Convertible debt is popular in financing start-ups. Just as preferred stock, convertible debt is designed to give investors certain economic and legal rights to elevate them above common stockholders.  This article discusses convertible debt valuation issues and whether such transactions can be indicative of the issuer’s business enterprise value.

The prevalence of convertible debt is growing.  Fenwick & West has recently published THIS REPORT where the firm summarized the terms of 100 convertible debt financings completed in just about 15 months.  Likewise, we have seen an increased number of situations, about 25% valuations in the last twelve months, where convertible debt replaced preferred equity as the main financing mechanism for a cash-burning business.

Venture-backed convertible debt is different from preferred equity or from traditional convertible debt.  Expected to be settled with equity shares, its common features include:

»»  Conversion discount when buying into the next round of financing.

»»  Valuation cap to provide investors with lower of pricing at conversion.

»»  Change of control premiums.

»»  Various optional conversion scenarios, e.g. upon maturity or non-qualified financing.

»»  Windfall remedy where investors receive securities that are different from those issued in the next round.

Valuation Considerations

Convertible debt valuations are complex. The value of debt can be viewed as a summation of its debt-like obligation to pay a fixed amount at conversion and embedded derivatives.  At inception, the value of the instrument can be equated to the amount of funds raised.  The valuation will change over time as the issuers drifting valuation and financing prospects will influence expected payoff amounts.

A conversion discount is one of the features that contribute to the value of the convertible. It can be valued as traditional debt since the discount sets the fixed amount (or fixed amount worth of equity shares) to be paid at conversion.  For example, a 20% discount will translate into 25% effective return.  An $80 of the original investment will buy a $100 worth of new stock ($100 / $80 – 1 = 25%).  This debt-like relationship will hold until the company reaches its cap, or triggers other scenarios, i.e. change of control premiums.

Both scenario analysis (probability-weighted expected return method, or “PWERM”) and Monte Carlo simulations are necessary to value multiple conversion scenarios or to bifurcate embedded derivatives.  Both the PWERM and the Monte Carlo methods require highly subjective estimates of probabilities and timing of various transactions such as change of control or non-qualified financing.

It is considered the best practice to calibrate key assumptions as of the note issue date when at least the sum of parts is known. Careful trending of key assumptions will produce meaningful valuation estimates in the following reporting periods.

What Can Convertible Note Tell Us About Equity Value?

Since there are no shares or prices of shares, a new debt financing will not create “unicorn” headlines.  It will increase the borrower’s overall business enterprise value (“BEV”), a total of debt and equity values, but it won’t provide any easy-math opportunity for bloggers, myself included.

The question is relevant in the context of IRC Section 409(A) valuations of common stock.  Because traditional income and market approaches are often reliable in valuing venture-backed startups, it is highly desirable to maximize the use of any transactional data.  Preferred stock financings are routinely used as the main indicators of equity, but not necessarily enterprise, values.

We find several issues with using convertible venture debt as an indicator of total equity values or BEV:

1. In the most likely scenario, the convertible debt will perform as a debt instrument. The borrower will have to deliver $X value on date Y.  Imagine guessing home equity value based only on the mortgage balance outstanding … we don’t think so.
2. A valuation cap may result in equity-like returns for a convertible debt investor, but it is often missing from debt covenants. Even less frequently it represents the company’s current or even future expected valuation.
3. Conversion features are embedded derivatives. They pay based on how well the company performs, thus linking convertible note and equity values. While conversion benefits values can be substantial, their amounts are not observable (unlike preferred equity valuations).
4. The standard OPM backsolve method produces a single common equity value estimate for every preferred original issue price.  The necessary estimations of volatility and term have limited influence in this relationships, especially in combination with the discount of lack of marketability.  This is not the case with convertible debt where unobservable assumptions can swing debt and embedded derivative valuations dramatically.
5. To add insult to the injury, the recently issued draft Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies indicates that the face value of debt is not always representative of its fair value when considered from the equity investor perspective (sec. 6.20). In a separate observation, the paper advises caution when including debt as part of the OPM model (Q&A 14.47).
6. Convertible venture debt allows issues to avoid valuing the company for funding purposes; it is one of its key benefits and often selected for that purpose.  Excel trickonomics notwithstanding, we question how the financial instrument designed to avoid valuing the issuer should be used as an observable indication of value.

Conclusion

Convertible venture debt is becoming more prevalent and so is the desire to infer business enterprise value information from such deals.  The complexity of appropriate valuation models linking the values of convertible debt and equity largely negates the benefits of pricing information embedded in such deals.

Yet, the dependencies between conversion benefits and BEV are undeniable. Management should take great care in setting discounts, caps and other important economic features, i.e. perform their own analysis and not rely on investors to set the terms of the next big funding.