Editor’s Note: We’ve got a fantastic lineup of speakers on tap for GeekWire’s Startup Day, taking place Saturday, Sept. 22nd at Meydenbauer Center in Bellevue. Among the entrepreneurs on the agenda are Box CEO Aaron Levie; Zulily CEO Darrell Cavens; and many others. It’s going to be an informative and high-energy day for those in the midst of building their startups (or those unsure about taking the plunge).
As Startup Day approaches, we’re highlighting some of our favorite talks from past events. This talk comes from Chris Hurley of Beacon Law and covers the basics of convertible debt notes. What are they? How are they structured?
The difficulties around raising money in Seattle has long been talked about, most recently highlighted by startup vet Tony Wright’s decision to leave Seattle for better terms in Silicon Valley. Knowing all of the options out there and how they work can help you move through the time consuming task of raising money and get you back to building your company.
Below are some notes from the talk (the video of the entire talk is above):
1. Convertible debt is just that, debt: “It’s a hybrid of part debt part equity. But until it converts, it’s debt. What does that mean? It means you have got to pay it back. There is a maturity date and if you don’t convert it via metrics or milestones that would force the conversion or the investor doesn’t elect to convert, you owe that money back. It’s a liability on your balance sheet. Say you get acquired or you have to wind down. That debt sits on top of the capital structure. It gets priority over paying out all the other shareholders. The punchline here is, it’s debt until it’s converted.”
2. It has the ability to convert to equity: “Convertible debt does convert into equity, but what type of equity does it convert into? Typically it converts into the equity security that you are going to issue in the real raise that you do some number of months later. That’s usually referred to in the documents as “the next equity financing.” Usually there is some minimum amount, so it will convert automatically into Series A preferred stock when the company closes on at least *fill in the blank* ($750,000) of Series A preferred stock. In that example, the investor is forcibly converted into that Series A preferred stock once that company has raised the $750,000 Series A. If you don’t hit that $750,000 auto convert trigger, it still stays as debt. It usually converts into that Series A preferred stock typically on the same terms and conversion price as the other investors that are investing in that Series A round. Once the convertible note is actually converted into equity it’s then removed as a liability on your balance sheet and it moves to the right side of your balance sheet as shareholders equity and shareholders capital.”
3. Look at it like an equity investment: “Convertible debt psychologically from an investors standpoint, really is an equity investment. They don’t expect to just get their money back with some interest. They want an equity type return. The styling as debt in the beginning is only a means of getting them comfortable that they’re on top of the capital structure until you fill the entire meaningful round. They don’t want to be the early bird in the round and then get screwed if the company doesn’t raise money and goes off a cliff.”
4. It favors entrepreneurs: ”You hear a lot of stuff like “Convertible debt has won the great debate and it’s the way to go.” I think some of that is overblown because there is not one solution that fits all situations. Convertible debt is very attractive from the company’s perspective as long as you avoid certain problems and situations. In general, why is it more attractive to a company? Well, you get the money and have it as operating capital and if you do what you say you’re going to do and hit your plan, your company valuation should go up. That means that per share conversion price should also go up meaning you’re giving up less of your company for the same dollar.”
5. When is convertible debt appropriate? “It’s appropriate right at the beginning when you’re just coming out of the gates and you’re approaching friends and family who are betting on you more than the actual opportunity.
Second is a bridge situation when you’re just basically funding a gap to some very clearly articulable, visible milestone. It could be you’re going to land this big customer deal in two or three months. There’s very little risk of that not happening but it’s going to take two or three months to get there and you’re bridging that situation. The bridge analogy is you can see land on the other side of the water as opposed to a pier situation where the land just goes out into the fog and you can’t really see what on the other side.
Also, when the company is a hot deal and you have a lot of demand to invest in the deal, it’s a no brainer to do a convertible debt deal, unless you give away to many equity kickers and make the all in cost of capital too low, or you put in to many constraints on valuation that interfere with the free market in setting the price in the next equity financing. Remember, one of the things you’re doing with convertible debt is kicking the valuation question down the road. You’re not valuing it now, you’re valuing it later when you’ll supposedly be worth more money.”
Look for more talks from the Startup Day archives in the coming weeks, and make sure to join us Sept. 22 for Startup Day 2012. Early-bird rates expire Wednesday, so make sure to get your tickets today!