From Crain's Dealmaker Alert: Need to Bridge a Funding Gap? Consider Convertible Debt.

Need to bridge a funding gap? Consider convertible debt

Blog entry: March 19, 2014, 9:57 am | Author: DOMINIC M. BRAULT

Dominic M. Brault is a managing director at Carleton McKenna & Co. LLC, a boutique investment bank. Dominic advises public and private companies across many industries on valuation, mergers and acquisitions, and capital raising.

Those who follow the local venture stage market are aware of the funding gap that has emerged as the development of the Midwest funding ecosystem has created an increasing number of post-revenue, growing businesses that need capital to scale.

Convertible debt (CD) has become an increasingly common financing tool for early-stage companies looking to fill the gap. As such, the fundamentals of convertible debt are worth considering for entrepreneurs, investors and advisers.

The funding gap: Angels, research institutions and governments (for example, Small Business Innovation Research) typically fund seed-stage deals with capital needs between a couple hundred thousand dollars and $1 million. However, there are very few sources of funding for companies looking for between $1 million and $5 million as early-growth companies transition from research and development to business model scaling (i.e. companies with nominal revenue/early adopter customers, but ongoing “cash burn”).

The venture capital industry has evolved to focus on companies that have reached meaningful revenue run rates and is predominantly comprised of larger venture capital firms that necessarily make larger and later-stage growth capital investments. As a result, there is an unmet need in the capital continuum, and entrepreneurs often turn to CD in order to bridge this funding gap.

What is CD? Convertible debt is a loan that is made to a company that converts into equity in the future, most often based on obtaining a larger round of capital. This type of security is not a “loan” in the typical sense as the investor does not expect to be repaid. Rather, the investor is looking to convert to equity and achieve equity-like returns with a debt-like structure (i.e., seniority in liquidation). The sources of CD funds are typically current investors, angels, angel funds and strategic investors (i.e., a customer or potential acquirer).

Headline CD terms: CD amounts can range from $1 million to $3 million and provide the company with 12 to 24 months of runway in order to show more meaningful financial results/market adoption to attract institutional capital. The conversion of CD into an equity instrument usually takes place at a discount to the next equity round in order to compensate the investor for the risk of being early.

Most conversion discounts range from 10% to 30% but can be as high as 50%. The conversion price also is capped usually in order to protect the investor from a material run-up in price. The capped conversion price frequently approximates a modest premium to current fair value.

CD offerings also accumulate interest, usually in the 4% to 8% range, in order to pay the investor for waiting. The accrued interest is converted as part of the overall investment amount into the next equity round. Other key terms include conversion triggers, such as the required size of the next round and maturity date. Overall, the headline terms can vary widely depending on the situation, and are intended to be attractive enough to attract capital at an important stage.

Advantages and disadvantages: CD offerings can be more certain, faster and more cost-effective (i.e., less legal fees) to put together than raising a priced round from an institutional investor looking to negotiate price, control, governance provisions and more. With CD, the company is also able to secure smaller funding amounts to continue to prove out the business model and build its valuation for the larger institutional round.

Investors enjoy some downside protection and both sides essentially defer the often difficult discussion around valuation. Investors are rewarded for both waiting and being early with accumulated interest and a conversion discount, but have less influence in negotiating the terms of the next raise.

Too much convertible debt can burden a company with dilution at the time of conversion and can be off-putting to some institutional investors. Also, if the company does not execute on its business plan and cannot attract an institutional round, there is also a looming maturity date when the debt needs to be repaid or a forced conversion takes place. Conversely, if the company executes very well and builds the valuation to well beyond the conversion “cap,” the company will incur incremental dilution.

Nonetheless, under most circumstances, convertible debt can be a valuable and adaptable tool to help fund early-growth companies through their funding gaps.

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