Convertible Debt – Discount or Warrant Coverage?

I am on the Campus to Campus back from NYC to Ithaca.  Smooth ride so far (better than the 6 hour trek on the way down yesterday).

I just read a very interesting article about how to best structure convertible debt rounds.  Typically, with convertible debt, the note holder expects the debt to convert into the next equity financing (often a Series A round).  And, typically, the note holder is given a discount on the conversion price.  For example, if the discount is 15%, then if the Series A round priced at $1 a share, the note holders would convert their debt (plus accrued interest) at $.85 a share (just divide the debt amount plus interest by $.85).   So, the debt holder ends up with Series A stock with a $1 value (and usually a 1X liquidation preference, in this hypo $1) for $.85.   Fairly, the convertible debt holder has been rewarded for taking the extra risk of bridging the company to the Series A round.  Below I refer to this fair risk incentive as the “reward”.

The article I just read, however, argues strongly that the convertible debt holder, and, more importantly, the new Series A investors, would be better off if the convertible debt had warrant coverage instead of a conversion discount.  Such a structure shifts the cost of the convertible debt “reward” to the founders and away from the Series A investors, which, if you think about is, eminently fair.  The article proves the point with math examples.

Here is the article.  Conversion Discount vs Warrant Coverage

Worth reading and seriously considering……

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