Jeremy Halpern, Partner and Co-Chair, Food and Beverage Practice Group, Nutter
Early stage food and beverage companies face a key early financing dilemma: to fund growth operations, they need to raise a lot of cash, yet they have little, if any, market value. Chicken, meet egg. Such companies typically are still refining an early set of SKUs including both the formulations and the packaging, they frequently have very little distribution and sales traction and they have virtually no brand awareness. The lack of such attributes means that, in a vacuum, they would have very low market value as a going-concern business. As such, if such a startup raised all of the cash it would need to fund even 6–12 months of operations at such low “intrinsic” valuations, the founders would experience massive dilution. This would be highly demotivating and likely kill the potential for building future value. So a solution had to be found.
The seed capital market responded to this dilemma by using investment mechanisms that use a floating rather than fixed valuation. By “kicking the valuation can down the road” and pegging the seed round valuation to the price paid by subsequent investors, founders avoid over-dilution while still providing seed investors with preferential pricing to reflect early risk. The most common instrument used in these friends and family, early angel, and incubator type deals has become convertible debt.
Convertible debt has two central components. On the debt side, investors lend cash to a company in exchange for a promise to repay the debt, plus interest. As might be expected, high growth companies almost never have sufficient cash to repay such amounts—which leads to the second component.
On the equity side, the company can avoid repayment by instead forcibly converting the principal and interest into equity at a rate determined by the next round of professional investors, but to which a discount is applied.
During the time such an investment remains debt, the holders of the debt act like unsecured noteholders, having few control rights over the company. Once converted, however, these holders become owners of equity, and have all the usual rights of angel or venture investors.
Bridge Not a Pier
Convertible debt, therefore, relies upon the premise that the issuing company will, in fact, successfully raise follow-on financing. In fact, this mechanism is only worth the trouble if such subsequent round is (i) likely to occur before note maturity, and (ii) priced at a substantially higher valuation that the company would have received at the time of issuing the notes. At a minimum, for the note mechanism to be of any value to the company and the preexisting shareholders, the company needs to grow faster than the rate at which the notes’ interest and discounts are creating additional dilution. If a company issues convertible debt and then doesn’t build value, the founders will experience even worse dilution than that which they sought to avoid in the first place. As they say, convertible debt is a good “bridge” mechanism but makes an awful “pier.”
Maturity – Maturity is the date on which the convertible debt must be repaid. As seed cash typically is intended to last the company 12–18 months, convertible note maturities tend towards 18–24 months to allow for the inevitable bumps in the road. If the company reaches the maturity date without having triggered a conversion of the debt, the company is likely to then be insolvent, with the holder of the notes owning a claim to all of the assets of the company. While noteholders rarely foreclose, if there is upside potential in the company, the noteholders will typically renegotiate to obtain a larger share of the value in exchange for their agreement to convert or extend the maturity date. A side effect of insolvency may be that it creates additional obligations and restrictions on how the company may operate until cured.
Recently, the market has fixed this risk by having the debt automatically convert into (the most senior) equity at the time of maturity, but at a price that is between the price the Company could get at issuance, and the price the Company hopes to achieve in the next financing. By way of example, if the Company thinks that the present valuation is $1,000,000 and that the next round might be at $5,000,000, then the maturity price might be at $2,500,000. It should be low enough to create strong incentives for the Company to build value, but not so low as to be equivalent to the pricing investors would demand in the foreclosure scenario.
In food and beverage companies, one way the parties can price the conversion at maturity is by reference to the actual performance of the Company. Typically, this might look like an aggregate equity valuation equal to 2-4x trailing twelve months’ net revenue (TTM). This perfectly aligns the performance of the Company with the price paid by investors. It might be asked why such mechanism isn’t used in the first place. The answer is that a Company at seed stage has such small revenue and such immature infrastructure that a price:revenue ratio is not sufficiently predictive of value. However, with the investment capital, the company can start a professionalization and scaling process, so that by the time of maturity, the price:revenue ratio is a more fair representation of true value and market potential.
Mandatory conversion and Qualified Financing – The parties typically agree that only a financing of a certain size and type will be usable as the reference valuation. This “Qualified Financing” triggers a mandatory conversion of the principal and interest into the type of equity securities issued in the Qualified Financing, which is in almost all cases, preferred equity. Shares of this preferred equity will have a liquidation preference either equal to the per share price paid by the subsequent investors or the price per share actually paid by the noteholders.
Interest – Interest is typically simple interest in the range of 4% – 8%, which compensates the noteholders for the time value of money. Interest will accrue but not be payable until maturity or conversion. As the interest will also convert into shares of preferred stock, converting noteholders will obtain more than $1 worth of shares for each $1 actually invested.
Discount – A discount is the reduction in price per share paid by the converting noteholders relative to subsequent investors. Typically 5%–25%, this discount is intended to compensate the earlier noteholder investors for the additional risk they undertook. Subsequent investors will resist permitting the company to convert noteholders at excessive discounts, particularly if substantial additional risk was not absorbed by the earlier noteholders. Discounts are either usually either fixed or tiered. If fixed, it’s usually a ballpark number like 10% or 20%. If tiered, the discount rises the longer the time between the bridge note deal and the Qualifying Financing. For example, it might be that an investor starts with a 5% discount that rises an additional 5% every quarter, with a maximum discount of 20%.
