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As more biotechs turn to convertible note financing instead of traditional venture capital, they need to be aware of investors' demands.
Most life sciences companies are intimately familiar with the market for angel and venture capital equity financings. The market trends and standard terms and conditions in preferred stock equity financings are widely known. Many biotech and pharmaceutical startups, however, are relying more and more on convertible debt rather than traditional equity financing, either as a primary form of financing or as a bridge to a future equity financing.
Peter N. Townshend
For biopharmaceutical companies, the biggest advantage of note financings is speed. Given the high stakes and the complexities of conditions involved, however, companies should weigh their options carefully before choosing convertible notes over traditional equity financing.
In the classic angel or venture capital equity financing, investors purchase preferred stock of the company. Preferred stock generally has dividend, liquidation, redemption, or voting rights superior to that of the company's common stock. Equity investors are stockholders of the company and have associated voting rights, which generally include the right to designate members of the board of directors and to approve key transactions, such as future financings or a company acquisition.
In contrast, convertible note investors make loans to the company and receive in exchange convertible promissory notes. These investors are creditors rather than stockholders. The principal and interest on these convertible notes, subject to certain conditions, generally are automatically convertible into shares of the company's preferred stock issued in its next financing—hence the common reference to these notes as bridges to a subsequent financing.
If the convertible notes are convertible into preferred stock, why not skip the note offering and just conduct a preferred stock financing?
Advantages for Companies
A company may opt to conduct a note financing for a variety of reasons. It may be close to developing a new product or completing a regulatory or other key milestone that will help justify an increased valuation. The company may need funds quickly, and note financings can often be closed sooner than equity financings because they generally involve fewer documents and a more limited due diligence process, and do not require the negotiation of a valuation of the company or, in most circumstances, approval of existing stockholders. Finally, a company may opt to conduct a note financing because it has not been able to line up enough funding sources to make worthwhile the time and expense of conducting a preferred stock financing.
Advantages for Investors
Note financings can also be attractive to investors. Note investors benefit from the time and cost efficiencies of a note financing. Additionally, because these investors are creditors rather than stockholders of the company until conversion of their notes, if the company should become insolvent or bankrupt prior to its next equity financing, the note investors will have priority over the company's stockholders in making claims against the company's assets. Note financings usually also include a conversion discount or warrant coverage, which sweetens the deal for the note investors.
The terms of note financings can vary widely from deal to deal, and are much less standard than a traditional venture capital equity financing. Moreover, note investors have become more sophisticated, creative, and aggressive in negotiating terms, so companies can expect note financings in the coming years to become more complex and potentially less favorable to issuers. Nevertheless, some terms are typical in most note financings.
Fixed Interest for a Fixed Term
Convertible notes usually provide for a fixed interest rate between six and 10% per annum. The term until maturity varies based on a wide variety of factors (e.g., expected timing of a future financing, timing of milestones, revenue expectations), but most notes become due from six months to two years from issuance, after which, if the debt has not been converted into equity, the company must repay the note on demand (upon request) by the investor.
What Sparks Conversion?
Typical convertible notes will not convert automatically unless the preferred stock financing has a minimum amount of gross proceeds. For example, in a $5 million note financing, the notes may convert automatically in the next equity financing in which the gross proceeds (excluding the convertible promissory notes) to the company total at least $10 million. Upon the occurrence of such a qualifying financing, the principal and, typically, the accrued interest on the notes will convert into the same type of preferred stock issued in the qualifying financing at the same price paid by the other investors. Some convertible notes may instead provide that accrued interest will be waived or repaid in cash rather than converted.
Some note investors may also negotiate for other contingencies, including a premium repayment if the company is sold prior to a qualifying financing or an optional conversion into common stock or a prior round of preferred stock at a pre-determined price if a qualifying financing has not occurred prior to maturity of the notes.
Investors generally demand more than simple interest to compensate for the risk of pre-investing in a qualifying financing, the specific pricing and terms of which are unknown to them and to the company at the time of the note financing. This extra compensation usually takes the form of either a discounted conversion price or warrant coverage, rarely both.
In the case of a discounted conversion price, the notes convert at a discount from the price paid by the other investors in the qualifying financing. This discount may range from 10% if the qualifying financing is expected soon to as much as 40% or more if the qualifying financing is more uncertain. For example, if a note with principal and accrued interest of $110,000 and no discount automatically converts in a qualifying financing in which shares of series B preferred stock are sold at $2.00 per share, the holder will receive 55,000 ($110,000 ÷ $2.00) shares of series B preferred stock upon such conversion. However, if the same note had a 20% conversion discount, the holder would instead receive 68,750 ($110,000 ÷ $1.60) shares. Companies and investors considering the discounted conversion structure should be aware that some investors do not like to participate in financings in which other investors are paying a lower price per share and may demand that the prior convertible note investors waive or eliminate their discounted conversion rights.
The other sweetener, warrant coverage, is generally less disagreeable to future investors. Warrant coverage entitles note investors to receive a warrant to purchase shares of the same type of preferred stock issued in the qualifying financing, most often at an exercise price equal to the price paid by the other investors in the qualifying financing. The warrant coverage amount is generally a percentage of the note investors' initial investment. A typical warrant coverage amount is 20%, but that amount can vary dramatically up or down, depending on the same factors described above with respect to discounts. As an example, assuming a convertible note with $100,000 in principal, $10,000 in accrued interest, 20% warrant coverage and a qualifying financing in which shares of series B preferred stock are sold at $2.00 per share, the holder would receive 55,000 shares of preferred stock plus a warrant to purchase 10,000 ($100,000 x 20% ÷ $2.00) additional shares. Note that accrued interest generally does not get considered in calculating warrant coverage. The warrants typically have a term of at least five years. Most warrants expire upon a sale of the company, and some also expire upon an initial public offering. Some investors also negotiate for the warrants to become exercisable for common stock or a preceding round of preferred stock if the company is sold prior to a qualifying financing or if a qualifying financing has not occurred prior to maturity of the underlying notes.
There are a variety of other terms and conditions which apply to some but not all convertible note financings.
Triggers for Early Maturity
For example, most notes specify that the debt will become due early upon insolvency or bankruptcy of the company, but some notes also specify a litany of other events of default that may trigger early maturity of the notes, including missed milestones, loss of key employees, or the breach of representations and warranties made by the company to the investors.
Securing Notes Against Patents
Investors may ask that the notes be secured by all or some of the assets of the company. For biopharmaceutical companies, those assets would likely include key patents. A security interest gives note investors priority rights in a dissolution of the company.
Investors may also ask for certain protective covenants, i.e., the right to approve certain actions by the company. These covenants might prevent the company from, for example, closing future financings, selling the company, incurring other debt or adopting a new employee equity incentive plan without approval of the note investors.
Investors may ask for representation on the board, either in a formal capacity or as an observer. Creative investors may also demand additional rights if the company does not meet key milestones, including higher warrant coverage or discounted conversion rights. Investors may also ask for personal guaranties from company principals. These and other terms and conditions may not be typical but companies should be aware that they are becoming more prevalent as the capital markets tighten.
Convertible note financings are an attractive and increasingly popular form of investment for companies and investors alike. But given the high stakes of these investments, the complexity of the terms, and the emergence of additional terms and conditions which may be much more onerous to issuers and their principals, companies should carefully consider the tradeoffs versus traditional equity rounds and be sure to understand fully the risks associated with such an offering.
Peter N. Townshend is a partner and George Colindres is an associate at McDermott, Will & Emery, San Diego, California, 858.643.1410, firstname.lastname@example.org