Why Start-Ups Use Convertible Debt Part III: The Virtues of Convertible Debt for a Start-Up

Foley & Lardner LLP

Over the course of our “Why Start-Ups Use Convertible Debt” series, we’ve discussed the two common paths start-up companies take to structure a financing. In Part I, we discussed common stock financing and in Part II, we discussed a convertible debt financing. In Part III, we will review the main principles start-up companies must remember when deciding to complete a convertible debt financing.

The convertible debt route is often chosen over the common stock round for many reasons. The difficult discussion about valuation can be avoided with the convertible debt route. While the parties will need to agree on a “Cap Price”, this is not an admission of valuation but simply an agreed upon price that protects the investors from up-side dilution. If the qualified financing is at a valuation less than the Cap Price, the investor will be entitled to the benefit of that lower valuation. Because the Cap Price is not an admission of valuation, the founders are free to grant options or issue founder equity at a lower price per share. As with any equity issuance to employees and advisors, there are still tax considerations that the Company and the equity recipient should address with their advisors.

Convertible debt holders do not own stock in the Company – so they do not vote as shareholders and are not entitled to the protections afforded to shareholders of a Company (such as shareholder inspection rights and fiduciary duties). Of course a well-represented investor may negotiate contractual rights into their purchase documents that provide them with similar protections. Convertible debt is also more attractive to the savvy investor. Debt is more senior to equity on liquidation, placing the investor in a better position should the Company shut down with distributable assets. Investors receive interest on their investment and the opportunity to receive preferred stock upon conversion, which will likely have significant preferences over common stock.

Throughout our series, we have discussed the differences between common stock financing and convertible debt financing, along with advantages and disadvantages of each structure. Keeping in mind all the benefits outlined, we often see convertible debt as the preferred financing choice for start-up companies and early stage investors. For more information on a convertible debt financing, make sure to check out the full “Why Start-Ups Use Convertible Debt” series!

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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