QUESTION:

My understanding of convertible debt is that it is designed to convert upon the next round of funding. The valuation is determined by next round of investors. So what happens to any convertible debt financing if my startup gets acquired before another round of funding takes place?

ANSWER:

Ethan Stone

Ethan Stone

by Ethan Stone, Stone Business Law

First, a quick but important clarification: I’m not your lawyer and this answer doesn’t establish an lawyer-client relationship. I’m giving a generic answer to a generic question to educate the users of this site.

Now to the question: The answer depends entirely on the terms of the convertible debt. That said, I’ll make some general observations.

Let’s start with the obvious: Convertible debt is debt. So eventually (usually 6-12 months) the debt will come due with interest. So if the note doesn’t specifically address a sale of the company, the investor will, generally speaking, be paid its principal and interest out of the proceeds of the sale. The precise timing and mechanics of paying the lender vary, depending on a number of factors.

Because the angel investors who invest through convertible debt generally aren’t looking to be paid back with interest, but rather are looking for an equity stake in the business, the convertible note will often give them more. One common provision is to give the investor some multiple of the principal (usually in addition to interest), say 2X or 3X. Another common provision is to allow the investor to collect on the basis of some share of the equity. Since angel convertible debt is typically not “priced” (i.e. the investor’s exact equity stake isn’t determined at the time of the investment), these provisions need to address how that share will be determined (often, there’s a price that applies specifically to sales). Often, the investor will be able to choose between these two ways of getting paid (i.e. the investor can take whichever is best under the circumstances). Many other variations are possible.

The bottom line is that the specific terms of the specific note will determine. Those are (or, at least, should be) a key point of negotiation when the investor invests.

Incidentally, if the sale is for less than the amount due on the debt, it will render the company insolvent. That is similar to a short sale of a house and, generally speaking, the investors will take all the proceeds of the sale, leaving nothing for the stockholders. That said, insolvency and bankruptcy can be very complicated. So anyone looking at a sale like this should consult qualified insolvency counsel (that’s not me) before doing anything.