I had a chance to review the terms of the convertible debt documents used in the transaction.

Below are the major points:

Interest rate:  higher of 2% or AFR (applicable federal rate).  (I think the intention to keep the interest rate as low as possible.  In the past, interest rates on convertible debt seemed to be in the 7% to 10% range, but I recently saw a VC fund offer $500K of convertible debt at a 3% interest rate.)

Maturity date:  two years or maturity date of other convertible notes.  (This also seems to be fairly company favorable as most convertible debt seems to have a one year term.)

Automatic conversion:  on a $1M equity financing with no conversion discount and no price cap, provided that the transaction documents provide for a right to purchase a pro rata share of future financings.  (I don’t know how to get a better deal than this.)

Optional equity conversion:  on other equity financings with no conversion discount and no price cap.  (Once again, I don’t know how to get a better deal than this.)

Optional maturity conversion: into Series AA Preferred Stock based on a $5M valuation.  The Series AA has a 1x non-participating liquidation preference, weighted-average anti-dilution, basic protective provisions (adverse changes to the Series AA, number of shares of Series AA, or merger/asset sale), right to maintain proportionate ownership, ROFR/Co-Sale rights and basic information rights.  (Please note that these are generally the terms of the Series AA Preferred Stock financing documents that Y Combinator previously published.)

Optional change of control/IPO conversion:  into common stock at the lesser of (A) fair market value (based on change of control or IPO), or (B) $5M valuation.

I can’t think a good reason to turn down this deal, unless a company is never planning to raise outside investment.  Congratulations to the Y Combinator companies that are benefiting from these terms.

Update:  In the second batch of YC companies, a “most favored nation” clause was added so that StartFund receives the benefit of terms negotiated by later convertible debt investors.

Convertible debt with a price cap seems to be the preferred structure for early-stage financings

Over the last 12 months, I’ve noticed a trend where early-stage startup companies raise seed financings of between $250K and $1M using a convertible note with a price cap.  In fact, it seems very rare to see a convertible note without a price cap these days, although it was fairly common to raise convertible debt without a price cap a couple of years ago.

Paul Graham has sparked some discussion on the topic in August 2010 when he tweeted “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”

Seth Levine asks, “Has convertible debt won?“  Seth points out that “the convert cap reflects a premium to the current fair market value of the business. One super-angel I talked to told me that while a year ago these caps “approximated what I’d pay in equity” that they’re now “33% higher than what I’d normally agree to pay now.”

I have also heard that many of the companies in the YC batch that Paul Graham was referring to have been dictating convertible debt terms with price caps in the high single digit million range when pitching to angel investors.  This leads me to believe that there is a mini-bubble in the early stage financing universe.

Is a priced Series A financing a valid alternative?

A logical alternative to convertible debt is a priced Series A preferred stock financing. Mark Suster does a good job analyzing whether convertible debt is preferable to equity, and concludes that convertible debt is better. I’ve pondered the issue of convertible debt vs equity and come to the same conclusion.  Most commentators generally seem to be concluding that convertible debt with a price cap is better than a priced Series A round.

However, Ted Wang points out that Series Seed documents are better than capped convertible notes.  (I’ve used the Series Seed documents twice in the last six months and have managed to keep company-side legal fees under $15K on both of the deals, although I suspect that the documents for the “real” Series A financing will end up being more painful to draft as the Series Seed documents don’t scale well in later rounds.)  Fred Wilson, while he doesn’t endorse the Series Seed documents, says that Union Square Ventures has never participated in a convertible note deal.  Jason Mendelson points out that the use of debt fundamentally changes the fiduciary duties of managers and board members of the company, as executives and directors of “insolvent” companies face potential suits from various creditors.

Tweaking convertible debt so that common stock (instead of preferred stock) is issued for the conversion discount in order to limit liquidation preference overhang

Given that convertible debt with a price cap seems to be firmly entrenched these days as a typical structure for early-stage financings, I’ve pondered some methods to make the structure more favorable to companies.

