In Part I of our “Why Start-Ups Use Convertible Debt” series, we discussed one of the typical start-up financing structures, the sale of common stock, along with the issues that should be considered when setting a valuation. Based on the issues that arise with the sale of common stock, another financing option that tends to make sense for start-up companies is the sale of convertible debt.

In a convertible debt financing, the Company prepares a simple convertible promissory note purchase agreement that contains the same basic representations about the company that would be contained in a common stock purchase agreement and the statement from the investor that he or she understands that this is a risky investment and has had the opportunity to evaluate the opportunity. The convertible promissory note purchase agreement also contains the form of promissory note that would be given to each investor. Each investor signs the same purchase agreement, and the company simply “peels off” the form of note for each investor and inserts the investor’s name, amount of the loan, and date of the investment. Companies often leave these financings open over a period of time – often over 1 year – and will pull in new investors on a rolling basis. Eventually the Company will mature to the point of being able to raise a preferred stock (Series A) round from a venture capital fund or other institutional investor, at which point the outstanding debt will automatically convert into the Series A round.

Typical convertible debt terms provide for interest on the loan – often 6-8% – that accrues and is payable in one lump sum at maturity or conversion, in which case it simply converts into shares along with the principal as discussed below. The debt will have a term of 1-3 years. If the debt is outstanding at maturity, it is typically due and payable upon the request of the holders of a majority of the debt then outstanding under this facility. This is a very important provision and one that should ripple throughout the convertible debt arrangement. By requiring debt holders to act by majority approval, it can prevent a rogue investor from demanding payment from the Company at a time when the funds are not available and such demand could potentially shut down the Company.

If the Company completes a “qualified” equity financing prior to maturity – often at least $1M of new capital from investor in exchange for preferred stock – the debt will automatically convert into the new financing shares. The price at which the debt converts is often the lesser of (i) a discount on the price per share of the preferred stock (typically a 20% discount) and (ii) the “Cap Price”. The Cap Price is an agreed upon maximum company valuation that is locked in for the convertible debt investors. This way, if the Company takes off and completes a qualified financing raise at a $25M valuation, and the Cap Price is based on a $5M valuation, the debt will convert at the Cap Price. This is because a price per share that is based on a $5M valuation will be significantly less than a 20% discount on a price per share that is based on a $25M valuation.

Check back soon for Part III of our convertible debt series, “The Virtues of Convertible Debt for a Start-Up.”