Convertible Debt

Overview

Convertible debt is a type of financing in which a company issues bonds or loans to investors that can be converted into equity later. This allows investors to lend money to the company while also having the option to participate in the company’s future growth by converting their debt into equity.

Advantages

The main advantage of convertible debt is that it allows companies to raise capital without giving up too much equity. This can be attractive to companies that are not yet ready to dilute their ownership or that want to retain control over their business. 

For example, a startup that is not yet ready to dilute its ownership may choose to issue convertible debt instead of selling equity directly. This allows the startup to raise capital without giving up any ownership or voting rights, giving the founders more control over the direction of the company.

Another advantage of convertible debt is that it can provide investors with the potential for a higher return on their investment. If the company’s value increases and the conversion price is below the market value of the company’s equity, investors can convert their debt into equity at a lower price and benefit from the increase in the company’s value. This can be particularly attractive to investors who believe in the company’s growth potential and want to participate in its future success.

For example, an investor may choose to lend money to a company through convertible debt because they believe in the company’s growth potential. If the company’s value increases and the conversion price is below the market value of the company’s equity, the investor can convert their debt into equity at a lower price and benefit from the increase in the company’s value.

In addition, convertible debt can be a flexible financing option for companies. For example, companies can structure the terms of their convertible debt to include a conversion trigger, such as reaching a certain level of revenue or achieving a certain valuation. This can provide the company with additional incentives to reach its goals and can also provide investors with added protection by ensuring that they can convert their debt into equity at a favorable price.

For example, a company may structure its convertible debt to include a conversion trigger, such as reaching $10 million in annual revenue. This provides the company with an incentive to reach its goals and provides investors with added protection by ensuring that they can convert their debt into equity at a favorable price.

Disadvantages

Here are five disadvantages of using convertible debt as a start-up:

Dilution of equity

Dilution of equity refers to the reduction in a shareholder’s ownership stake in a company because of the issuance of new shares. When a company issues new shares, the total number of outstanding shares increases, and the percentage ownership of each shareholder is reduced. In the context of convertible debt, dilution of equity can occur when the debt is converted into equity. This can especially be a problem if the company’s equity is already highly diluted due to previous rounds of funding.

For example, if a start-up company raises $1 million in convertible debt at a conversion price of $1.50 per share, the conversion of the debt will result in the issuance of 666,666 new shares. If the company already has 1 million shares outstanding, the conversion of the debt will dilute the ownership stake of each shareholder by approximately 40%.

Increased risk

There are a few ways in which convertible debt increases risk for start-ups:

1. Repayment risk: As mentioned, convertible debt must be repaid with interest, which can be a significant burden for a start-up that is still in the early stages of growth. If the company is unable to generate sufficient revenue to cover the cost of the debt, it may struggle to repay the loan and could be forced into bankruptcy.
2. Conversion risk: Convertible debt is typically converted into equity later, usually when the company raises additional funding or goes public. If the company is unable to raise additional funding or go public and is unable to convert the debt into equity, it may be forced to pay off the debt with cash. This can be a significant financial burden for a start-up that is still in the early stages of growth.
3. Market risk: Convertible debt is typically issued with an interest rate that is higher than the prevailing market rate for traditional debt. If market interest rates rise significantly between the time the debt is issued and the time it is repaid, the company may be forced to pay a higher cost of capital than it had anticipated.

For example, a start-up company that raises $1 million in convertible debt at a 12% interest rate may find that the cost of the debt is significantly higher than the cost of equity financing. If the company is unable to raise additional funding or go public and is forced to pay off the debt, the cost of the debt could significantly impact its profitability. Additionally, the company may be at risk of bankruptcy if it is unable to generate sufficient revenue to cover the cost of the debt. In this case, the increased risk of convertible debt may outweigh the potential benefits for the start-up.

Higher cost of capital

Convertible debt typically has a higher interest rate than traditional debt, as it is considered higher risk. This can increase the company’s overall cost of capital and reduce its profitability. If the company is unable to raise additional funding or go public and is forced to pay off the debt, the cost of the debt could significantly impact its profitability.

