I recently dealt with a tense situation regarding the “Qualified Financing” trigger in a standard convertible note financing. For background, convertible debt documents typically provide that the debt will automatically convert into a future0 Qualified Financing equity round. And that conversion is typically at a discount to the Qualified Financing equity round price. Here is an example of actual language from a promissory note:
“Upon the closing of a Qualified Financing, the principal and accrued interest of this Note shall be converted automatically without the consent of the Holder into securities of the same class or series as are issued in the Qualified Financing. The number of securities to be issued in such conversion shall be determined by dividing the sum of the then outstanding principal amount of this Note and all accrued but unpaid interest thereon by the Conversion Price. The “Conversion Price” means an amount equal to eighty five percent (85%) of the price per share paid by the investors in the Qualified Financing.”
It is extremely straightforward — here the discount was 15% to the Qualified Financing price. (Sometimes, though not in this example, you will see a valuation cap built in too so that the debt holder gets the better of the discounted price of the valuation cap price. I suppose I should do a post on valuation caps too at some point.)
Here is the definition of Qualified Financing from the same promissory note:
“Qualified Financing” means the issuance of equity interests (or debt securities convertible into equity interests) in the Company to investors prior to the Maturity Date (as the same may be extended) in one or a series of related transactions, the principal purpose of which is to raise capital, which transaction or series of related transactions result in the Company receiving gross proceeds of not less than $700,000 (inclusive of the principal amount of the Notes that will convert into equity in connection with the consummation of the Qualified Financing).”
Typically you set the Qualified Financing trigger to be a meaningful amount of NEW equity financing so that the convertible debt is converting in a financing that will give the company some meaningful cash burn runway. That is the whole premise behind having the conversion be automatic. If the company is successful in raising the equity round that gives it some breathing room and runway, then the debt automatically converts and everyone is happy. Goal accomplished.
I have used the word “typically” a few times in this post. I am now going to use it again. Typically, in the definition of Qualified Financing the amount of the outstanding convertible debt notes do NOT count towards achieving the Qualified Financing threshold as it is NEW cash that gives the company the breathing room and runway. In the definition above the threshold is $700,000, which would give the company meaningful time to achieve its next set of milestones and set it up for additional capital raising if required. Now, I hope some of you see the problem in the definition above. It uses the word “inclusive” as opposed to “exclusive”. I underlined “inclusive” in the definition. In all the convertible debt deals that I have done (probably 50 or more), I have only used the word “inclusive” once. And I honestly do not know why on that one occasion I agreed to it. Mental lapse? Maybe! I actually think what happened is that when we advanced the first promissory note we were highly confident that the Qualified Financing was not far off so that including the note amount was okay because the note amount was small (like $100,000). Well, the Qualified Financing got delayed and delayed and delayed…..and the amount of convertible debt grew and grew and grew as more debt was advanced to support the company prior to a Qualified Financing.
Ultimately, the amount of the debt approached the $700,000 Qualified Financing trigger amount. We could not advance more than the trigger amount — that would be nonsensical and put the noteholders in a very bad spot. The resulting conversations were awkward, but the solution was easy. Just amend the notes to change “inclusive” to “exclusive”, which is incredibly normal anyway.
Originally published at ithacavc.com on February 12, 2016.