Corporate Law

Author: Jesse Ahuja & Andrew Hennigar

In an earlier article, we discussed some of the reasons why startups (i) have difficulty securing a traditional loan and (ii) struggle with valuing the company when issuing shares. Today we provide an overview of how many of the problems associated with these issues can be solved by employing an equity/debt hybrid commonly referred to as convertible debt.

In broad terms, convertible debt is simply a loan that can be converted to equity in certain circumstances. However, convertible debt becomes more complex once you consider that, as a hybrid instrument, all of the various features of both equity and debt instruments are available to define the terms of a convertible debt investment. The key variables include the interest rate (simple interest or compounded, payable on a rolling basis or at maturity, payable in cash or in shares), the term, and the conversion price and timing (including who or what may trigger conversion).

Recently, we are seeing loans for fixed terms in the range of 1-3 years, with an interest rate between 5-10% that accrues and is payable by the company in cash at maturity or in shares upon conversion. Where there is a group of investors participating in a convertible debt financing, we also typically suggest that demand for repayment be permitted only if a majority of the investors agree. This condition prevents a single investor from demanding repayment when the timing is not in the company’s best interest.

The fundamental tension point when negotiating a convertible debt financing is typically between conversion price and interest rate. A higher interest rate justifies a higher conversion price (i.e. fewer shares issued upon conversion of the debt to equity) because (i) existing shareholders should receive less dilution if the company is paying a higher interest rate, and (ii) the investor should reasonably expect a return on investment either via interest or conversion, not both.

It is common for the debt to convert to equity automatically if the company completes a “qualified” equity financing (meaning a Series A round that satisfies certain agreed upon criteria such as a minimum issue price and offering size) before the loan reaches maturity. The conversion price is typically the lesser of (i) a set discount on the Series A round price, and (ii) a “cap price” (an agreed upon maximum valuation that is locked in for the convertible debt investors). The cap price protects the convertible debt investors from up-side dilution since, without a cap, the greater the valuation at the time of the “qualified” financing, the fewer shares are issued to the convertible debtholders.

It is important to note that, unlike issuing equity at a certain price, the cap price does not suggest a valuation of the company. From the company’s perspective, this is important because it allows the company to continue to grant options or issue founder equity at a lower price (other tax issues for the company and the equity recipients aside).

Investors should be aware that, unless and until the debt is converted, convertible debtholders are not shareholders, which means they do not have voting rights and are not owed a fiduciary obligation by the directors. Any protections that the convertible debtholders hope to negotiate must be included in the underlying agreements (typically a subscription agreement and convertible debentures or promissory notes). Investors may also be pleased to know that debt ranks senior to equity on any liquidation of the company, meaning that as a creditor the investor may be in a better position than equity holders if the company decides to shut down but still has some assets to distribute.

From the entrepreneur’s/company’s perspective, the prospect of loan repayments, interest accumulation and still (possibly) giving up equity at the end of it all may not seem attractive. Companies should get comfortable with convertible debt though, because it is very appealing to investors. Investors love it because (i) if the company’s share price does not materially increase during the term of the loan, their investment is repaid with interest, and (ii) if the company’s value does pop, the investor can convert to equity with a greater potential for significant returns.

Interested in hearing more? Don’t miss our upcoming webinar, Show Me the Money: Corporate Finance for Early/Growth Stage Companies, jointly presented with Boast Capital from 11:00am – 12: 00pm PST on February 25, 2016, or contact MEP Business Counsel at 604-669-1119. To participate in the webinar REGISTER HERE.

This post is for informational purposes only and does not constitute legal advice or an opinion on any issue. If you are interested in receiving additional details on the topic above or advice about specific circumstances, please contact MEP Business Counsel at 604-669-1119.