One issue that has bothered me is that the conversion discounts and price caps result in a company creating more liquidation preference than the amount of money that investors have invested.  For example, if the amount of money raised in the convertible debt financing is large (say $1M), and the conversion discount is 50% (or the price cap is 50% of the Series A valuation), then the company will end up issuing $2M (+ interest) of Series A preferred stock to investors that only paid $1M.  This Series A preferred stock will typically have a 1x liquidation preference, so $2M of liquidation preference overhang will be created as a result of the conversion discount/price cap.

Thus, a company is in a worse situation by using convertible debt with a price cap than if the company simply did a Series A financing at the price cap valuation instead of the convertible debt.

Please keep in mind that there are two principal economic features of preferred stock:  the liquidation preference, and the equity on an as-converted to common stock basis.  Convertible debt with a price cap preserves the investor’s “equity” ownership, but gives the investor extra liquidation preference.

In order to solve this problem, I have resorted to modifying the conversion discount formula in certain deals so that the conversion discount is paid in common stock.  In other words, the principal and interest on the convertible debt will convert into preferred stock with no discount, and the discount portion will converted into common stock valued at the preferred stock price. This is an attempt to make convertible debt with a price cap economically equivalent to a priced Series A financing.

One might note that this is not the exact economic equivalent, as the application of the anti-dilution formula on the preferred stock issued upon conversion of the debt will not be as favorable as if the convertible debt financing was originally done as preferred stock. However, many seed equity financings don’t provide for anti-dilution protection, as the valuations are low to begin with.

[Note: A better way to make convertible debt identical to a seed financing is to have the convertible debt convert into its own series of preferred stock.  In other words, the new investors would purchase Series A and the convertible debt would convert into Series A-1 with an aggregate liquidation preference equal to the principal and interest of the debt (and a liquidation preference per share lower than the Series A price per share).  However, most people don't like the messiness of creating an extra series of preferred stock.]

[Please also note: It probably doesn't make sense to entirely focus on the equivalent theme, as there are plenty of other ways that convertible debt and equity are different. For example, convertible debt has no voting rights, and typically don't have protective provisions. However, seed investors don't seem to mind the lack of these features.]

An example of a term sheet provision to provide for the conversion discount to be paid in common stock and the math involved is below.

Term sheet excerpt:

CONVERTIBILITY:        In the event the Company consummates, prior to the Maturity Date, an equity financing pursuant to which it sells shares of its preferred stock, which are expected to be Series A Preferred Stock (the “Preferred Stock”), with an aggregate sales price of not less than $[1,000,000], excluding any and all indebtedness under the Notes that is converted into Preferred Stock, and with the principal purpose of raising capital (a “Qualified Financing”), then all principal, together with all accrued but unpaid interest under the Notes, shall automatically convert into shares of the Preferred Stock and the Company’s Common Stock at the lesser of (i) 80% of the price per share paid by the other purchasers of Preferred Stock in the Qualified Financing and (ii) the price obtained by dividing $5,000,000 by the Company’s fully-diluted capitalization immediately prior to the Qualified Financing (the “Discounted Purchase Price”).  The total number of shares of stock that a holder of a Note shall be entitled to upon conversion of such holder’s Note shall be equal to the number obtained by dividing (i) all principal and accrued but unpaid interest under such Note by (ii) the Discounted Purchase Price (the “Total Number of Shares”).  The Total Number of Shares shall consist of Preferred Stock and Common Stock as follows (see also example on Exhibit A):

The number of shares of Preferred Stock shall be equal to the quotient obtained by dividing (i) all principal and unpaid interest under the Note by (ii) the same price per share paid by the other purchasers of the Preferred Stock in the Qualified Financing (such price, the “Undiscounted Purchase Price,” and such number of shares, the “Number of Preferred Stock”).

