This content was delivered during a lunch and learn session on July 3, 2013 by Dr. Richard Reiner.

1. C O N V E R T I B L E D E B T

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AGENDA
WHAT?
CONVERTIBLE DEBT
PARAMETERS
TYPICAL TERMS
WHY?
TROUBLE IN PARADISE
PRICE CAPS
SUMMARY

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CONVERTIBLE DEBT
Paul Graham (Y Combinator) tweeted in 2011:
“Convertible notes have won. Every investment so
far in this YC batch (and there have been a lot) has
been done on a convertible note.”

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WHAT?
• Debt (typically a promissory note) issued by an investor to a startup…
… where the principal and accrued interest convert into equity under certain
conditions
• Used when the investor’s intention is ultimately to own equity, rather than
to earn a return through interest payments

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PARAMETERS
• $ amount
• Interest rate
• Conversion upon next financing
• Minimum trigger amount
• Discount or warrants
• Optional: price cap
• Conversion price if no next financing
• Conversion on exit before financing or maturity
• Merger premium (multiple)
• Maturity date and repayment terms
• Secured? Against what?
• Board rights
• Information rights
• Pre-emptive rights on next financings
• Right of First Refusal
• Co-sale rights
• Protective provisions
• Fancy stuff, e.g. discounts that increase over time

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TYPICAL TERMS
• Conversion into Series A preferred
• Median conversion discount: 20%
• Median interest: 5.5%
• Median maturity: 18 months
• Merger premium: 2x (Fenwick and West, 2012)
• Secured against company IP
• No board set

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TYPICAL TERMS - DETAILS
Fenwick and West, Seed Finance Survey 2012
http://www.fenwick.com/publications/Pages
/Seed-Finance-Survey-
2012.aspx?WT.mc_id=2012.SEED_BK_email

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WHY?
• Punts on negotiation over valuation and many pref share terms
• Simplifies legals
• Simplifies and speeds up negotiation over terms
• Lower transaction costs
• Some angels will even do them without legal counsel
• Avoids taking on liabilities of Directors and Shareholders (because
you aren’t one)
• As a creditor, near the front of the line in case of adverse liquidation
(after employees)

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TROUBLE IN PARADISE
• Can be a bad deal for angels
• Does a 20% discount
sufficiently compensate
for a year or two of
additional risk vs. the
Series A investors?
• Series A investors will
generally veto higher
discounts, may sometimes
resist even 20%
• Misaligned incentives vs.
founders on Series A valuation
• Founders want it high
• You want it low

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PRICE CAPS
• Solution proposed for the risk/reward and alignment issues:
conversion price
• Sets a maximum conversion price, e.g.“20% discount to Series A, not
exceeding a price per share based on a valuation of$5M”
• Most sophisticated angels post 2010 will not do uncapped converts
• Still not perfect
• Valuation negotiation with founders has come back into the
deal
• Founders have sometimes received the (bad) advice to refuse
capped converts
• This has become a contentious enough issue that early-
stage convert deals have actually begun to decline in
number again after peaking in ~ 2011
• Some VCs look at the cap and see it as a price ceiling for the A
round!

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SUMMARY
• Cheaper and easier, but:
• Without a price cap, not fair to angels
• With a price cap, not quite as easy
• Capped converts are often a good choice
• But there are also good alternatives: simplified standardized equity
terms
• Series Seed (Fenwick & West)
• Series AA (Y Combinator)
• Plain Preferred (Founders Institute)
• TechStars model documents
• Etc.

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