[Legal Q&A] Convertible Debt vs. Equity

Question: What are the advantages and disadvantages of convertible debt vs. equity?

Answer: As we’ve discussed in previous postings, I am very much in favor of the convertible note scenario for non-institutional rounds of financing. To recap, the convertible note structure replaces the sale by early stage companies of equity securities, at a set valuation per share, with the sale of promissory notes that are convertible into Company equity in connection with the next round of equity financing by the Company (usually defined as the “first round of institutional equity financing”).

The upside to the convertible note structure is that you can get to a deal faster—without the haggling over valuation at an early stage of a company’s development when there usually isn’t a whole lot upon which to base that discussion. As a result of the transaction being a debt deal, the covenants and protective provisions with respect to Company operations are more abbreviated than those found in equity deal documentation. It is also unnecessary to spell out the detailed management and interest transfer provisions that are always found in institutional-level equity purchase documents. This translates into a transaction that allows the Company to obtain equity-like cash funding much faster and less expensively.

The downside to the convertible note structure results from the convertible note holders demanding a conversion rate for their debt that reflects too high a discount to the purchase price paid by the institutional players in the equity round. The institutional equity players are familiar with the convertible note structure and in almost all cases accept a discount of up to 15%–an acceptable cost for the “early funding” risk taken by the note holders. But when the convertible note holders demand a discount in excess of that level (and they frequently do—especially if the distance between note funding and equity round exceeds 12 months), you can run into resistance from the institutional round players. This can hold up—or kill– your equity round while the note holders and the institutional equity players have fun playing “chicken” –at your expense– over the acceptable level of discount to the purchase price.

So, be careful sports fans. It’s dangerous out there.

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Question provided by Bruce Colwin – (LinkedIn, Twitter) President & CEO of LegalMinds Media LLC .

Answer provided by Peter Rothberg – (website, LinkedIn Twitter), Partner at Duane Morris, Ultra Light Startups sponsor and counsel.

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