The number of shares of Common Stock shall be equal to (i) the Total Number of Shares minus (ii) the Number of Preferred Stock.

Example:

Assumptions:

Principal + Interest    $1,000,000
Discounted Purchase Price    $1.00
Undiscounted Purchase Price    $2.00

Total Number of Shares:

Principal + Interest ($1,000,000)        =    Total Number of
Discounted Purchase Price ($1.00)        Shares (1,000,000 shares)

Number of Preferred Stock:

Principal + Interest ($1,000,000)        =    Number of Preferred
Undiscounted Purchase Price ($2.00)        Stock (500,000 shares)

Number of Common Stock:

Total Number of Shares             -    Number of Preferred          =    Number of Common
Shares (1,000,000 shares)            Stock (500,000 shares)    Stock (500,000 shares)

Observation 1 — Convertible debt is a bad deal for angel investors

I think many sophisticated angel investors realize that convertible bridge notes do not adequately compensate angel investors for the risk that they take in funding early-stage companies. For example, typical provisions in a company-friendly pre-Series A convertible bridge note financing may include a 20% conversion discount from the Series A price and a 2x return on a sale of company.

Assume the angel investor invests $500K. If the company eventually raises $50M in a Series A financing at a $100M valuation, a 20% discount from that price is not particularly attractive compensation for that investment risk, as the investor would only own about 0.4% of the company after the financing (assuming that the shares issued upon conversion of the bridge were not included in the pre-money fully-diluted share number). Similarly, if the company is sold for $100M, the investor would only receive 2x their investment back (plus interest), or a total of $1M, which would only be 1% of the sale price.

If the investor had invested $500K in a Series A Preferred Stock at a $4.5M premoney valuation, then the investor would own 10% of the company. If the company raises $50M in a Series B financing at a $100M valuation, the investor would own 6.67% of the company post-Series B financing.

Similarly, if the company was sold for $100M before another round of financing, the investor would receive 10%, or $10M.

Observation 2 – Angel investors realize convertible debt is a bad deal so they demand price protection provisions (i.e. a price cap)

Due to the economic results described above, many sophisticated angel investors refuse to do convertible note bridge financings unless the conversion price on the debt is capped.  In other words, an investor may request that the conversion price is the lower of (i) a 20% discount from the Series A price, or (ii) the price per share determined if the valuation was $[X]M.  Typically, the valuation might be some reasonable projection of the valuation range in the eventual Series A financing.  The valuation is typically higher than what would be set if the investor and the company negotiated a valuation at the time of the convertible debt financing, but lower that the expected Series A valuation if the company achieved their objectives.

Similarly, in the event of a sale of company before a Series A financing, a sophisticated angel investor may request that they receive the better of (i) 2x their investment back (plus interest), or (ii) the return if they had invested their money at an $[X]M valuation.

In any event, I think that convertible debt financings are still easier to complete than a Series A financing, so a convertible note with a cap achieves the investor’s objective without the complexity of a Series A financing.

However, the licensing requirements of the CFLL are not triggered by a qualified bridge loan (“QBL”), which is defined as a “commercial bridge loan” made by a “venture capital company” to an “operating company.”  Thus, a venture capital fund that made only QBLs would not be required to obtain a license under the CFLL.  However, a fund that makes other types of loans should be subject to licensing requirements only if those loans cause the fund to be engaged in the business of a finance lender or broker.

In general, a “commercial bridge loan” is any loan that: 

1.         Has a principal amount of $5,000 or more;

2.         The proceeds of which are intended to be used by the borrower other than for personal, family or household purposes;

3.         Matures in one year or less;

4.         Is made in connection with, or in contemplation of, an equity investment in the borrower;

5.         Is secured, if at all, solely by the borrower’s business assets (but not by real property); and

6.         Is subject to the implied covenant of good faith and fair dealing arising under Section 1655 of the California Civil Code.

