Startups and emerging growth companies frequently issue convertible debt as a way to raise capital while delaying the determination of the company’s valuation until a later date.
This strategy can be beneficial for businesses looking to continue operating and building value without having to negotiate with investors at an early stage and pull focus away from overall growth initiatives.
Our team at Kranz has compiled some essential information about convertible debt, key complications to look out for, and tips and strategies to address these complications.
Important things to know about convertible debt:
- Key conversion features in convertible debt agreements.
- Why accounting for convertible debt is complicated for startups and emerging growth companies.
- What the fair value option is and how to prepare for fair value and mark-to-market accounting.
What is a convertible note or convertible debt?
A convertible note is a debt instrument with a provision that allows the note holder to convert the debt into equity at a future date. Convertible debt helps the company reduce the potential for rescinding too much equity ownership by waiting to convert the debt until the shares increase in value.
Convertible debt agreements typically contain all the terms one commonly expects to find in a debt agreement: principal, interest rate, and maturity date. However, what makes them different from a standard debt agreement are the conversion features.
The conversion features allow most companies to issue convertible debt with lower interest rates than those that would be required with traditional debt.
Key conversion features in convertible debt agreements for startups and emerging growth companies:
- Conversion triggers: Describes the future events that allows the note holder to convert the debt to shares of company stock. This conversion can only take place if any of the defined trigger events occur, the most common of which is a subsequent financing round or a corporate transaction, such as an IPO.
- Conversion rate: Defines the number of shares received for each dollar of debt.
- Conversion discount or valuation cap: Defines the discount on the price per share, if any, that the convertible debt holder will receive upon conversion of the convertible debt into equity shares vis-a-vis the cash issue price paid by new investors. In a new equity financing round, this discount is expressed either as a set percentage discount of the cash issue price or via the application of a valuation cap calculation.
Other important convertible debt terms that affect financial statements:
- The stated maturity date.
- The interest rate and whether it is fixed or variable.
- The existence of any call, put, or anti-dilution provisions.
- Whether the convertible debt was issued with warrants.
- Whether the note holder can early exercise the conversion option.
- Whether or not company performance will affect conversion price.
Why accounting for convertible debt is complicated for startups and emerging growth companies
Based on their terms, convertible debt contains elements of both debt and equity. US Generally Accepted Accounting Principles (GAAP) requires the reporting entity to evaluate the embedded features within a convertible debt instrument to determine which features, if any, meet the definition of embedded derivatives that would require bifurcation from the convertible debt host and separate accounting.
Determining which features may require bifurcation and separate accounting requires a detailed analysis of the agreement, the application of detailed accounting rules, and the exercise of highly trained and experienced technical judgment.
Additionally, the Financial Accounting Standards Board (FASB) has issued a recent Accounting Standards Update (ASU), ASU 2020-06, Debt-Debt With Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging – Contracts in Entity’s Own Equity (Subtopic 815-40), that significantly changes how convertible instruments are to be accounted for under US GAAP.
ASU 2020-06 eliminates certain legacy accounting models, namely those for convertible debts with beneficial conversion features and cash conversion features, and modifies the derivative scope exception which impacts the analysis of whether an embedded feature requires bifurcation.
In addition, when warrants are issued with convertible debt instruments for no additional consideration, companies are required to determine if an allocation of value from the total proceeds received is required to be made to the warrants.
What may impact this determination will be whether the warrants are concluded to be freestanding under US GAAP and, if so, the amount to allocate will depend on whether the warrants require classification as liability or equity instruments.
Startups and emerging growth companies can find these accounting assessments daunting.
The fair value option
If a company concludes that its convertible debt instrument contains embedded derivatives that require bifurcation and separate accounting, a company may elect to instead apply the Fair Value Option to account for the entire convertible debt instrument at fair value.
Application of the Fair Value Option is not automatic and requires certain criteria to be met.
How to prepare for fair value and mark-to-market accounting
Whether an entity is required to account for the bifurcatable embedded derivative features of its convertible debt at fair value or elects the Fair Value Option for the entire convertible debt instrument, successfully estimating the fair value of convertible debt requires highly specialized expertise and the establishment of a robust fair value measurement process.
Final Thoughts on Convertible Debt for Startups and Emerging Growth Companies
Convertible debt is a worthy consideration for startups and emerging growth companies looking to raise capital without negatively affecting their existing shareholder’s ownership stake.
But be aware that once the company is required to issue US GAAP-compliant financial statements, significant adjustments likely will be required to comply with those standards. Analyzing those agreements to make the proper adjustments is time consuming and requires specialized accounting expertise.
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