Nivi · May 30th, 2007
Summary: Convert your debt into equity if you can’t pay it on time. Determine your lender’s return if you sell the company early. Reserve the right to raise more debt. Finally, reserve the right to amend the debt agreement.
Previous convertible debt hacks have discussed
- The benefits of debt in a seed round
- The economics of debt vs. equity
- Making your debt attractive to investors
- Keeping your Series A options open
This article collects 4 convertible debt microhacks you can use to supersize your convertible debt.
Convert the debt into equity if you can’t pay it on time.
Your Series A financing may not occur before the debt comes due. In that case, the company should have the right to
- Pay the debt and interest back, or
- Convert the debt to common or preferred stock at a predetermined valuation.
Note that the company makes the decision to convert the debt to equity—not the investors. This term lets the company avoid defaulting on the loan. See this great article by Yokum Taku for more details.
Determine your lender’s return if you sell the company early.
The company may be acquired before the Series A. In that case, the debt holders should have the right to
- Get their money and interest back, or
- Convert their debt to common stock at a predetermined valuation.
The lender chooses between these two options at the time of sale. This term simulates the liquidation preference of preferred stock. You can use the same valuation that you negotiated in the microhack above.
Reserve the right to raise more debt.
If you are raising $500K in debt, you should reserve the right to use the same documents to conduct subsequent closings up to some cap, say an additional $250K of debt.
Many debt agreements don’t require you to get the current lender’s permission to raise more debt in the future. But it is better if your current debt investors clearly understand this possibility. And it will be cheaper if you can use the same documents to close the additional debt.
Reserve the right to amend the debt agreement.
The company and a majority of the lenders should be able to amend the debt agreement and make the changes binding upon the other lenders. This is much easier than getting agreement from every single debt investor.
Examples of amendments include changing the date that the debt matures or the size of a qualified financing.
This term is especially useful if one of your angels is inexperienced or malicious. Without this term, he may try to negotiate a better deal when you request the amendment.
What are your debt microhacks?
Use the comments to share your experiences and questions regarding debt microhacks. We’ll discuss the most interesting comments in a future article.
Topics Convertible Debt · M&A
Don’t you think that you are opening a Pandora’s box as soon as you start to discuss valuation at all in reference to a note? It seems to me that the whole point of taking a note early in the process is to avoid the problem of under or overvaluing the company while it is hard to do it effectively. As soon as a number gets used for conversion purposes it seems to me to kill the whole reason for using a note in the first place.
I think there are a lot of benefits to debt in a seed round.
The valuations mentioned in these microhacks only pertain to situations where your Series A doesn’t happen in time or you sell the company early.
Other options include a really long maturity term, say 24 months, to give you more time to raise a Series A. In the case you sell the company early, you could give them a liquidation preference, say 2x instead. In both cases, I think the lender would rather take the “valuation”.
On microhack 1 (convert the debt into equity if you can’t pay on time), this debt conversion is typically at the option of the investor, not the company. It would be an unusual case for the investor to agree that the company could convert the debt into equity without the investor’s consent (except in the event of the next round of preferred financing raising $X million — as the pre-negotiated trigger to an auto-convert). Of course, if the company is able to negotiate this upfront, it would be a good thing for the company. However, this is an example of a microhack that is not common and entrepreneurs should be wary of making the “ask” and potentially losing credibility in negotiations.
On microhack 2 (determine your lender’s return if you sell the company early), one additional potential provision is to pay a special premium in the event of a sale before the next round of preferred financing. This special premium could range from something greater than simple interest (i.e. 20%) to a multiple of the amount invested (i.e. 100% or 1x, perhaps greater depending on the situation). The reason for a percentage of amount invested-based return is to avoid the price per share valuation discussion to peg the conversion to.
Yokum,
Regarding microhack 1: “Convert the debt into equity if you can’t pay it on time”:
I have seen debt deals where the company has negotiated this term. I think it is really important. If you can’t pay the debt by the maturity date, the investors have a lot of leverage. You should be able to convert it into equity if you can’t pay it. Of course, the company can’t convert the debt whenever it wants – only if the maturity date occurs prior to a Series A.
I suppose another option is to first give the investor the chance to extend the maturity date. If the investor exercises that option, the company could automatically lose the right to force the conversion into equity.