Understanding Convertible Debt

Financing

Presented by:

Neil R. Milano

Executive-In-Residence

Commercialization Center for Innovative Technologies

June 10, 2015

1

What is a Convertible Note?

• A short-term debt instrument that converts into shares of

preferred stock upon the closing of a Qualified Pricing

round such as Series A offering.

• The investors receive shares of preferred stock as part of

the initial preferred stock financing instead of getting their

money back with interest.

• Since a valuation is unnecessary, there are no dilution,

taxes or option pricing issues for the founders.

2

Neil R. Milano

Glossary of Terms • Conversion Trigger: Closing of qualified priced round.

• Interest Rate: Rate of interest on the note, usually simple interest, but can be compounding. Principal and accrued interest convert into shares.

• Conversion Cap: Sets the maximum valuation at which the investment can be converted into equity. The investors typically get converted at the lesser of the pre-money valuation of the next qualified priced round and the cap.

• Conversion Discount: A mechanism to convert the amount of the note, plus accrued interest, at a reduced price (in percentage terms) to the next qualified priced round.

• Preemptive Pro Rata Rights: A right to participate in future rounds of financing

3

Neil R. Milano

Typical Terms for Investors

• Amount Raised: $500K to $1M

• Interest Rate: 4%-8%, simple or compounding interest

• Term: 12-24 months, converts upon successful completion of a

qualified priced financing

• Conversion Discount Rate: 10%-30%

• Conversion Valuation Cap: $2M to $8M

–Can contain both Discount and Valuation Cap

• Change of control Premium: 2x return

• Automatic Conversion: Upon acquisition or Qualified

Financing

4 Neil R. Milano

Advantages and Disadvantages

Advantages

• Often don’t include control

provisions

• Often don’t have board seats

attached to them

• Documentation can be a

simple note agreement

• Low legal fees to prepare

• Valuation, liquidation

preferences and participation

rights postponed

Disadvantages

• Investors may ask for a cap or discount, or both

• Short Maturity dates trigger repayment or conversion

• May contain restrictive covenants such as security interests

• It’s a liability on your balance sheet until repaid or converted

5

Neil R. Milano

Pre-Money Cap Table

• Founders fund company with $100,000 and issue

1,000,000 shares common stock with $.01 Par Value

Owner $ Common Shares

Ownership %

Founders $100,000 1,000,000 100%

6 Neil R. Milano

Pre-Money Cap Table with Convertible Note

• Company issues $1M Convertible Note

–Conversion Discount 30%

–Valuation Cap $5M

$ Shares Ownership %

Senior Notes $1,000,000

Founders $ 100,000 1,000,000 100%

Total $1,100,000 1,000,000 100%

7 Neil R. Milano

Post-Money Cap Table-Qualified Round

• $2M Series A Financing

–$8M Pre-Money valuation ($8/share)

–$1M notes convert with 30% discount ($5.60/share)

$ Shares Ownership %

Senior Note Holders

$1,000,000 178,571 12.5%

Series A Shareholders

$2,000,000 250,000 17.5%

Founders $ 100,000 1,000,000 70.0%

Total $3,100,000 1,428,571 100.0%

8 Neil R. Milano

Post-Money Cap Table-Qualified Round

• $2M Series A Financing

–$8M Pre-Money Valuation ($8/share)

–$1M Convertible Notes Convert with Cap ($5.00/share)

$ Shares Ownership %

Senior Note Holders

$1,000,000 200,000 13.8%

Series A Shareholders

$2,000,000 250,000 17.2%

Founders $ 100,000 1,000,000 69.0%

Total $3,100,000 1,450,000 100.0%

9 Neil R. Milano

Is A Convert the Best Option?

What is the Entrepreneur thinking about?

• A faster, cheaper and better than equity investment option

–Convertible Notes when structured properly can achieve that

goal

• Note-Alternative Securities

–SAFE (Simple Agreement for Future Equity)

–KISS (Keep It Simple Security)

10

Neil R. Milano

SAFE

Convertible Security- sometimes referred to as Series AA

Preferred Stock

• An equity security

–No maturity date or interest

–Conversion Cap and Discount

–Automatic Conversion at Valuation Cap upon change of control or

Qualified Financing

–Optional Conversion at some lower predetermined valuation if no

Qualified Financing takes place

11

Neil R. Milano

KISS

Hybrid Security- something between Convertible Debt and a

SAFE

• More Investor Friendly

–Contains interest rate and maturity date

–Conversion Cap and Discount

– Information Rights

–Automatic Conversion at Valuation Cap upon change of control or

Qualified Financing

–Optional Conversion at some lower predetermined valuation if no

Qualified Financing takes place

12

Neil R. Milano

Conclusion

• Convertible Debt can provide founders access to seed capital without setting a valuation, however

• Terms such as:

–Maturity dates, interest, insolvency and security interests can have unintended consequences

• Note-Alternative Securities include :

–SAFE or KISS

• Hire outside counsel for legal advice and to prepare documents. In the long run it will be money well spent.

13 Neil R. Milano

Contact Information

Neil R. Milano

nrmilano@hotmail.com

908-391-5595 (C)

14 Neil R. Milano