As is the case with accrued interest, the discount will provide converting noteholders with more than $1 worth of shares for each $1 actually invested. By way of example, if the new investors would pay $1.00 per share and the noteholders were entitled to a discount of 20%, the new investors would convert all principal and interest at $0.80 per share.
Cap – The valuation cap is the maximum value at which the noteholders will convert their principal and interest, regardless of the valuation used in the Qualified Financing. Investors often require that they receive the lower of (i) the discount times the new price, and (ii) the cap. This means that if, in the prior example, the company caps the conversion at $3,000,000, and then issues shares at a $3,000,000 price, the noteholders will convert at $2,400,000 because of the 20% discount. Food and beverage companies can, again, use a floating cap that is based upon a multiple of performance rather than a fixed number.
Liquidity – Recently, as many companies went from seed financing directly to acquisition, investors have negotiated for the right, upon an acquisition, to receive the greater of (i) a multiple of their investment (in some cases plus interest), typically 1.5–3x, or (ii) the right to convert at an agreed valuation as of immediately prior to the transaction, enabling them to participate as equity holders. In negotiations, many companies resist any requirement to pay a multiple of capital upon an exit, as the investors have not fully absorbed equity risk at the time of acquisition. The agreed upon valuation is often the same as the Cap, but not necessarily.
Prepayment – In many cases investors prohibit the company from prepaying the debt, as they are not really investing for the interest payments and do not want to absorb equity risks for debt returns.
Unsecured—In almost all cases the convertible notes will be unsecured by the company’s assets. This both helps the company raise other standard credits from lenders, vendors etc., but also avoids the substantial costs of negotiating security and collateral agreements.
Convertible notes have many advantages over equity deals. They are typically cheaper to document and can be sold to investors much quicker and on a rolling basis. Convertible debt also allows the company to offer larger discounts to earlier investors to incentivize early closings. Convertible debt deals also avoid the possibility of a “down round” in which the company raises money in the second round at a lower valuation than in the seed deal, triggering various investor rights and sending terrible signals to the marketplace. Lastly, convertible notes often do not require companies to offer or negotiate board seats or extensive control rights for seed investors. In addition, where friends, family and extended network are often part of the investor group at the early stage, the ability to have a floating price allows the parties to not haggle over the valuation. This often is key in preserving relationships and giving everyone a sense that they are getting a fair deal.
The combination of the maturity, the cap, the interest and the discount place a huge burden on the company to build value very quickly. Unlike an equity deal in which investors and founders are in the same boat if the company grows slower than expected, in a convertible debt deal there is strong dis-alignment of both incentives and outcomes if the company does not meet expectations. Investors will end up with a much larger share of the company than anticipated if the company does not meet its goals. Additionally, companies typically want early stage investors to be their biggest champions – and setting up a structure where such investors are economically rewarded if the Company does worse rather than better is troublesome.
Deals in which there is no forced conversion at maturity may also lead the company to a position of insolvency, or, at a minimum, to a very painful renegotiation with the noteholders, where the company reaches maturity but has not raised a qualifying financing, experienced an exit transaction, and has insufficient cash to repay the debt. This describes a large number of early stage companies who have taken convertible debt, and in a down market, may describe a company that is performing well but unable to raise cash because of external market conditions.
Equally important, the price cap often works as an unintended bellweather to next round investors about where to begin negotiations. This critically reduces the opportunity of the founders to use convertible debt to avoid over-dilution—the whole point of the convertible debt transaction. If the next deal will happen at the cap price, founders would be better off pricing the existing round at that valuation and avoiding the extra dilution resulting from the discounts and interest.
It is generally the case that shares issued upon the conversion of the debt are eligible for capital gains treatment. Investors who want to start the clock on the one year holding requirement permitting the most favorable tax treatment need to consider the possibility of an exit transaction occurring within a year from the conversion date, as opposed to the date on which the convertible notes were issued.
It is also likely that the original convertible debt mechanism does not deprive investors of the ability to treat shares issued upon conversion as qualified small business stock. These very favorable provisions allow stockholders to shield all or a substantial portion of the potential gains from taxes.
Often overlooked, convertible debt can create interest reporting obligations as well as change the taxable character of the investment. First, even where interest on convertible notes is accruing and will not be paid until maturity or conversion (if ever), companies and investors are required, for tax purposes, to treat the interest accruals as if cash has been paid. This means investors will have presently taxable income without having received any cash, a situation many find unpalatable. Second, and more troubling, is that the payments due to investors upon an acquisition prior to conversion (usually calculated as a multiple of principal and interest), are likely taxed as ordinary income rather than capital gains. Such treatment massively reduces the net return on investment for investors.
Convertible debt deals offers some very useful features for early stage food and beverage deals, principally by delaying the valuation negotiation. The ability of such companies to tie outcomes to downstream revenue performance also reduces the potential for the misalignment often seen in other sectors. As long as the parties understand the choices, convertible debt can be a powerful tool in the kit of food and beverage entrepreneurs to raise capital for their high growth businesses.