FINANCING 101 FOR STARTUPS: PART 2 – CONVERTIBLE DEBT FINANCINGS
Startups need capital to grow and scale their business. In this three-part series, we will walk you through the most prevalent methods of raising capital at an early stage for emerging growth companies. This series will provide founders with a high level understanding of three common investment structures: SAFE financings, convertible debt financings and equity financings.
In this post, we will discuss convertible debt financings.
A convertible debt instrument is similar to a SAFE instrument in that it includes a conversion mechanism on a future financing or liquidity event. The major distinctions between convertible debt and SAFEs are that convertible debt is repayable (often with interest) and can be secured by a charge against the company’s assets in the event the company becomes insolvent before the debt is repaid or converted. For these reasons, convertible debt can be a more investor-friendly way to structure a financing if the parties cannot agree on a set company valuation, and often provide a way in which investors can recalibrate risk as opposed to a SAFE investment.
A convertible debt instrument typically has a negotiated interest rate and maturity date. In most cases, accrued interest will convert alongside the principal amount of the note in the event of a future financing, a liquidity event or on maturity. Almost all standard convertible debt instruments automatically convert in the context of a future equity financing, although a minimum financing threshold is often recommended to avoid unintentionally converting debt in connection with a small bridge financing or subscription. Conversion into a liquidity event or on maturity can be either automatic or at the option of the investor or the company based on the where the parties land in the context of negotiations. In some cases, a convertible debt instrument may only be repayable on the maturity date, with no option to convert for either party.
Convertible debt instruments are similar to SAFEs in that they often convert into equity at either (A) a discount to the price paid on a future equity financing or liquidity event, (B) at a valuation cap, or (C) both. In contrast to SAFEs, the calculation of the “Valuation Cap” can vary widely with respect to whether a conversion based on the Valuation Cap should account for other converting securities, allocated and unallocated options or new unallocated options to be created at the time of a future equity financing.
In the event there is more than one investor participating in a convertible debt financing, the company and investors will need to address intercreditor arrangements if the debt instruments ultimately need to be repaid or the company defaults on their terms.
Convertible debt instruments can be secured or unsecured. A secured convertible debt financing will be more costly for the company at the time of the financing, and can also add complexity in the context of obtaining future debt or bank financing, where a priority or intercreditor agreement will become necessary between any existing convertible debt holders and a new institutional lenders. If the convertible debt instruments are secured, the lender (or your legal counsel) will register a security interest in the location where your assets are situated. In the event the company defaults on the loan or becomes unable to repay, the convertible debt holders can realize on the company’s assets (which assets could include land, an office, equipment, intellectual property, vehicles, etc.)
Convertible debt financings are a useful way for a company to access capital from investors who are more risk adverse. However, because terms can widely vary, it is best to engage experienced advisors familiar with venture financing to provide you with insight on market terms. If you are in early discussions to raise capital by issuing convertible debt, please feel free to reach out to Chase Irwin (email@example.com) or Sean Del Giallo (firstname.lastname@example.org) at Dentons Canada LLP and we’d be happy to discuss.