Convertible debt terms Flashcards
Convertible debt
A loan that has the ability to convert into stock in a future equity financing round. It usually converts at a discount and pays the investor a modest interest rate. Some argue it is easier as no valuation is being set, it has few, if any of the rights of preferred stock offerings and requires a lot less paperwork and legal fees.
Discount
The discount the debt holder gets at the next funding round. Usually implemented by a straightforward discount or by using warrants. Typically 10-30%, and occasionally it increases over time
Valuation cap
A ceiling on the conversion price of the debt. Used by early stage investors to ensure the price of the next financing is appropriate to reward their risk
Term
Conversion mechanics. The time limit for the company to sell equity if it wants the debt to be automatically converted. Debt holders often enjoy superior control rights.
Amount
Conversion mechanics. The amount the company must raise for the debt to be automatically converted.
Warrants
options to purchase shares often used to grant discounts on convertible debt. Typically the debtor receives shares from conversion of the debt, along with warrants to purchase additional shares at the price of the previous/upcoming round
Warrants - term length
The length of time the warrants are exercisable for. Typically 5-10 years. Shorter is better for entrepreneur, longer better for investor.
Warrants - Merger considerations
What happens to the warrants if the company is acquired. Outstanding warrants that survive a merger are often a bone of contention with the acquirer.
Safe
Simple Agreement for Future Equity. Created by Y Combinator as an alternative to convertible debt. Basically an unpriced warrant in the company. Eliminates risk of maturity date for entrepreneurs. Typically lacks a pro-rata right too
Pre-money method
A method for conversion of debt. In this case, the pre-money valuation is set and the conversion price is based on that. In practice, this means the investors who are coming in on the round where the debt is converted get diluted
Percentage-ownership method
A method for conversion of debt. In this case, the investor’s percentage is fixed, so the founders are diluted. Essentially the same as a fixed post-money valuation. Means more for the noteholder too as the defacto share price is pushed down
Dollars-invested method
A method for conversion of debt. In this case, the post-money valuation is fixed as the pre-money plus the dollars invested by the new investors, plus the principal and accrued interest on the notes that are converting. Founders and investors are diluted a little. The rationale is that converting debt without a discount doesn’t change investor’s percentage of the enterprize value
