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Jumpstart with debt

Convertible debt provides a fairly simple solution to some of the valuation and timing issues faced by entrepreneurs and investors alike. Given today's difficult financing environment, the use of convertible debt is likely to continue to grow as attorneys, accountants, entrepreneurs and investors become more familiar with the structure. Michael Fieweger of Baker & McKenzie explains.

As venture capitalists pull back from financing early stage ventures in the current conservative funding environment, entrepreneurs face a growing funding gap between raising their initial and follow-on rounds of capital.

Start-ups typically fill this gap through piecemeal investments from friends and family and angel investors. But valuation of these investments can prove perplexing for both the investors and the entrepreneur. Without the up-to-the-minute knowledge of the funding marketplace, investors typically do not have the time or resources to conduct the thorough due diligence and valuation modeling necessary for a venture investment. The time pressure faced by the company as it depletes its internal
funding resources only adds to the difficulty of determining an accurate valuation.

To combat these valuation problems, entrepreneurs and angel investors are increasingly turning to another financing technique: convertible debt. This technique provides expedited funding while delaying the valuation decision until the company has completed a larger institutional financing round.

Convertible debt is simply debt that may be converted, either at the discretion of the lender or in certain cases upon demand of the borrower, into equity of the borrower. In the typical start-up convertible debt transaction, an angel investor will loan the company funds and receive a convertible promissory note that carries interest at a market rate.

When a subsequent qualifying round of financing closes, the principal and interest balance due on the note will be converted into the preferred stock sold in the qualifying round. The terms of the convertible note typically require the issuance of at least $2m of preferred stock to the lender. The convertible debt may convert into preferred stock either at the price paid in the qualifying round, or at a discount — typically between 5 and 15 per cent — to acknowledge the added risk taken by the lender.

Because the convertible debt is incurred in anticipation of a subsequent qualifying round, the maturity date is tied to the expected closing date of the subsequent round (usually between three and twelve months from issuance). If the subsequent round of financing isn't raised prior to the maturity date of the convertible note, the lender can call the note or convert the debt into common stock, at a predetermined (low) valuation. Investors employ several variations on this convertible debt structure to account for the risk that the company will not complete a subsequent round of financing in a timely manner. One variation involves a conversion discount that increases over time. Under another variation, lenders receive a warrant to acquire additional shares of the company's stock at a nominal price if the subsequent round isn't closed by a certain date. The convertible debt described here is essentially equity that hasn't been valued. The lender expects to convert the debt to equity. In contrast, the traditional bridge loans typically employed by companies that have burned through their venture financing are essentially debt that must be repaid either through additional financing or cash flow.

The advantages of using convertible debt include:

• Valuation. The use of convertible debt removes the valuation risk for both the company and the investor. The company — by allowing the valuation to fluctuate as a per centage of the next round of financing — avoids the obvious problem of setting the value too low. A fluctuating valuation also avoids the problem of setting the value too high, which can turn off venture capital investors or, more typically, sour the company's relationship with the angel investor if the subsequent round is completed at a lower valuation.
• Speed and expense. The typical convertible debt transaction can be closed in only a few days, compared with the weeks or months invested in the due diligence, negotiation and documentation of a venture capital round. The documentation, which typically consists of a simple purchase agreement and convertible promissory note, is less complicated than that associated with a preferred stock offering. Furthermore, unlike the creation and issuance of a new class of preferred stock, the issuance of convertible notes typically does not require stockholder consent. Finally, the investors tend to conduct minimal formal due diligence, relying on the subsequent investors to turn up any issues that would negatively effect the valuation. Despite the abbreviated due diligence, however, the use of convertible debt does not exempt the company and its representatives from their obligation not to make any material misstatements or omissions of material facts in connection with the sale of securities.
• Uniformity. A start-up that receives multiple small interim investments may end up with a series of investment agreements granting a variety of rights to different investors. In contrast, convertible debt documents typically contain few if any of the investor rights typically associated with venture financing.
• Liquidity and priority. For investors, convertible debt is advantageous because investors may demand repayment if the company does not complete the second round of financing prior to the maturity of the note. This arrangement gives the company a strong incentive to complete the second round of funding in a timely way, so the investor won't call its loan and force the company into bankruptcy. While beneficial to investors, this arrangement limits the company's business development options by locking it into development on a scale and in a time frame calculated to attract a larger institutional investment.

In bankruptcy, convertible debt remains debt, and lenders are entitled to a claim ahead company shareholders. This benefit to investors should not be overstated, however, as the typical start-up will have few, if any, assets to repay its debt in the event of a bankruptcy. In addition, given the nature of the instrument, it is possible that a bankruptcy court could treat the debt as equity, placing it behind the other debts of the company in priority of repayment.

The use of convertible debt does have a few drawbacks however, which include:

• Taxation of interest. The interest that is converted into company stock will be taxed as interest income to the noteholder. But if the investor invested the original principal amount of the convertible note to purchase the same number of shares of stock as are issued upon conversion of the principal and interest, they would not be subject to taxation on such purchase.
• Dilution. If a start-up issues a large amount of convertible debt with a conversion discount, the convertible debt itself could drive down the valuation in the subsequent institutional round. If the company has issued a large amount of convertible debt with a conversion discount to the next round of preferred stock financing, the venture capitalists will have difficulty calculating the dilutive effect of the convertible debt.

For example, a venture capital fund is looking at investing in two companies, Company A and Company B, each with four million shares of common stock outstanding and onem shares reserved for issuance under their incentive stock option plans. Each company has a pre-money valuation (the valuation before the investment) of $5m, or $1.00 per share. Company A has issued a $200,000 convertible note with a 15 per cent conversion discount. Company B has issued $2m in convertible notes with a 15 per cent conversion discount. When calculating the price per share for each company, the venture capitalist will need to factor in the dilutive effects of the convertible debt. The calculation for Company A and B would be as follows:

In the case of Company A, the dilutive effect of the convertible debt was below $0.01 per share and as such would probably be ignored by the investors in the subsequent round. In Company B's case, however, the dilutive effect of the convertible debt was over five per cent of the total value of the company. The conversion discount, because it is calculated as a percentage of the value in the next round of financing, is a circular function. The higher the amount and greater the discount, the lower the value of the shares in the next round, which in turn leads to a lower conversion price for the convertible debt. The lower the price of the shares in the next round, the more shares are issuable upon the conversion of the convertible debt, which in turn leads to an even lower price for the new shares.

Convertible debt provides a fairly simple solution to some of the valuation and timing issues faced by entrepreneurs and investors alike. Given today's difficult financing environment, the use of convertible debt is likely to continue to grow as attorneys, accountants, entrepreneurs and investors become more familiar with the structure.

Michael Fieweger is an attorney in the corporate and securities group in the Chicago office. Mr. Fieweger's practice focuses on representing high growth companies in emerging industries from formation through initial public offerings as well as acquisitions and sale transactions. He counsels mature companies in establishing joint ventures and other entrepreneurial initiatives, with an emphasis on Internet, e-commerce, telecommunications and other technologies. Mr. Fieweger represents venture capital funds, later-stage equity funds, institutions, angels and hedge funds in their global investment activities. michael.j.fieweger@bakernet.com