What Sparks Conversion?

Typical convertible notes will not convert automatically unless the preferred stock financing has a minimum amount of gross proceeds. For example, in a $5 million note financing, the notes may convert automatically in the next equity financing in which the gross proceeds (excluding the convertible promissory notes) to the company total at least $10 million. Upon the occurrence of such a qualifying financing, the principal and, typically, the accrued interest on the notes will convert into the same type of preferred stock issued in the qualifying financing at the same price paid by the other investors. Some convertible notes may instead provide that accrued interest will be waived or repaid in cash rather than converted.

Some note investors may also negotiate for other contingencies, including a premium repayment if the company is sold prior to a qualifying financing or an optional conversion into common stock or a prior round of preferred stock at a pre-determined price if a qualifying financing has not occurred prior to maturity of the notes.

Investors generally demand more than simple interest to compensate for the risk of pre-investing in a qualifying financing, the specific pricing and terms of which are unknown to them and to the company at the time of the note financing. This extra compensation usually takes the form of either a discounted conversion price or warrant coverage, rarely both.

Discounted Conversion

In the case of a discounted conversion price, the notes convert at a discount from the price paid by the other investors in the qualifying financing. This discount may range from 10% if the qualifying financing is expected soon to as much as 40% or more if the qualifying financing is more uncertain. For example, if a note with principal and accrued interest of $110,000 and no discount automatically converts in a qualifying financing in which shares of series B preferred stock are sold at $2.00 per share, the holder will receive 55,000 ($110,000 ÷ $2.00) shares of series B preferred stock upon such conversion. However, if the same note had a 20% conversion discount, the holder would instead receive 68,750 ($110,000 ÷ $1.60) shares. Companies and investors considering the discounted conversion structure should be aware that some investors do not like to participate in financings in which other investors are paying a lower price per share and may demand that the prior convertible note investors waive or eliminate their discounted conversion rights.

Warrant Coverage

The other sweetener, warrant coverage, is generally less disagreeable to future investors. Warrant coverage entitles note investors to receive a warrant to purchase shares of the same type of preferred stock issued in the qualifying financing, most often at an exercise price equal to the price paid by the other investors in the qualifying financing. The warrant coverage amount is generally a percentage of the note investors' initial investment. A typical warrant coverage amount is 20%, but that amount can vary dramatically up or down, depending on the same factors described above with respect to discounts. As an example, assuming a convertible note with $100,000 in principal, $10,000 in accrued interest, 20% warrant coverage and a qualifying financing in which shares of series B preferred stock are sold at $2.00 per share, the holder would receive 55,000 shares of preferred stock plus a warrant to purchase 10,000 ($100,000 x 20% ÷ $2.00) additional shares. Note that accrued interest generally does not get considered in calculating warrant coverage. The warrants typically have a term of at least five years. Most warrants expire upon a sale of the company, and some also expire upon an initial public offering. Some investors also negotiate for the warrants to become exercisable for common stock or a preceding round of preferred stock if the company is sold prior to a qualifying financing or if a qualifying financing has not occurred prior to maturity of the underlying notes.

OTHER TERMS AND CONDITIONS

There are a variety of other terms and conditions which apply to some but not all convertible note financings.

Triggers for Early Maturity

For example, most notes specify that the debt will become due early upon insolvency or bankruptcy of the company, but some notes also specify a litany of other events of default that may trigger early maturity of the notes, including missed milestones, loss of key employees, or the breach of representations and warranties made by the company to the investors.