1. Higher interest expense: Convertible debt typically has a higher interest rate than traditional debt, which means that the company will pay more in interest expense over the term of the loan. This can significantly increase the company’s overall cost of capital and reduce its profitability.
2. Reduced cash flow: Higher interest expense can reduce the company’s cash flow, as a larger portion of its revenue will need to be dedicated to paying off the debt. This can make it more difficult for the company to fund its operations and invest in growth.
3. Reduced competitiveness: Higher cost of capital can make it more difficult for the company to compete with other businesses in its industry, as it may have less capital available to invest in marketing, research and development, and other key areas.

Complexity

Convertible debt can be complex and may require the company to engage legal counsel to draft and negotiate the terms of the loan agreement. This can be time-consuming and costly.

1. Time and effort: Drafting and negotiating the terms of a convertible debt agreement can be time-consuming and may require the company to engage legal counsel. This can take valuable time and resources away from the company’s core business activities.
2. Legal fees: Engaging legal counsel to draft and negotiate the terms of a convertible debt agreement can be expensive. The company may need to pay legal fees upfront, which can further reduce its available capital.
3. Complex terms: Convertible debt agreements can be complex and may include a wide range of terms and conditions that may be difficult for non-experts to understand. This can make it challenging for the company to fully understand the implications of the agreement and may increase the risk of misunderstandings or disputes.

For example, a start-up company that is considering raising $1 million in convertible debt may need to engage legal counsel to draft and negotiate the terms of the loan agreement. This process may take several weeks and could cost the company several thousand dollars in legal fees. The company may also need to spend additional time and resources reviewing and understanding the complex terms of the agreement.

Loss of control

Convertible debt can give the lender certain rights, such as the right to receive updates on the company’s financial performance and the right to participate in certain corporate actions. This can reduce the borrower’s control over the company and may be a concern for founders and shareholders.

1. Information rights: Many convertible debt agreements include provisions that give the lender the right to receive regular updates on the company’s financial performance and other key metrics. This can be a concern for founders and shareholders who are sensitive to the confidentiality of their company’s financial information.
2. Corporate actions: Convertible debt agreements may also include provisions that give the lender the right to participate in certain corporate actions, such as the issuance of new shares or the sale of the company. This can reduce the control of the company’s founders and shareholders over these key decisions.
3. Board representation: In some cases, convertible debt agreements may give the lender the right to appoint a representative to the company’s board of directors. This can further reduce the control of the company’s founders and shareholders and may be a concern for those who are committed to maintaining control over the company.

For example, a start-up company that raises $1 million in convertible debt may be required to provide the lender with regular updates on its financial performance and may need to seek the lender’s approval before making certain corporate decisions. The company’s founders and shareholders may be concerned about the potential loss of control that comes with accepting convertible debt and may prefer to use alternative financing options that do not include these types of provisions.

Market conditions

The convertible debt financing market in Europe has been steadily growing in recent years, as more and more companies turn to this type of financing to fund their operations and growth. One of the key drivers of the growth in the European convertible debt market has been the increasing number of technology start-ups in the region. Many of these companies have limited credit history and may not have the collateral or financials to qualify for traditional bank loans. Convertible debt allows these companies to secure financing using their future potential as collateral, rather than their current assets. Another factor contributing to the growth of the European convertible debt market has been the increasing demand for alternative financing options. Many companies, particularly small and medium-sized enterprises, have struggled to access traditional bank loans due to the economic impact of the COVID-19 pandemic. Convertible debt has provided these companies with a flexible financing option that allows them to fund their operations and growth without taking on significant debt. Overall, the convertible debt market in Europe has demonstrated resilience and flexibility in the face of economic uncertainty. While there are certain risks associated with convertible debt, such as the possibility of dilution of equity and the need to repay the debt with interest, it can be a useful financing tool for companies that are unable to access traditional bank loans or that are seeking to conserve cash.

There are also several resources available to companies that are considering raising convertible debt in Europe. For example, the European Investment Fund (EIF) offers a range of financing instruments, including the Risk Sharing Finance Facility (RSFF), which provides convertible debt financing to innovative SMEs in the EU. There are also a few venture debt firms and investment banks in Europe that specialize in providing convertible debt financing to early-stage companies. In conclusion, the convertible debt financing market in Europe has demonstrated strong growth in recent years and is likely to continue to be an important source of financing for companies in the region.

