How does convertible debt work? 2

I just received the loan agreement for a convertible.

Highlights: $200k loan, 5% interest, 3-year term, 15% discount and $2.5m cap.

Then article 4.2 says: “Unless earlier converted (..), at the election of the Lender Majority at any time on or after the Maturity Date, the Conversion Amount will be converted into that number of Conversion Shares equal to the quotient obtained by dividing the Conversion Amount by the higher of (a) two times the aggregate amount of all Permitted Convertibles or (b) $400,000, in each event divided by the Fully Diluted Capitalization immediately prior to the conversion.”

And article 7.1 says: “In the event that the Lender Majority has not decided to exercise its conversion option following the Maturity Date as described in Article 4.2 within 6 months from the Maturity Date, at the election of the Lender, the Borrower shall repay the Loan plus accrued interest.”

Lawyers – how can you not love them?

Let’s try to understand this.

Picture1

Assume that I don’t raise any more money.

Then 1 of 2 things happens.

Option 1

Article 4.2:
The Series Seed investor has the right to convert $200k * (1 + 5%) ^ 3 = $232k into shares.

He pays either (a) 2 * $250k / 1,000 = $500 per share or (b) $400k / 1,000 = $400 per share – whatever is highest.

So the Series Seed investor gets $232k / $500 = 463 shares.

I own 1,000 / 1,463 = 68% of the shares.

Option 2

Article 7.1:
Alternatively, the Series Seed investor has the right to get repaid $200k * (1 + 5%) ^ 3 = $232k.

I own 1,000 / 1,000 = 100% of the shares.

Even after consulting the lawyers, I am still unclear why article 7.1 exists/an investor would ever choose option 2. Let’s think this through:

  1. The startup does well. In fact, so well that they didn’t even have to raise additional financing. Obviously the investor will choose to convert instead of getting repaid = option 1.
  2. The startup doesn’t do well. The investor would like to get repaid = option 2. But the startup cannot repay him – because they don’t do well. So the startup defaults. And the investor ends up with nothing. So even though the investor would like to get repaid, he will choose to convert = option 1. That way he has at least a chance of getting some money back. Maybe. Someday.

OK, now I get how a convertible works – part 2.

 

Thanks to Hans Westerhof, Chretien Herben, Sjoerd Mol, Maurits Bos and Jaap Dekter.

Joachim Blazer is founder at Venture Value. Contact him at joachim@venturevalue.com.

Venture Value does startup valuations for founders who want to raise money with an investor.