What are the different options for convertible debt financing that startups usually encounter?

QUESTION:

I’m talking to angels now about convertible debt financing. What are the different options for convertible debt financing that startups usually encounter?

ANSWER:

Russell Greenman

Russell Greenman

by Russell Greenman at Raines Feldman LLP

Convertible debt can be seen as a middle ground between debt financing and equity financing. In very simple terms, convertible debt is a loan that can be converted into equity upon, among other events (see below), a future financing. A convertible debt financing will avoid the pitfalls of valuation at such an early stage and may prevent early investors from being diluted, further, early investors in convertible debt are interested in maximizing the conversion discounts/bonuses. Some of these discounts/bonuses include, most commonly: (i) discount on the equity price at the time of conversion (often 20-25 percent per year), (ii) cap on equity price that the debt converts into, (iii) warrant coverage, or (iv) some combination of (i) through (iii). Some things to think about:

1. Conversion Discounts – Should you offer a discount upon conversion (or how much discount to offer)? Remember, you may not be able to attract investors without a discount, but if the discount is too great, future investors may frown upon this discount and reduce your valuation accordingly.
2. Conversion Triggers – Will conversion be mandatory or elective? What business milestones will cause conversion? Some to think about are revenue goals, financing goals or other similar business milestones.
3. Term of Debt – How long will the debt be outstanding? What happens if the term expires and no conversion event has occurred? Should the debt holder have the ability, in their own discretion, to convert the debt into equity?

Always remember, that different companies (different situations and different facts) call for different terms in any capital and/or financing structure. As always, it is hard to say what is “fair”, and you should reach out to your attorney and other entrepreneurs in your area or sector to get an idea of what terms are currently “standard.”

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