Previously SDA shared the key startup jargon you need to know to raise funds for your startup. We continue this by including below key jargons associated with convertible debt term sheets.
Term sheets will vary as the type of financing being sought. Implying that a term sheet for equity financing is not the same as that for debt or convertible debt. Therefore, depending on the type of funding you’re seeking, the term sheet shall vary.
Though this article will focus on the key terms you’re likely to find or use in a convertible debt term sheet. In case you do not know what convertible debt is, Investopedia breaks it down for you here.
But, basically, convertible debt is a financing instrument that has both debt and equity-like features. When one invests as convertible debt, the investment is treated as debt with interest payments periodically. But, the investor retains the right to convert to equity at a known discount to the company’s valuation as defined in a future funding round.
It could be at IPO, Seed round, or VC round. But within a set period else the investment amount, which is debt principal, is paid back.
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. Hopefully, if the valuation of the business goes up then the founders are not diluted as much.
A convertible debt termsheet will usually be negotiated, just like all financing termsheets, after the pitch deck has been shared. As well as all the questions and due diligence have been done.
The term sheet then forms the basis for the convertible debt agreement or Convertible Debt Note that shall be signed between the Company/Issuer and the Investor.
Now, what are the key terms to negotiate or as defined in a convertible debt term sheet:
1. Issuer/Obligor: The Company seeking convertible debt
2. Investor(s): Investor buying or investing as convertible debt
3. 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.
4. Purpose: The reasons for which the convertible debt is required, usually accompanied with an investment plan/company business plan
5. Unsecured Security Interest: Convertible debt is generally an unsecured obligation of the Company.
6. Issue Date: Days from the signing of the term sheet that the convertible debt is provided to the Company
7. Maturity Date: Period from the issue date by which the convertible debt must be paid back or converted into equity
8. Coupon/ Interest: [X]% per year, with the option to capitalise on 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.
9. Payment Dates: Dates on which the interest and/ or Principal will be paid.
10. Interest: This may be quarterly on the amount outstanding at start of the quarter, paid in arrears.
11. Principal: This may be paid all at maturity but the Issuer may reserve the right to prepay with no prepayment penalty
12. 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.
13. 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.
14. Conversion Price upon a Qualified Financing: The Conversion Price for convertible debt when a Qualified finance occurs is usually defined as the lesser of;
- (i) a set percentage (the “Conversion Discount”) of the share price paid by the investor(s) in the Qualified Financing. The percentage depends 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. This is inclusive of all convertible and exercisable securities then outstanding (the “Valuation Cap”).
15. 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. This may include, 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. 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 percentage of the share price paid in the transaction resulting in the Change of Control.
16. Covenants: The Note will contain standard affirmative – call them do’s – and negative call them dont’s – covenants for a financing of this type. Including but not limited to the following; a waiver of the Covenant shall usually require the consent of Note holders representing a majority percentage of the outstanding principal and interest on the Notes.
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.
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 an 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 favour of suppliers incurred in the ordinary course of business
- incur any additional indebtedness, including guarantees, 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 the number of members
- increase the annual cash compensation for an employee by more than set percentage over the previous year
17. Conditions Precedent to Disbursement: These are the terms required to be fulfilled prior to the investment or money being disbursed for the convertible debt. These may be determined following due diligence on the Issuer
18. Events of Default: These include actions that if they occur, are considered to be a breach of the convertible debt terms. These may include;
- Failure to pay
- Continuous breach of any other material representation or warranty, and
- Bankruptcy or insolvency.
19. 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, these terms to a third party without the prior written consent of the other 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.
20. Governing Law: The Law of the Country that will apply, for example, Uganda. The Law that shall govern disputes and arbitration.
21. 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 the right to convert to shares.
Kenneth Legesi is a Management Consultant and Corporate Finance Advisor. He is also passionate about catalyzing financing for startups and SMEs in Africa.