Why use convertible debt?
A convertible funding round is generally a more efficient process than traditional equity or debt fundraisings, with convertible loan notes typically being priced more competitively than long-term institutional debt and being subject to fewer conditions.
Crucially in an early-stage business they allow for the valuation to be determined at a future point in time, upon conversion of the notes. Where the business is at a pre-revenue or development stage this can be useful in giving both investors and founders comfort that the business will have time to develop and demonstrate its model.
In addition, convertible notes are non-dilutive to shareholders at the point of issue. However, the conversion metrics are key, and all shareholders should be aware of the potentially dilutive effect.
Conversion mechanisms
Central to the function of convertible notes are the provisions by which the loan is converted into equity. Conversion is usually triggered automatically on the occurrence of a further funding round or an exit event. Usually (although not always) the notes convert into the class of equity that other investors are allotted at that time. However, the notes may also include a discretionary conversion right, afforded to the investor or the company if sufficient time passes without a conversion event; or may convert into a subordinate class of equity to a new senior investor.
The negotiation of these conversion provisions represents the fusion of various factors: what stage is the company at? What is the capital required for? Is a future funding round proposed? What are the timelines to achieve these milestones?
Agreeing an instrument which satisfies both parties may present challenges. The duality of being able to elect creditor or shareholder status is desirable to an investor. However, founders will desire control over their balance sheet and the ability to manage dilution by triggering conversion rights at a point of their choosing.
Ultimately, the agreed terms will be a product of the business's strength, the underlying commercial rationale for the note issuance, and pricing.
How to approach conversion pricing
The price per share at which the debt will convert into equity (the conversion price) is the key commercial term of the notes.
Typically, the conversion price is set by reference to the next issue of shares, on the basis that an incoming investor will determine the market value of the business at that time.
Market practice is to apply a discount to that price for the noteholders, in recognition of the risk taken by investing through the convertible round. A discount of 10% - 20% of the subscription price paid by other subscribers is not uncommon, although this is variable, with a lower discount applying if the company achieves a higher valuation ("descending ratchet").
The discount rate, along with discretionary powers and the conversion class of equity, are all tools for negotiation. Investors may, for example, be prepared to waive discretionary privilege in favour of a greater discount, or vice versa.
Other key terms
While generally regarded as a 'light touch' instrument as regards investor protections, noteholders may require certain information rights during the life of the notes, for example monthly management accounts, and updates on material matters.
Due diligence is likely to also be light touch, however an investor may wish to see key legal, IP, regulatory or commercial documents to support the business case. Founders should also be aware that any information provided to an investor during the process could be deemed an inducement to invest that the investor has relied upon, and therefore should seek to ensure the accuracy of any factual information, and that any opinions or forecasts are prudent and can be supported by evidence.
Founders may also be asked to give warranties regarding such matters as the accuracy of the information provided and the legal status of the business. It is advisable to seek advice regarding warranties, as these can attract personal liability for founders, which can be mitigated by a formal disclosure process.
In summary
Convertible loan notes are a commonly used and very useful instrument for early stage and high growth businesses looking to raise short-term development capital quickly. They allow flexibility and the headroom to begin scaling a business - although they are rarely a long term funding solution, and are usually a stepping-stone to a more substantive balance sheet event.
As well as the financial benefits of increased liquidity, they also allow businesses to build relationships with investors, giving them a 'seat at the table' on their growth journey, and access to investors' expertise as an experienced partner.
Commercial terms can vary greatly and will be a product of the strength of the business and the investor's appetite for risk. Choosing the right partner, being open and transparent with investors, and maximising the company's strengths are key to a successful negotiation.
DWF has a market leading venture and growth capital practice in the UK, supporting investors and companies across several sectors including financial services, technology, media and telecommunications, life sciences and healthcare and real estate and infrastructure. If you have queries on any of the issues covered in this article please contact one of our experts: Dhruv Chhatralia BEM, James Bryce, Caroline Colliston (as the tax representative for the corporate articles), Darren Ormsby, Gemma Gallagher, Gary MacDonald, Paul Pignatelli, Scott Kennedy, Will Munday, Alex Stoughton, Francesca Kinsella, Graham Tait and Rosie Spencer.
Authors: Lily Maffei, Narissa Pankhania, Matthew Kernohan and James Bryce.
