Limiting financing risk with convertible debt

By odhiambo ocholla

Debt financing is considered a relatively cheaper source of business capital, especially when compared to equity, which involves giving up part of the ownership of the company.

Unfortunately, very little debt financing is available to early-stage entrepreneurs, because lenders expect loans to be paid back in a pre-defined manner, with interest. Furthermore, lenders expect borrowers to demonstrate their credit-worthiness by providing collateral, which in essence guarantees repayment.

Due to their inherent high risk and lack of liquidity, early-stage firms are not considered sufficient collateral for debt financing.

Loans from friends and family are often used as pre-seed capital for start-up ventures. This debt is attractive because it is often available without interest, and the entrepreneur is not required to repay loans on schedule.

While useful in the initial stages of a business, this source of funding is usually only available in small quantities. Many high-growth firms require more capital to achieve the positive cash flow necessary to grow on internally generated funds and the primary sources of capital for these companies are equity investments.

Equity investors

It is not uncommon for equity investors to structure early-stage investments as convertible debt. Since the conversion from debt to equity is almost always at the option of the lender, most entrepreneurs consider this a form of equity investment and therefore an expensive source of capital.

Convertible debt has all the rights of debt financing, requires reasonable interest payments, and can be converted to common or preferred stock, depending on the structure of the deal, at the pleasure of investors, usually upon triggers signaled by the success of the company.

The value of the company at conversion is predetermined and is often based on a modest discount to the pricing of a future round of investment. Conversion is often triggered when the company closes a substantially larger round of equity investment.

Investors insist upon convertible debt financing for a number of reasons. Debt is a lower risk investment than equity. In the case of the liquidation of the company, lenders are ahead of shareholders for repayment. All debt generally must be repaid prior to any liquidation to shareholders.

Convertible debt instruments allow lender/investors to enjoy a modest return on investment as interest, with all the upside opportunity of shareholder after conversion. Structuring a convertible debt financing is relatively easy; hence, legal fees for completing this form of investment are substantially lower than conventional equity investments.

Also, bridge loans can be structured as convertible debt. Bridge loans are debt-funded by earlier investors to provide the entrepreneur with sufficient cash to "bridge" the time gap between running out of earlier raised capital, and the closing of a round of new funding for the company.

Since new investors prefer that all new funds be used to grow the company and not to repay debt, bridge loans are converted into debt at the closing of the next sub-round of equity financing.

Compromise and convenience

In general, convertible debt is often a compromise between entrepreneurs and investors, when they cannot agree upon a valuation for the company at the time the loan is closed. The investor believes the company is worth less than does the entrepreneur.

They agree to a convertible loan, which is priced at the closing of the next subsequent round of equity investment and a discount, usually 10 to 30 per cent of the valuation of that next round of investment.

Some angel investors prefer this form of investment, as they fear investing at too high a valuation, only to see a subsequent institutional investor price their deal at a lower valuation, resulting in very unfavourable dilution to the earlier stage investor.

Convertible notes are also a convenience to investors. They remove the risk of equity investments at valuations that prove to be too high.

—The writer ([email protected]) is an Investment Banker.