A venture capital fund generally will be a “venture capital company” if it: 

1.         Engages primarily in the business of promoting economic, business, or industrial development through “venture capital investments” or the provision of financial or management assistance to operating companies;

2.         At all times maintains at least 50 percent of its assets in venture capital investments or commitments to make venture capital investments;

3.         Maintains or, assuming consummation of the equity investment to which a commercial bridge loan relates, will maintain a material equity interest in the borrower;

4.         Approves each loan made to an operating company through the fund’s board of directors, executive committee, or similar policy body, based on a reasonable belief that the loan is appropriate for the operating company after reasonable inquiry concerning the operating company’s financing objectives and financial situation; and

5.         Complies, when making the loan, with all applicable federal and state securities laws.

A ”venture capital investment” is “an acquisition of securities in an operating company that a person, an investment adviser of the person, or an affiliated person of either, has or obtains management rights to.”  The statute provides no definition of the term “management rights,” but the term is well defined in other places.  The first is the definition of “venture capital operating company” under the Employee Retirement Income Security Act of 1974 (“ERISA”).  The second is Rule 260.204.9 of the California Code of Regulations, which deals with the regulation of investment advisors.

In general, a borrower is an “operating company” if it: 

1.         Engages (directly or through subsidiaries) in the production or sale, or the research or development, of a product or service other than the management or investment of capital;

2.         Uses all of the bridge loan proceeds for the operations of its business; and

3.         Approves the bridge loan through its board of directors, executive committee, or similar policy board, based on a reasonable belief that the loan is appropriate for the borrower after reasonable inquiry concerning the borrower’s financing objectives and financial situation.

In the example of 20% conversion discount versus 25% warrant coverage, the formulas below apply.

The value of investment with the 20% conversion discount = {[Investment amount] / [0.8 * Series A price]} * [exit value of Series A]

In other words, the above formula represents: how many shares of Series A do you get after the discount * the exit value of Series A per share.

The value of the investment with 25% warrant coverage = {[Investment amount / Series A price] * [0.25] * [exit value of Series A - Series A warrant exercise price]} + {[Investment amount / Series A price] * [exit value of Series A]}

In other words, the above formula represents: the exit value of the Series A warrant shares (taking into account the warrant exercise price) + the exit value of the Series A shares issued upon conversion of the note.

If Series A price (and Series A warrant exercise price) = $1.00, then the 20% conversion discount will always be slightly more valuable than 25% warrant coverage. (This is simple algebra to solve for the above equation.)

There is a reason why I think corporate attorneys need strong math skills. I hope someone will check the above math and concur or correct me.

Company counsel fees could be under $10K if there is no negotiation on terms and a single investor to over $30K if there is extensive due diligence and complexity. Company counsel fees on convertible loans may exceed $100K for later stage companies or extremely complicated deals. Company counsel fees are higher than investor’s counsel fees because company counsel drafts documents (on the West Coast) and needs to solve diligence issues. In addition, there is typically some deferred corporate housekeeping that needs to be done by company counsel before the financing.

In order for the rights of the investor to become enforceable against third parties with respect to the collateral, the holder must “perfect” the security interest. Perfection is typically achieved by filing a document called a UCC financing statement with the secretary of state where the corporation is located. The investor will not be able to enforce its rights in the collateral against third parties, such as other creditors who claim a security interest in the same collateral or a trustee in bankruptcy, without “perfecting” the security interest.

Security interests are rare in seed stage convertible note bridge financings and not particularly common in bridge loans for venture backed companies, unless the loan is particularly risky, such as in connection with a bridge to a sale of company when the company is running out of money.

Traditionally, equipment leasing facilities and equipment loan facilities, which are secured solely by the equipment financed, are not treated as senior indebtedness (nor are they typically subordinated to other forms of a company’s indebtedness). However in certain circumstances, this type of financing may be deemed to be senior indebtedness (i.e., if secured by a blanket lien).