Issuing Convertible Debt? Avoid This Costly Trap

Raising growth capital is a known challenge for SMBs. Bank loans can be virtually impossible to get, depending on your annual revenue and the amount of hard assets your business has, and venture capitalists aren’t interested in built-to-last companies. At this point, some SMBs decide to raise money by issuing convertible debt, which can be sold to small investors, family, and friends.

This option may seem straightforward enough, but many founders get burned by a little known and confusing flaw with the standard structure of convertible debt. In a nutshell, investors who purchase convertible debt with a valuation cap are often getting much greater higher liquidation preference compared to what they actually invested in the business. Since the money needed to give convertible debt holders their extra liquidation preferences will ultimately come out of the entrepreneur’s pocket, this little catch can cost founders a lot of money. In addition, having multiple liquidation preference terms in your convertible debt contracts can make it difficult to raise more money later on, as future investors may be reluctant to invest in a company that already has so much committed to early investors.

A Few Key Terms

Before we delve into the ins and outs of how multiple liquidation preferences happen, it will help to walk through a few key terms.

A valuation cap is an investor-friendly term in a convertible debt deal that ensures that if the valuation of a company exceeds the cap when the debt converts to equity, the valuation cap will be used to determine how many shares the investor gets on conversion, not the actual valuation of the company.

A liquidation event is an event that triggers a payout to investors. It could be an IPO, an acquisition, or a bankruptcy.

Liquidation preferences are the terms that determine who gets paid what—and in what order of priority—in different liquidation events.

How Multiple Liquidation Preferences Happen

On his blog The Silicon Hills Lawyer, José Ancer summarizes the critical problem of multiple liquidation preferences. He provides an example that shows how and why early investors may inadvertently be getting a much larger liquidation preference than entrepreneurs would expect. Assume the following:

• $500K seed round of convertible debt with a $2.5 million valuation cap
• Series A round, with a $10 million pre-money valuation, and a per-share price for new investments of $4.00
• The Series A investors get a 1x liquidation preference. This means that the Series A investors have a per-share liquidation preference of $4.00.
• The $2.5 million valuation cap means the notes convert at $1.00.

In the above example, the original $500K will convert, not including interest, into 500,000 shares.   

If the original convertible notes convert directly into the same Series A preferred stock as “new money” investors get (as most notes require), the effective liquidation preference is $2 million–that is, 500,000 shares * $4.00 (the current value of the shares).

So those original investors only paid $500,000, but they have $2 million in liquidation preferences. In other words, they got a 4x liquidation preference. 

Therefore, instead of the early convertible noteholders having a run-of-the-mill 1x liquidation preference, which is typical for preferred stockholders, they’re getting a 4x liquidation preference!

What’s the Solution?

Virtually all early investors will insist on preferred stock given the risk they’re taking. That’s fair enough. Just make sure that everyone is getting a simple 1x liquidation preference. This is common practice for investments and your convertible notes shouldn’t be any different.

Legally, there are a few ways entrepreneurs can protect themselves against inadvertent multiple liquidation preference. We’ll look at a few strategies here, though ultimately, you need a seasoned investment lawyer to walk you through the process — ideally one who doesn’t have a conflict of interest because they are also working with your potential investors.

• Spell out in the convertible debt agreement what the liquidation preferences will be upon conversion. In a spot-on blog post, VC Mark Suster offers a simple suggestion of text you should include: “If this note converts at a price higher than the cap…your stock [will] be converted such that you will receive no more than a 1x non-participating liquidation preference plus any agreed interest.”
• Issue sub-series of preferred stock. Another way to prevent the hidden multiple liquidation preference trap is to take Jose Ancer’s advice and insert a convertible note clause that creates a special sub-series of preferred stock to be issued to seed-round noteholders if and when the notes converts. This special sub-series of preferred stock prevents the inadvertent multiple liquidation preference. Continuing on with his earlier example, Ancer suggests that “instead of issuing 500,000 shares of Series A to [seed-round] noteholders, issue them 500,000 shares of Series A-2. Series A-2 would just be a series of stock that is exactly the same as the Series A in all respects…except for the liquidation preference…The Series A would have a per share liquidation preference of $4.00 per share, and the Series A-2 would have $1.00 per share. Problem solved.”

Stand Firm

Obviously, investors like the multiple liquidation preference, so don’t be surprised if you get some push-back if you insert verbiage into your convertible note to limit the liquidation preference. But keep in mind that early investors are already getting significant perks for taking a risk on your company. First, they’re getting a built-in discount — often of 20 to 30 percent — when their note converts. Second, they’re getting an additional discount if their note converts at a time when your company’s valuation is greater than the valuation cap. So really, they don’t need the extra unearned reward of multiple liquidation preferences.

For new entrepreneur struggling to secure capital, it’s easy to ignore what may seem like a trivial detail in a contract. But hidden liquidation preferences can literally cost you millions of dollars under the right — or wrong — conditions. So invest in a seasoned investment lawyer before you start a fundraising campaign — and stand your ground in the face of investor push-back.