Examples

Celonis

One example of a successful convertible debt financing transaction in Germany is the €10 million ($11.9 million) financing round that software company Celonis raised in 2017. Celonis, which provides data analytics software to help companies optimize their operations, raised the funding from Summit Partners, a global growth equity firm, and Next47, a venture capital firm backed by Siemens. The financing round was structured as a convertible debt financing, with the funds being issued as a loan that could be converted into equity in the company later. The terms of the deal included a conversion price of €12.50 per share and an interest rate of 8%. Celonis used the funding to accelerate its growth and expand its presence in the global market. The company has since gone on to become a leading player in the data analytics space and has raised additional funding from investors including SoftBank Group and Insight Venture Partners. As of 2021, Celonis had a valuation of over $2 billion.

Zalando

Another example of a successful convertible debt financing transaction in Germany is the €2.5 million ($2.9 million) financing round that online retailer Zalando raised in 2009. Zalando, which operates an online fashion store and is headquartered in Berlin, raised the funding from a group of investors led by Holtzbrinck Ventures. The financing round was structured as a convertible debt financing, with the funds being issued as a loan that could be converted into equity in the company at a later date. The terms of the deal included a conversion price of €0.50 per share and an interest rate of 8%. Zalando used the funding to accelerate its growth and expand its presence in the European market. The company has since gone on to become one of the largest online retailers in Europe and has raised additional funding from investors including Kinnevik and Summit Partners. As of 2021, Zalando had a valuation of over $10 billion.

Prerequisites for convertible debt financings

1. Clear business plan: To secure convertible debt financing, it’s important for a company to have a clear and compelling business plan that outlines its goals, financial projections, and growth strategy. This will help investors understand the company’s potential and how the funds will be used to support its growth.
2. Strong management team: Investors in convertible debt will want to see that the company has a strong and experienced management team in place that can execute on the business plan. This includes the CEO and other key executives, as well as the company’s board of directors.
3. Track record of growth: Companies that are seeking convertible debt financing should be able to demonstrate a track record of growth, such as increasing revenue or expanding their customer base. This will help investors see that the company has the potential to achieve its growth goals.
4. Clear exit strategy: Convertible debt is typically issued with the expectation that it will be converted into equity later, such as when the company raises additional funding or goes public. It’s important for the company to have a clear exit strategy in place that outlines how the debt will be repaid or converted.
5. Attractive valuation: To secure convertible debt financing, the company’s valuation should be attractive to investors. This means that the valuation should be in line with the company’s growth potential and the terms of the financing round.
6. Strong market position: Companies that are seeking convertible debt financing should be able to demonstrate a strong market position, such as a dominant market share or a unique value proposition. This will help investors see that the company has the potential to achieve its growth goals.
7. Scalable business model: Companies that are seeking convertible debt financing should have a business model that is scalable, meaning that it can be easily expanded as the company grows. This will help investors see that the company has the potential to achieve its growth goals.
8. Proven product or service: Companies that are seeking convertible debt financing should be able to demonstrate that their product or service is proven and in demand. This will help investors see that the company has the potential to achieve its growth goals.
9. Adequate collateral: Some convertible debt financing deals may require the company to provide collateral, such as assets or intellectual property, as security for the loan. It’s important for the company to have adequate collateral to secure the financing.
10. Legal and regulatory compliance: Companies that are seeking convertible debt financing should ensure that they are following all relevant legal and regulatory requirements. This includes compliance with financial reporting and disclosure requirements, as well as any industry-specific regulations.

