In a down economy, when raising capital to fund operations may seem like a Herculean challenge, convertible debt may present an attractive alternative to equity financing for early stage businesses and their prospective investors. Convertible debt financings may be applied in a variety of contexts and may avoid some of the cumbersome issues of early stage equity financings. Convertible debt financings may be an ideal investment vehicle for raising capital to fund startup ventures during the friends/family round of financing, especially in high-growth businesses where issues of valuation may prove particularly difficult. Operating businesses may also use convertible debt financing (sometimes called “bridge financings”) to satisfy working capital needs between rounds of capital stock offerings. In this context, they are often viewed as providing a “bridge of capital” between rounds of equity financings and subsequent (often preferred) equity financings. In a typical convertible debt financing, the borrower issues convertible promissory notes to investors for a limited term. These convertible promissory notes often mature within one to two years from the date of issuance of the note. Parties commonly negotiate alternative structures relating to the note’s maturity, for example, providing for acceleration of the note’s maturity upon consummation of an equity financing. Upon maturity or some other negotiated event, the note holder may have the option of calling the convertible promissory notes (with accrued but unpaid interest) or converting the convertible promissory notes into capital stock of the borrower based on a pre-determined formula. To compensate the investors for the investment risk they are assuming, convertible promissory notes are often secured against all of the assets of the borrower.
According to Louis R. Dienes and Ekong I. Udoekwere, convertible debt financings offer several advantages—and a few disadvantages—when measured against typical equity financings, including the following:
Cost-Effective and Efficient. Equity financings, particularly preferred equity financings, require the negotiation and documentation of a legally complex financial relationship between the business and its prospective investors, often including stock purchase agreements, amendments to charter documents setting forth preferred stock rights, shareholder agreements, voting agreements, registration rights agreements, and other documents unique to early stage equity financings. This translates into higher legal costs for businesses. On the other hand, convertible debt financings may eliminate much of the legal complexity and unwieldiness of equity financings, as well as the time required to negotiate and document such transactions. The cost-effective nature of convertible debt financings often appeals to both early-stage businesses with limited capital resources and better established businesses looking to contain costs and access capital sooner. Further, because convertible debt financings are relatively common financing structures, they will not create impediments to future preferred
Valuation. Equity financings necessitate a valuation of the business. Valuation of startup businesses is especially difficult because such ventures often have short operating histories, limited or no revenues, unproven technologies and other considerable risks, notwithstanding their potential for dramatic growth. Moreover, business valuation is a specialized and expensive service—a cost that early stage businesses may be reluctant, or unable, to bear. Frequently, founders with no experience in finance but great enthusiasm for their technologies assign a value to their businesses that are significantly greater than the “market rate” and raise seed capital at that value from family and friends. What often happens next is that the equity positions of the founders (and their families and friends) are appreciably diluted by subsequent rounds of equity financing with more sophisticated investors. The latter often reassess and write down the founders’ arbitrary and inflated valuation of the business. By contrast, in a convertible debt financing, the business and its prospective investors avoid valuation pitfalls: the business gets the capital it needs, and the issue of valuation is postponed until the business is further along in its growth and both better equipped to afford an appraisal and easier to appraise reliably. Moreover, convertible debt financings tend to put the founders and the note holders on the same side of the table in determining the business’s valuation with later rounds of equity investors.
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