Peter N. Townshend
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Most life sciences companies are intimately familiar with the market for angel and venture capital equity financings. The
market trends and standard terms and conditions in preferred stock equity financings are widely known. Many biotech and pharmaceutical
startups, however, are relying more and more on convertible debt rather than traditional equity financing, either as a primary
form of financing or as a bridge to a future equity financing.
For biopharmaceutical companies, the biggest advantage of note financings is speed. Given the high stakes and the complexities
of conditions involved, however, companies should weigh their options carefully before choosing convertible notes over traditional
equity financing.
WHAT MAKES NOTE FINANCING DIFFERENT?
In the classic angel or venture capital equity financing, investors purchase preferred stock of the company. Preferred stock
generally has dividend, liquidation, redemption, or voting rights superior to that of the company's common stock. Equity investors
are stockholders of the company and have associated voting rights, which generally include the right to designate members
of the board of directors and to approve key transactions, such as future financings or a company acquisition. In contrast, convertible note investors make loans to the company and receive in exchange convertible promissory notes. These
investors are creditors rather than stockholders. The principal and interest on these convertible notes, subject to certain
conditions, generally are automatically convertible into shares of the company's preferred stock issued in its next financing—hence
the common reference to these notes as bridges to a subsequent financing.
WHY A NOTE FINANCING?
If the convertible notes are convertible into preferred stock, why not skip the note offering and just conduct a preferred
stock financing?
Advantages for Companies
A company may opt to conduct a note financing for a variety of reasons. It may be close to developing a new product or completing
a regulatory or other key milestone that will help justify an increased valuation. The company may need funds quickly, and
note financings can often be closed sooner than equity financings because they generally involve fewer documents and a more
limited due diligence process, and do not require the negotiation of a valuation of the company or, in most circumstances,
approval of existing stockholders. Finally, a company may opt to conduct a note financing because it has not been able to
line up enough funding sources to make worthwhile the time and expense of conducting a preferred stock financing.
Advantages for Investors
Note financings can also be attractive to investors. Note investors benefit from the time and cost efficiencies of a note
financing. Additionally, because these investors are creditors rather than stockholders of the company until conversion of
their notes, if the company should become insolvent or bankrupt prior to its next equity financing, the note investors will
have priority over the company's stockholders in making claims against the company's assets. Note financings usually also
include a conversion discount or warrant coverage, which sweetens the deal for the note investors.
BASIC TERMS AND CONDITIONS
The terms of note financings can vary widely from deal to deal, and are much less standard than a traditional venture capital
equity financing. Moreover, note investors have become more sophisticated, creative, and aggressive in negotiating terms,
so companies can expect note financings in the coming years to become more complex and potentially less favorable to issuers.
Nevertheless, some terms are typical in most note financings.
Fixed Interest for a Fixed Term
Convertible notes usually provide for a fixed interest rate between six and 10% per annum. The term until maturity varies
based on a wide variety of factors (e.g., expected timing of a future financing, timing of milestones, revenue expectations),
but most notes become due from six months to two years from issuance, after which, if the debt has not been converted into
equity, the company must repay the note on demand (upon request) by the investor.