Typical Terms of a convertible debt financing

1. Conversion price: The conversion price is the price at which the debt will be converted into equity in the company. This price is typically based on the company’s valuation at the time of the financing round and may be adjusted for certain events, such as dilution of equity.
2. Interest rate: The interest rate is the percentage of the loan amount that the borrower will be required to pay as interest. This rate is typically higher for convertible debt than for traditional debt, as it is considered higher risk.
3. Conversion triggers: Conversion triggers are events that trigger the conversion of the debt into equity. These triggers may include the company raising additional funding, going public, or achieving certain milestones.
4. Conversion discount: A conversion discount is a reduction in the conversion price of the debt that is applied when the debt is converted into equity. This discount is intended to compensate the investors for the risk they are taking by investing in the company.
5. Maturity date: The maturity date is the date on which the debt must be repaid. This date may be extended if the debt is not converted into equity before it matures.
6. Prepayment provisions: Prepayment provisions outline the circumstances under which the borrower is allowed to prepay the debt before it matures. These provisions may include a requirement to pay a penalty or a premium.
7. Default provisions: Default provisions outline the circumstances under which the borrower is in default of the debt agreement and the consequences of default. These provisions may include the lender’s right to accelerate the debt and demand immediate payment.
8. Warrant coverage: Warrant coverage refers to the percentage of the debt that will be covered by warrants, which are options to purchase shares in the company at a later date. This percentage is typically based on the company’s valuation at the time of the financing round.
9. Information rights: Information rights outline the company’s obligations to provide the lender with regular updates on its financial performance and other key metrics.
10. Board representation: In some cases, convertible debt agreements may give the lender the right to appoint a representative to the company’s board of directors. This can give the lender some influence over the company’s decision-making processes.
11. Covenants: Covenants are conditions that the borrower must adhere to in order to maintain the loan. These may include financial covenants, such as minimum levels of liquidity or debt-to-equity ratios, and operational covenants, such as maintaining certain business practices or obtaining consent for certain actions.
12. Voting rights: Convertible debt agreements may include provisions that give the lender certain voting rights, such as the right to vote on the company’s board of directors or certain corporate actions.
13. Anti-dilution provisions: Anti-dilution provisions are designed to protect the lender’s equity position in the company and may include provisions that adjust the conversion price of the debt in the event of dilution of equity.
14. Restructuring rights: Restructuring rights outline the lender’s rights in the event of a restructuring or reorganization of the company. These rights may include the right to receive additional equity in the company or to participate in the restructuring.
15. Change of control provisions: Change of control provisions outline the lender’s rights in the event of a change of control of the company, such as a merger or acquisition. These provisions may include the right to convert the debt into equity or to receive a payment in lieu of conversion.

Steps of a typical convertible debt transaction

1.  Preparation: This includes developing a clear and compelling business plan, identifying potential investors, and determining the terms of the financing round, such as the conversion price and interest rate.
2.  Marketing: Actively seeking out potential investors and promoting the company’s growth potential and the terms of the financing round. This may involve pitching the company to investors through presentations, meetings, and other marketing materials.
3.  Negotiation: Discussing and negotiating the terms of the financing round with potential investors. This may include negotiation of the conversion price, interest rate, and other terms of the deal.
4.  Due diligence: Investor reviewing the company’s financial and operational information to assess the risk of the investment. This may include reviewing the company’s financial statements, business plan, and legal documents.
5.  Documentation: Drafting and finalizing the legal documents that outline the terms of the financing round. This may include the loan agreement, the term sheet, and any other necessary documents.
6.  Signing: Finalizing the financing round and executing the legal documents. This typically involves the company receiving the funds and the investor receiving the right to convert the debt into equity later.

Conclusion

Convertible debt can be a useful financing tool for companies that are seeking to fund their operations and growth without taking on significant debt. It allows companies to raise capital using their future potential as collateral and gives investors the opportunity to participate in the company’s future success through the conversion of the debt into equity.

However, there are also certain risks associated with convertible debt, such as the possibility of dilution of equity, the need to repay the debt with interest, and the potential loss of control over the company. It’s important for companies to carefully consider these risks and to choose a financing option that aligns with their growth goals and risk tolerance.

Overall, the decision to use convertible debt as a financing tool will depend on the specific circumstances of the company and the terms of the financing round. Companies that are considering raising convertible debt should seek the advice of financial and legal professionals to determine whether this type of financing is the right fit for them.

If you are a company considering raising convertible debt and would like further information or guidance, please do not hesitate to contact us. We would be happy to answer any questions you may have and provide more information on the pros and cons of using convertible debt as a financing tool.