In today’s episode of our convertible debt series, we discussion a few other terms that come into play with a transaction.
Interest Rate: We believe interest rates on convertible debt should be as low as possible. This isn’t bank debt and the funders are being fairly compensated through the use of whatever type of discount has been negotiated. If you are an entrepreneur, check out what the Applicable Federal Rates (AFRs) are to see the lowest legally allowable interest rates are and bump them up just a little bit (for volatility) and suggest whatever that number is. Typically we see an interest rate between 7% and 10%.
Pro-Rata Rights: This term allows debt holders to participate pro-ratably in a future financing. Since many times the dollars amounts are low / lower in a convertible debt deal, investors may ask for “super pro-rata” rights. For instance, if an investor gave a company $500,000 in a convertible debt deal and the company later raises $7,000,000, the investor’s pro-rata investment rights wouldn’t allow them to purchase a large portion of the next round. Sometimes investors will ask for pro-rata rights that are a multiple of their investment. In this case the investor may ask for two to four times their amount. While pro-rata rights are pretty typical, if you have people asking for super pro-rata rights, or a specific portion of the next financing, you should be careful as this will likely limit your long term financing options.
Liquidation Preferences: Every now and then you’ll see a liquidation preference in a convertible debt deal. It works the same as it does in a preferred stock deal – the investors get their money back first, or a multiple of their money back first, before any proceeds are distributed to anyone else. This usually happens in the case when a company is struggling to raise capital and current investors offer a convertible debt (also called a bridge loan) deal to the company. Back in the good old days usury laws prevented such terms, but in most states this is not an issue and allow the investors to not only have the security of holding debt, but the upside of preferred stock should a liquidation event occur.
Other Terms: If you see other terms in a proposed deal outside of these, we’d guess that they are unique to your situation, as the ones we’ve discussed should cover the vast majority of debt transactions.