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……
Interesting one Zach. Thanks!
Looks like I am a little late to this party, but I will throw in my thoughts anyway.
The article you post is misleading on a number of points. First the analysis assumes participating preferred. Participating preferred is very uncommon (at least as of now on the West coast – I can’t speak for other areas). If the preferred isn’t participating the dillutive effect would go away when the exit value of the company increases such that it is more beneficial for the preferred to convert to common prior to an exit event. Also, the articles says the warrant coverage can be calibrated to equal the value of a discounted conversion rate. This is true if you know the exit value. When the convertible debt is issued no one knows what the exit value will be and thus the warrant coverage is impossible to calibrate. 80% warrant coverage becomes extremely generous as the exit value increases above the 20% used in the examples.
Also, it is very important to note that the vast majority of companies will not be sold after an A round of financing, there will usually be multiple rounds at different values. Thus preferred investors very often have misaligned interest. This will happen at some point for the majority of funded comopanies. The note round is an alternative to a priced equity round. If the seed investors did a priced round instead of a note, the later VC investors would still be diluted and have misaligned interests merely because they came in later at a higher price.
The article could have been one paragraph long and should have come to a better conclusion. The article should have merely stated that when a conversion discount is applied the seed investors get a magnified liqudidation discount. To account for this the discount amount can be paid in common stock at the time of the financing round. The note converts into the number of preferred and common shares equal to the principal plus interest divided by the discounted price. The number of preferred shares is equal to principal plus interest divided by the full series A price. The number of common shares equals the total shares that should be issued, minus the number of preferred shares to be issued.
This way the investors get the benefit of a conversion discount (which is often better than warrant coverage depending) but the liquidation preference is not skewed, and the company doesn’t have to try the impossible task of setting warrant coverage percentage to equal the discount without know the exit value.
Chris, thanks. you might consider writing to the author of the article. thx again!