Structuring for convertible notes in venture lending transactions: Key considerations

With the availability of venture capital still constrained, and valuations yet to recover from their recent decline, convertible notes have become an increasingly attractive financing vehicle for many emerging growth companies. This alert discusses the protections venture lenders typically require to accommodate convertible debt in a borrower’s capital structure, as well as the flexibility some later-stage borrowers may request in their secured credit facilities.

Convertible note basics

Convertible notes combine many characteristics of traditional debt (such as the accrual of interest, a fixed maturity date, and the triggering of certain events of default) with a conversion feature that permits and/or requires the holder to exchange such notes into common equity in the future. Venture capital-backed companies have long used these instruments to raise capital for several reasons:

• They can be negotiated more efficiently and less expensively than a priced equity raise
• They avoid sensitive and time-intensive negotiations regarding valuation, and
• They enable founders to retain control of the company prior to the conversion into equity while providing the investor with customary lender protections.

The versatility of their features makes convertible notes suitable for a wide range of financing scenarios. For example, emerging growth companies often issue convertible notes when raising capital from so-called insiders – such as the company’s founders or existing investors – or unaffiliated venture capital investors in private transactions or from a larger number of third-party investors in publicly registered transactions. The form and terms of the convertible notes can vary based on the type of transaction and investor (and their relative negotiating power).

Permitting convertible notes

Although the issuance of convertible notes can be beneficial to the company, its investors, and its lenders, it requires the careful attention of venture lenders providing debt financing on a senior-secured basis.

Debt covenant

In its simplest form, any convertible notes acceptable to a lender must be permitted under the credit facility’s debt covenant. This is easily accomplished for existing convertible notes by referencing the convertible notes in the definition of “Permitted Indebtedness,” or in the exceptions to the debt covenant itself.

The parties may sometimes prefer to permit convertible notes on an ongoing basis including certain guardrails to ensure the new notes fit within the parameters of the lender’s underwriting model. Such guardrails might grant the lender a right to consent to the future convertible notes, or impose pre-negotiated restrictions on the terms of the convertible notes or the circumstances in which they may be issued.

Subordination

Convertible notes issued to insiders and other venture capital providers are almost always required to be subordinated to obligations under the credit facility, regardless of whether the notes are already in existence or permitted to be issued in the future. To the extent an existing investor has signed a subordination agreement in connection with a previous issuance of notes, lenders are encouraged to undertake a careful review of the agreement to determine whether the newly issued convertible notes are also subordinated. Holders of public convertible notes, however, are typically not required to subordinate the obligations under the convertible notes to the credit agreement due to the practical limitations of doing so.

Lastly, lenders and borrowers alike are advised to be mindful of the interplay of the provisions related to the convertible notes and those related to other subordinated debt. Some agreements expressly exclude convertible notes from the definition of subordinated debt (and the scope of the related provisions); others take the opposite approach. Whatever agreement is reached by the parties, each should confirm that the drafting of the credit documentation aligns with their respective expectations.

Other covenants

Additional language may sometimes be needed to permit publicly traded convertible notes under the credit facility’s other negative covenants, particularly those restricting certain investments, restricted payments, payments on junior debt, and dispositions. This language carves out the borrower’s issuance of such convertible notes and its performance thereunder (including the issuance of common stock in connection therewith) from the scope of such covenants so long as the specified actions are taken in accordance with the applicable subordination agreement or other clearly defined limits.

Lenders may further consider what informational needs they might have with respect to a borrower’s convertible notes. As noted above, many lenders receive copies of (and have consent rights with respect to) the convertible debt documents. Some may find additional transparency – such as notice of any election by convertible noteholders to exercise the conversion feature under any permitted convertible notes – beneficial. Any such requirements should be included in the credit facility’s affirmative covenants.

Events of default

Many lenders look to expressly clarify in the credit documentation that the event of default trigger for defaults under other material debt applies to the permitted convertible debt (subject to a limited number of technical exceptions). Others may also include an additional event of default trigger if an early payment is required under any permitted derivative transaction related to the convertible debt, or if such transactions are prematurely unwound or terminated.

Additional flexibility for publicly traded convertible notes

Derivative transactions

Some borrowers may seek to mitigate the financial impact of their publicly traded convertible notes by entering into a series of derivative transactions (sometimes called “call spread transactions”). For example, a borrower might purchase a call option on its common equity shares and simultaneously sell a warrant with a higher strike price to synthetically increase the conversion price on the convertible notes. Such transactions are typically prohibited under a credit facility’s negative covenants despite having a justifiable business purpose, so some borrowers may request express authorization to do so in their credit documentation. Similar to the treatment of publicly traded convertible notes under the negative covenants (as described above), the permitted derivative transactions are often carved out from the applicable negative covenants, including any covenant restricting the borrower’s ability to enter into swap agreements.

Limitations on redemption

Some borrowers with publicly traded convertible notes may further request the ability to redeem or repay in cash the principal amount of such notes before the stated maturity or the exercise of the conversion feature. Doing so will often raise credit concerns, as any funds used to make such payments would otherwise be available to repay the obligations under the credit facility. Some lenders may be willing to permit such a redemption, subject to certain conditions to address these concerns.

Refinancing indebtedness

Some later-stage companies may additionally push to allow the replacement or refinancing of their current or future publicly traded convertible notes. If permitted by the lender, such replacement indebtedness is often subject to additional conditions, including a requirement that any derivative transactions related to the replaced convertible notes be unwound or terminated.

If you would like to discuss or have any questions regarding the topics discussed in this alert or related matters, please contact one of the authors or any member of DLA Piper’s Venture and Growth Lending and Corporate teams.