Convertible debt a good deal for
but a last resort for cash-starved firms
minute it's debt, the next it's an equity investment. That's the
changeling nature of convertible debt, a bit of financial legerdemain
that small-business owners may want to tuck up their sleeves as
a last-resort move.
"Generically, it's debt that is convertible
to equity," explains George Shea, president of the Ambassador
Capital Corporation, an Atlanta-based investment banking firm
that works with high-technology companies.
it to sweeten the deal
Convertible debt often is used as a deal-sweetener -- the clincher
that convinces a lender to finance a fledgling company. With convertible
debt, a lender has a big upside: If the company takes off, the lender
can opt for stock in a fast-growing company. Or, the lender can
stick with the original loan setup and get its money back plus interest.
"Susie, a private investor, doesn't know you
and whether your company will succeed or not. Convertible debt is
basically a hedge for backers like Susie," Shea says. "She gets
the advantage of converting the loan into stock and, if your company
succeeds, she may have a strong preference for that."
Michael Troy, founder and president of KnowledgePoint,
has used it twice to get financing for his human resource software
company in Petaluma, Calif.
"My attorney suggested it to me and went in
that direction," Troy recalls. "I wanted to have a clear exit strategy
for my investors ... This way, I could say, 'Here's how you'll get
your money back -- with a loan that gets paid back with the option
to convert it to stock. It gave them a clear path to liquidity.'
The first time he used convertible debt was
in 1985. He gave eight lenders the option to convert in exchange
for $76,000. Under their agreement, the investors received a quarterly
guaranteed interest rate payment (5 percent above prime, capped
at 15 percent) and could exchange their loan for an equity stake
anytime after November 1988 but before the last six months of the
five-year loan. Half the investors chose to convert their loan repayment
Troy used the same mechanism 10 years later
to raise $500,000. While those loans are still outstanding, he expects
all the investors to convert to equity.
it's a last resort
While convertible debt can bring in the money, it has several important
It can be complicated to arrange and administer.
It can be done, but it takes a lot of work and probably should only
be used as a last resort.
It can be much more costly: Not only are you
paying interest, but you may be giving up a chunk of your business.
For that reason, Shea suggests that a small-business owner using
convertible debt should hold out for an interest rate that's only
a couple of points above prime.
Finally, convertible debt can turn off future
lenders. Troy says his original convertible debt deal made KnowledgePoint
debt heavy and unappetizing to bankers. The company wasn't able
to get a bank loan until 1991 -- when half its debt holders converted
their debt to equity.
Experts give the following advice on how to make convertible debt
work for your company:
- Work closely with your lawyer to make sure
the conversion agreement (under what conditions and when debt
can be converted to stock) is a good one. For example, make sure
you have as much control as possible over the conversion process.
"I think the challenge is to do what's legally appropriate and
you need to have a good attorney involved," Troy says.
- Spend adequate time on valuation; that is,
what price will be set for the stock. Ask your accountant for
assistance. Make sure your CPA has experience in such dealings
and has a good understanding of IRS regulations.
- Try to use the conversion as leverage with
your lenders, for example, to negotiate a lower interest rate
or to get an investor, who would otherwise walk away, to commit.
Follow that advice and your company's convertible
debt plan won't just be financial mumbo jumbo, but will deliver
for you and your backers.
"Even with all the venture capital money that's
around, not every business can get venture capital," Troy says.
"This is an option that falls below the radar scope of venture capital
and can help companies that can't get backing through more traditional
Jenny C. McCune is a contributing
editor based in Montana
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-- Posted: July 6, 2000