Anatomy of a Financing: The Benefits of Convertible Debt
Back in 1987, when Michael Troy founded his Petaluma, Calif., software company, KnowledgePoint, he figured he'd need about $250,000 in start-up capital. "We didn't pay salaries for about a year, and that saved us $80,000. I contributed $24,000, borrowed $20,000 from credit cards, and took out a $50,000 home-equity loan." Still, Troy knew he had to raise an additional $80,000, from family members, friends, and business associates.
"When I structured my investment proposal, I addressed the issue of an exit strategy," he recalls. "A lot of entrepreneurs don't think about that during the start-up phase, but I was convinced that we needed to plan for the back end of the investment up front."
From that perspective, Troy concluded that convertible debentures made the best sense for KnowledgePoint and its prospective investors. Unlike equity, convertible debentures "would pay an attractive rate of return from the beginning, and they offered our investors the chance to convert to equity, with its upside potential, at a date later in the company's development," says Troy.
He designed the debentures to pay investors a quarterly guaranteed interest rate: five percentage points above prime, capped at 15%. After five years the company would return the principal to all investors who had not, within a specified period, chosen to convert the debt to common stock.
Any financing deal that includes a conversion feature needs to include specific details in its offering prospectus that tell exactly how and when investors can convert.
KnowledgePoint's description of conversion rights was two paragraphs long, including a detailed requirement that investors notify the company of conversion plans in writing, not earlier than November 1, 1988, and not later than six months before final payment of the debentures was due. (The company could also trigger an early conversion opportunity by paying off 10% or more of the principal amount of its debenture obligation.)
The deal clicked: through a private-placement sale, Troy raised $76,000 from eight investors. "We had trouble making our interest payments only one or two times," he recalls, "and when that happened, we paid our investors in equity rather than cash." Two years after that private placement, when investors were given the option to convert their debt to equity, half of the investors went along with the conversion.
"That actually worked well," says the CEO. "If all the investors had converted, they would have ended up owning 18% of our stock. Instead, the group that converted wound up with a stake that totaled 7%." Troy himself owns 65%.
Was the deal a good one? Absolutely, says Troy. Still, he offers one important caveat: "It's hard to get bank financing after you've completed an offering like this, because to bankers, you look very debt heavy. We weren't able to get a bank loan until 1991, when half of our debt holders had converted to equity."