for a startup. Syndication of investment for remaning $150K as a note seems like hte fastest way out of a bad position. But can be done?

  • Aaron Cother
    Posted at 06:11h, 13 August Reply

    @ Mick Grant/ J Adams

    On a related but not direct subject – Dave McClure has great commentary of timing for Angel funding. This doesn't address structure, but when an investor is looking or should be looking to double down.

    http://500hats.typepad.com/500blogs/2010/07/money

    Sorry for the linkout Ryan – But Dave McClure rocks.

  • Marc Gayle
    Posted at 08:35h, 28 August Reply

    Do these convertible notes typically come with a coupon rate? How often is the coupon paid?

    Or is it typically interest free, with the discount included as compensation for the forgone interest?

    If it does include a coupon, then your Joe Angel example above misses out that minor detail, which could cost the startup say $5K every 6 months (assuming a 10% coupon, payable semi-annually).

    Is that a correct assessment?

  • Anonymous
    Posted at 17:00h, 30 August Reply

    There is typically a nominal interest rate (not 0 but also not something high, i.e. 10% or more) and it pays usually upon maturity or other event like a sale or financing. All are negotiation points, though.

    These types of notes differ from a late stage PE deal re how interest is calculated and payment terms.

  • Vivek
    Posted at 08:45h, 24 October Reply

    What happens if the company is not able to raise further rounds of funding? Does the promissory note become payable at a certain date like a normal bank loan? Or is there some clause which at some point of time compulsorily converts the note into equity?

    If it becomes payable, isn’t this a highly risky form of capital raising for a seed stage startup? Things are so volatile at that stage that anything could go wrong!

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  • Gary
    Posted at 19:09h, 21 December Reply

    I don’t believe the new investor should be diluted by the discount or warrant coverage. It seems to me that that the new investor gets a percentage of the equity based on the pre-money value including the debt. If there is warrant conversion or additional shares issued to the bridge investor, it should only dilute the existing investors, not the new investor. End of the day, Post Money = Pre-Money Value (including note) plus New Money. No value is created by virtue of the discount or warrant coverage being triggered, and the new investor should not pay for it. The formula above does not take this into account? It dilute the new investor when the discount or warrant coverage kicks in. Can you explain?

  • Javier Rincón
    Posted at 09:09h, 01 February Reply

    Great explanation, simple and direct. Thanks a lot!

  • Rk
    Posted at 21:50h, 11 February Reply

    The initial promissory note will bear an interest right ? Or only if it is termed as convertible bond, will it bear an interest ?

    My question is, if it bears interest, will it still be automatically converted to equity ? When can the interest payments stop ?

    Could you also explain, what does warrant mean ?

  • Peter M
    Posted at 12:52h, 22 June Reply

    What would be the appropriate conversion structure if a prospective convertible debt investor wanted some ability to convert to equity if the company received a sizeable non-dilutive grant from a State agency that could prevent or significantly delay the need for additional capital?

    Any thoughts would be appreciated. Thanks.

  • Quora
    Posted at 18:14h, 04 August Reply

    What are the best online resources (blogs, podcasts, articles, etc.) on startups and entrepreneurship?…

    Incorporation * Startup Company Laywer: What type of entity should I form? (http://www.startupcompanylawyer.com/2009/03/12/what-type-of-entity-should-i-form/) * Startup Company Lawyer: What state should I incorporate in? (http://www.startupcompanylawye

  • Pedro Moore
    Posted at 13:33h, 07 August Reply

    In your example of the convertible note there was no interest converted. If the note is canceled just the principle is converted or the interested accured from the note converted too?

  • Convertible Question
    Posted at 12:49h, 29 August Reply

    What forms would one need to fill out to extend the maturity date on a convertible note? All investors have agreed verbally but we are unsure of what needs to be legally.

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  • Rodrigo
    Posted at 16:19h, 11 October Reply

    Thanks Ryan, this was very useful… we issued a convertible note and got our financing, so now we need to convert the note to equity.

    Question: How does this work from the accounting side?

    So, when the note is issued ($100K as per your example), we need to make a journal entry:

    Cash (Assets): +100K
    Long Term Notes (Liabilities): +100K

    What’s the journal entry we need to make once the note
    converts?

    I assume:
    Long Term Notes (Liabilities): -100K (to cancel the note)
    Paid-in Capital (Equity): +100K?
    Common-stock?: +25k?

    This doesn’t balance. How do I account for the discount that the investor got? Any help would be greatly appreciated!

  • Jo
    Posted at 04:44h, 08 April Reply

    do compay has just 875.000 shres left to sell on the second round, or they issue 1.125.000 shares in general?

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  • Nick
    Posted at 19:23h, 29 May Reply

    What about option pools? If the A requires a 20% employee option pool how does that work? Is the share discount taken before or after the pool increase? For example if the $1M raise requires the addition of 5,000 shares to get to the 20% pool how does that effect the equity from the series seed?

  • Bob
    Posted at 22:16h, 14 July Reply

    What happens when the startup goes bankrupt and folds? I’m guessing the dept holder will become the creditor and take over all remaining assets… but can they go after the owners personal assets?

    The company I’m partnered with is an IBC and I only own a small percentage of shares (slightly above 5%). Can the creditors come after my personal assets even though I’m not the one who signed the Convertible Credit Agreement (due to lack of voting power)? I’m guessing I shouldn’t worry but I’d like to ask anyway just to be absolutely certain.

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