In convertible note financing transactions, the interest rate on the notes is often quite low (6% seems to be market these days) and doesn’t even begin to compensate the investors for the risk that they are taking. That is why investors are compensated with an extra “equity kicker” when purchasing convertible notes. The equity kicker used to be structured as a warrant (5-10 years ago), now the equity kicker tends to be structured as a conversion discount on the notes (last 5 years or so). What are the differences?
A warrant is an option—the right but not the obligation to purchase a certain number of securities for a certain period of time at a certain price. In a convertible note financing, the warrant will normally be exercisable for the class and series of shares issued in the Qualified Financing (the “Qualified Financing” is the future equity financing that triggers conversion of the convertible note into equity securities). The warrant is pure upside, giving the investors economic ownership of more shares for their money than they would be purchasing in the Qualified Financing. Investors will normally sit on their warrants and exercise them, purchasing the underlying stock only if the warrant is “in the money” (meaning the fair market value of the underlying stock is greater than the exercise price of the warrant). Investors will normally wait until a sale of the company to exercise their warrants and then pocket the spread between the sale price per share in the sale of the company and the exercise price of the warrant. See related post What is Warrant Coverage?.
The conversion discount functions differently. It is not an option to purchase stock at some point in the future, but a lower purchase price per share in the Qualified Financing for the convertible note investors than the other purchasers of stock in the Qualified Financing. The benefit to investors is more immediate: They get their equity kicker stock in the Qualified Financing and don’t have to wait until a sale of the company to purchase additional shares. The investors also don’t have to “pay” for the additional shares that are the equity kicker (like in a warrant). There is no exercise price. The discounted purchase price per share pays for the additional shares that convertible note investors will receive in the Qualified Financing for the same money as other investors purchasing shares in the Qualified Financing–they just get more shares for their money.
There are a number of big advantages for investors to structure the equity kicker as a conversion discount in lieu of warrants:
- Long-Term Capital Gains. Investors with conversion discounts will receive the additional equity kicker stock at the time of the Qualified Financing, thereby starting their long-term capital gains holding period for the additional stock. When the company is sold, there is a much greater chance they can get long-term capital gains treatment for the sale of their additional stock if the holding period has been met. An investor who exercises a warrant in connection with a sale of the company would not have the requisite holding period to get long-term capital gains tax treatment for the underlying warrant shares.
- Greater Up-Side per Share. The investor with the conversion discount pays for the additional equity kicker shares in full in the Qualified Financing and enjoys the full economic ownership of those shares, whereas the investor with a warrant has to pay the exercise price per share (which is normally the price per share of the securities sold in the Qualified Financing) and only pockets the spread between the ultimate fair market value or sale price of the stock and the exercise price per share.
- Number of Shares of Stock. A conversion discount yields more shares to investors using the same percentage number than convertible a note transaction with warrants. What? That sounds odd. Look at the numbers. The economics of a transaction with 20% warrant coverage are different than the economics of a transaction with a 20% conversion discount:
|20% WARRANT COVERAGE||20% CONVERSION DISCOUNT|
|Amount of Convertible Note:||$100,000||$100,000|
|Qualified Financing Price Per Share:||$1.00||$0.80|
|Number of Shares on Conversion of Note (excludes conversion of Interest):||100,000||125,000|
|Number of Warrant Shares||20,000||N/A|
There isn’t any magic to the math, just realize that 20% does not produce the same economics under both the warrant coverage and conversion discount scenarios. A 20% conversion discount equates to 25% warrant coverage. A lot of entrepreneurs (and even some investors) don’t realize this when negotiating term sheets. They think a 20% kicker is a 20% kicker, meaning an additional 20% of stock.
- Liquidation Preference Multiplier. Another big advantage for investors with conversion discounts is that it has a multiplying effect on the liquidation preference. See related blog posts Less Risk, More Reward and Term Sheet 101: The Liquidation Preference for discussions on liquidation preferences in preferred stock financing transactions. Using the same numbers from above, when a convertible note with warrant coverage is converted into shares of stock in a Qualified Financing, the convertible note converts dollar for dollar at the purchase price per share in the Qualified Financing. A $100,000 convertible note converts into $100,000 of preferred stock with a liquidation preference of $100,000 (these calculations assume a 1X liquidation preference and exclude the conversion of interest). The warrant for 20,000 shares of preferred stock has an aggregate exercise price of $20,000, meaning that the investor will have to pay $20,000 for shares that have a liquidation preference of $20,000. There is no multiplier; the investor will have to pay to get its full liquidation preference on 120,000 shares.
With a conversion discount, however, the investor purchases 125,000 shares of stock with an aggregate liquidation preference of $125,000, but it only had to pay $100,000. The investor is immediately “in the money” if the company was sold. The investor just picked up $25,000 of additional liquidation preference and didn’t have to pay for it!
(SIDE NOTE: The liquidation preference multiplying effect causes a lot of angst among new investors who are only getting a dollar-for-dollar liquidation preference, and it should cause a lot of angst among founders whose shares of common stock are now going to be sitting behind an even greater liquidation preference on the share of preferred stock. In response, an interesting approach is to apply the conversion discount toward the purchase of shares of common stock instead of Qualified Financing securities (normally preferred stock with a liquidation preference). This is the approach taken in the “Convertible Security” documents by Yokum Taku published by The Founder Institute. The same concepts can and should apply to convertible notes. We will soon be rolling out convertible note documents with this feature in our Convertible Note Financing document sets.)
Given the advantages to the conversion discount structure for investors, why don’t we see more deals with warrant coverage instead of conversion discounts? Aren’t we in a founder-friendly investing environment?
Two objections to warrant deals seem to be prevalent. The first is transaction costs. If investors also get warrants, it means the transaction will be more paper-intensive and cost more. This is complete BS. Go to our Convertible Note Financing wizard and click the box for warrants. It is no more expensive. The second objection is that notes issued with warrants will have original issue discount (OID), because part of the purchase price will be allocated to the purchase of the warrants. If this is a concern, allocate a few hundred dollars to the purchase of the warrants, or pay a little bit more for the purchase of the warrants. The warrants are worth very little at the time of a convertible note financing: they are exercisable for a security that does not exist and will never exist unless the company completes a Qualified Financing at some point in the future, which is a big if. The OID problem can be handled, and in fact we’re handling it with specific language in a future release.
If you are the investor in a convertible note financing, you have the advantage right now. The conversion discount is better for you and is market. If you are the company raising funds in a convertible note financing, consider using warrants in lieu of a conversion discount (whatever you do don’t do both). Warrant coverage is better for you, but you may have an uphill battle negotiating warrant coverage in lieu of a conversion discount.
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