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Bob Bishop, Goodwin Procter LLP & Founders Workbench @BostonBishop Ben Littauer, Boston Harbor Angels & Walnut Venture Associates @LittWeb Olivia Dufour, NTT Data @Olivia_Dufour

Convertible Debt

Ben Littauer: viz.me/littauer @TCNupdate #tcnLIVE

Review  of  an  Equity  Deal  

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•  Company  and  Investors  agree  on  a  “pre-­‐money  valua=on”  (PM)  which  leads  to  a  price  per  share  

•  Investors  put  in  $X  •  Investors  then  own:  X  /  (X  +  PM)  of  the  company  

Example:  PM  =  $1M  X  =  $0.5M  Investors  own  0.5/1.5  =  33%    Remember:  New  issuance  NOT  transfer  of  shares  

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What  is  Conver=ble  Debt  

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•  Many  seed-­‐stage  companies  use  an  instrument  called  Conver=ble  Debt.  

•  Conver=ble  debt  is  not  tradi=onal  bank  debt  •  Converts  exist  for  several  reasons  

–  Investors  and  Entrepreneurs  find  it  hard  to  agree  on  a  PM  valua=on  

– Some=mes  quicker  and  cheaper  to  document  than  equity  deals    

– May  allow  for  “rolling  close”  accre=on  of  investment  @TCNupdate #tcnLIVE

Basic  Structure  of  Conver=ble  Debt  

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•  Investor  loans  $  to  Company  an#cipa#ng  another  round  of  funding,  usually  triggered  by  the  size  of  the  next  raise  

•  Investment  accrues  small  interest  (6-­‐8%  typical)  •  Debt  is  usually  unsecured  and  inferior  to  most  other  debt  

•  When  the  funding  occurs,  investment  +  interest  convert  to  equity  on  same  terms  as  new  money,  usually  at  a  discount  (15-­‐25%  typical)  and  subject  to  a  maximum  valua=on  (cap)  

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Structure  of  Conver=ble  Debt  Ex1  

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Example:  •  Investors  loan  $200K  to  Company    •  20%  discount;  $2M  cap  •  As  of  conversion,  interest  of  $10k  has  accrued  •  Next  Round  PM  =  $2m;  1M  shares  before  financing  •  New  Shares  offered  at  $2/each    At  Conversion,  Noteholders  receive  210K  /  1.60  shares  =  131,250  shares  

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Structure  of  Conver=ble  Debt  Ex2  

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Example:  •  Investors  loan  $200K  to  Company    •  20%  discount;  $2M  cap  •  As  of  conversion,  interest  of  $10k  has  accrued  •  Next  Round  PM  =  $4m;  1M  shares  before  financing  •  New  Shares  offered  at  $4/each;  share  price  at  $2M  

pre  would  have  been  $2/each    At  Conversion,  Noteholders  receive  210K  /  2  shares  =  105,000  shares  Without  cap  would  be  210K  /  3.2  =  65,625  shares  

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Converts–  Complica=ons!  

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•  What  if  only  a  lihle  money  comes  in?  •  When  does  the  debt  convert?  •  What  happens  if  PM  of  next  round  is  huge?  •  Does  the  investor  have  any  say  in  things?  •  What  if  there  is  an  equity  investment  that  doesn’t  trigger  conversion?  

•  What  happens  if  it  never  converts?  •  What  happens  if  Company  gets  bought?  

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Converts–  Solu=ons?  

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•  Caps  and  Floors  •  Default  conversion  price  and  security  at  maturity  •  Open  round,  minimum  close  •  Quick  sale  preferences  (ex.  2x)  •  Governance  provisions  •  Careful  ahen=on  to  conversion  condi=ons  Typical  legal  documents  are  a  Promissory  Note,  a  Note  Purchase  Agreement,  and  (for  exis=ng  shareholders),  a  Shareholder  Agreement  that  codifies  other  condi=ons  of  the  note  (e.g  crea=on  of  board).  

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Converts:  When  Do  They  Work?  

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•  “Bridge”  financing  in  an=cipa=on  of  an  “event”  – Another  financing  – A  big  sale  – Company  sale  

•  Seed  stage  investment  – Valua=on  not  understood  – Rolling  closes  (ooen  with  ratche=ng  caps)  – Proof  points  as  an  “event”  – When  the  investor  loves  the  company  (cf.  exuberant  equity  valua=ons)  

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Bob Bishop, Goodwin Procter LLP & Founders Workbench @BostonBishop Ben Littauer, Boston Harbor Angels & Walnut Venture Associates @LittWeb Olivia Dufour, NTT Data @Olivia_Dufour