Opting for convertible debt financing? Here are some key terms you should know

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Opting for convertible debt financing? Here are some key terms you should know

Opting for convertible debt financing? Here are some key terms you should know

Previously an article on startup jargon founders need to know as they raise funds for their company was published here. I would like to contribute to this by including below some key jargons associated with term sheets, especially convertible debt.

A term sheet will usually be negotiated, like all financing term sheets, after a pitch deck has been shared, all the questions and due diligence have been done. Just when you thought it was going to get easier!

Term sheets vary depending on the type of financing being sought ie equity, debt, convertible debt. One of my favorite form of investing is through convertible debt. For those who do not know about convertible debt, there is a primer here.

Convertible debt suits early stage businesses as it offers flexibility by providing financing now while allowing a fair valuation of a business to be determined at a later date. If, hopefully, the valuation of the business goes up then the founders are not diluted as much.

In addition, if the interest payments on the debt are accrued and rolled up, the cash flow effects are the same as equity. While still providing tax benefits as the interest payable on debt instruments is tax deductible. [Caveat: This may not fully apply in Uganda as there are limits on allowable interest deductible for tax purposes].

The term sheet forms the basis for the convertible debt agreement or Convertible Debt note which is signed between the Company/Issuer and the Investor.

Also read: Learn more about the 5 tech startup investments by EWB Ventures in Africa

But, what are the key terms to negotiate or understand when you decide to consider a convertible debt term sheet? Find them below;

Issuer/Obligor: The Company seeking convertible debt.

Investor(s): Investor buying or investing as convertible debt.

Amount/ Instrument: Amount of financing being sought, convertible debt is unsecured convertible promissory notes (the “Notes”). In other words, the debt is secured against a promise to pay back in the future or convert into equity in the business, the Principal.

Purpose: The reasons for which the convertible debt is required, usually accompanied by an investment plan/company business plan.

Unsecured Security Interest: Convertible debt is generally an unsecured obligation of the Company.

Issue Date: Days from the signing of the term sheet that the convertible debt is provided to the Company.

Maturity Date: Period from the issue date by which the convertible debt must be paid back or converted into equity.

Coupon/ Interest: [X]% per year, with the option to capitalize into the Note’s principal. The interest that shall be applicable per year on the convertible debt, there is an option to capitalize the debt into the Principal. Typically a [Y%] per year default penalty may apply if the Coupon/Interest is not paid.

Payment Dates: Dates on which the interest and/ or Principal will be paid.

Interest: This may be quarterly on the amount outstanding at the start of the quarter, paid in arrears.

Principal: This may be paid all at maturity but the Issuer may reserve the right to prepay with no prepayment penalty.

Ranking: This defines the hierarchy convertible debt holders will have in event of repayment of obligations. Ordinarily, holders of the convertible debt notes shall be subordinated (paid after) to any credit or debt facility issued by a bank or other lending institution to the Company. However, equity investors are subordinated to convertible debt holders.

Mandatory Conversion: It is typical for convertible debt to automatically convert to equity at the Conversion Price upon a Qualified Financing.

“Qualified Financing” means a transaction or series of transactions for the purpose of raising capital pursuant to which the Company issues and sells shares of its stock for an aggregate gross of an agreed amount (this excludes all proceeds from the conversion or cancellation of the Notes into stock).

Also read: Take a look at these 14 Y Combinator graduates from Africa

Conversion Price upon a Qualified Financing: The Conversion Price for convertible debt when Qualified finance occurs is usually defined as the lesser of (i) a set [%] (the “Conversion Discount”) of the share price paid by the investor(s) in the Qualified Financing, % depending on the stage of the business and (ii) the price per share equal to a set amount, [$], divided by the aggregate number of outstanding shares of the Company’s common stock as of immediately prior to the Qualified Financing (inclusive of all convertible and exercisable securities then outstanding (the “Valuation Cap”).

The Conversion Discount and Valuation Cap are the key terms usually negotiated in a Convertible Debt Termsheet.

Voluntary Conversion: The Notes may be converted into Ordinary shares at the option of the Investor upon announcement by the Company of a “Change of Control”. An example of “Change of Control” may mean:

“Change of Control” means either: (i) the acquisition of the Company by another entity by means of any transaction or series of related transactions (including, without limitation, any reorganization, merger or consolidation or stock transfer, but excluding any such transaction effected primarily for the purpose of changing the domicile of the Company), unless the Company’s stockholders of record immediately prior to such transaction or series of related transactions hold, immediately after such transaction or series of related transactions, at least 50% of the voting power of the surviving or acquiring entity (provided that the sale by the Company of its securities for the purposes of raising additional funds shall not constitute a Change of Control hereunder); or (ii) a sale of all or substantially all of the assets of the Company.

The Conversion Price applicable upon a Change of Control shall be a set [%] of the share price paid in the transaction resulting in the Change of Control.

Covenants: The Note will contain standard affirmative (do’s)and negative (dont’s) covenants for a financing of this type, including but not limited to the following.

Affirmative covenants will require the Issuer to: continue its corporate existence; comply with applicable law; pay taxes; protect its intellectual property; prepare financial reports [in accordance with financial reporting standards] on a quarterly basis and annual reports [AUDITED] by an outside accountant.

Also read: This is how Matibabu has evolved since its founding 5 years ago

Negative covenants will forbid the Issuer to: change its business or enter a new line of business; dispose of its assets other than in the ordinary course of business [and not to exceed a set amount, in the aggregate]; enter into any agreement to merge or combine with another company; make any acquisition of another company, its business or assets [except for certain purchases of inventory in the ordinary course of business]; issue dividends, stock repurchases or redemptions, make payments with respect to subordinated debt, or make other restricted payments exceeding a certain amount; Make any loans or investments exceeding a certain amount [other than in the ordinary course of business]; incur any lien or make any negative pledge, other than mechanics’ liens in favor of suppliers incurred in the ordinary course of business; incur any additional indebtedness, including guaranties, sale-leasebacks, and other contingent obligations exceeding a certain amount [other than in the ordinary course of business]; increase the size of its Board of Directors beyond [number of] members; increase the annual cash compensation for any employee by more than set [%] over the previous year

Conditions Precedent to Disbursement: These are the terms required to be fulfilled prior to the investment/money being disbursed for the convertible debt. These may be determined following due diligence on the Issuer

Events of Default: These include actions that if they occur, are considered to be a breach of the convertible debt terms, may include: Failure to pay; Continuous breach of any other material representation or warranty; and Bankruptcy or insolvency.

Confidentiality: The terms of this term sheet shall be kept confidential by the parties for one year from the date of its delivery to the investor. Neither party shall disclose (directly or indirectly) without the prior written consent of the other party, these terms to a third party (other than the employees, lenders, owners, counsel, accountants and other agents of the party, provided such persons shall have agreed to keep such terms confidential) except in order to comply with any applicable law, order, or regulation.

Also read: Why your tech startup should really consider applying to YC’s Startup School

Governing Law: The Law of the Country that will apply, for example, Uganda. The Law that shall govern disputes and arbitration.

Transfer/Conversion Terms: Define the conditions governing transfer and or conversion of the convertible debt. The transfer and conversion may be subject to some restrictions for example: i) a minimum convertible or transferable amount say [$10,000] Notes at a time; ii) the holding of/or sale of the equity to an entity in violation of Country laws may not be permitted; iii) transfer without the prior written consent of Company may result in a loss of right to convert to shares.

This article first appeared on Kenneth Legesi's Medium and was reproduced with his permission.