INSIGHT: Convertible Notes Are Coming of Age

Fenwick & West LLP has released a survey of market terms and common provisions in convertible debt financings for emerging companies. See Convertible Debt Terms – Survey of Market Trends 2017/2018. In short, deal sizes are up, and investors are seeking more protections.

Background: Preferred Stock vs. Convertible Debt

A convertible note is short-term debt that converts into equity of the issuer in the issuer’s next round of preferred stock financing. The conversion usually occurs at a discount to the price paid by the investors in the preferred stock round in order to compensate the noteholders for taking a risk on a startup company.

Because of this seemingly simple structure, convertible notes are a common way for companies to raise initial financing. In many cases, such “First Money” financing comes from friends and family, but increasingly it comes from sophisticated angels and institutional investors.

From a founder’s perspective, a convertible note is superior to a priced round (of Series Seed Preferred Stock, for example) because the documentation is simpler, the legal fees are lower, it sidesteps the need to put an official valuation on the company, and it gives noteholders fewer economic and control rights than preferred stock investors are typically able to negotiate.

No Longer Just for Small Investments

Even for raises at a company’s earliest stages, investment sizes have increased. This mirrors a long trend in venture capital financings generally – median round sizes continue to go up across the board, from Series Seed rounds to much later ones.

At later stages, convertible notes typically serve as a “bridge” between financing rounds – to facilitate cash flow while negotiations are underway with new equity investors, for example. However, the market is also seeing convertible notes substituting for equity rounds at later stages in mature private companies. (See, for example, details of WeWork’s recent $1B convertible debt financing.)

On balance, the increasing prevalence of convertible notes can be seen as pro-issuer.

However, as issuers find themselves negotiating ever larger sums across the table from increasingly sophisticated investors, the ‘market’ on some terms of these supposedly simple instruments has shifted and become more complex.

Ways Convertible Notes are Becoming More Investor-Friendly

Conversion Pricing

Most convertible notes (at all stages) offer the noteholder a discount upon conversion of the note into equity in a later round of financing. This discount is typically 15-20%. At the First Money stage, sophisticated investors generally ask for (and get) either-or treatment, allowing them the more favorable economics of either a conversion discount or a valuation cap at conversion.

A valuation cap addresses the scenario where an early investor takes a convertible note with a modest discount and by the time of the next preferred stock financing, the company’s valuation has skyrocketed, resulting in the noteholder converting into a much smaller percentage of the issuer’s equity than anyone anticipated at the time of issuance. Setting a valuation cap allows an investor to get comfortable that this extreme outcome won’t occur; the cap should be high enough, however, that the issuer can take comfort that the noteholder’s conversion won’t be excessively dilutive in other scenarios. The current median valuation cap in First Money convertible notes is $7.25M.

For later-stage Bridge notes, the valuation cap (on top of the discount) is still a minority provision, but other nuances have arisen, such as discounts that ratchet up over time as the period between the note and the financing event (financing, acquisition, IPO) increases.

What Happens in a Change of Control?

On a sale of the company, most convertible note deals provide for a premium payout to the noteholder that is a multiple of the principal. The amount of the premium is typically .5x-1x the outstanding principal balance of the note (in addition to repayment of the outstanding principal balance and accrued interest). The amount of this premium has remained steady, but the number of notes that give the investor this premium has trended up over time. It now appears in roughly 70% of all convertible note transactions.

Additionally, a majority of notes now give the noteholder the option to convert into equity upon a change of control (in lieu of taking the premium payout).

Liquidation Preference Windfall

A majority of notes allow noteholders to convert into the same series of equity as the new preferred stock investors. If the noteholders converted at a discount, then the liquidation preference on their new preferred shares may be more than the amount they paid for the note, resulting in a “liquidation overhang.”

An overhang situation can be averted by having noteholders convert into a series of “shadow preferred” with a different liquidation preference or by having the notes convert into a combination of preferred and common stock, with the common stock representing the discount portion. However, these ‘remedies’ remain distinct minority provisions.

Conclusion: Be Prepared to Negotiate a ‘Simple’ Convertible Note

Any legal matter that can be done on standard, simple documents with little negotiation can be done relatively cheaply. This is still an argument in favor of using convertible notes, but with their increasing popularity and the overall trend toward larger financing rounds has come increased investor wariness and appetite for negotiation.

Alicia Ryan is the knowledge and innovation delivery manager at Fenwick & West. She works primarily on knowledge management and business analytics initiatives in the firm’s corporate group, including formalizing and expanding the group’s knowledge base and assisting in the implementation of cross-functional projects designed to increase the accessibility of information and expertise within the firm. Kristine Di Bacco is a corporate partner at Fenwick & West. She represents emerging technology companies primarily in the consumer Internet, e-commerce, FinTech, digital health, consumer hardware and software sectors. Her practice includes a broad range of corporate transactional matters, including the formation of new startup companies, venture capital financings, mergers & acquisitions and public offerings.