In the context of the rapid development of the technology industry, especially in emerging markets such as Vietnam, convertible notes have become a popular fundraising tool for startups and technology companies. Convertible bonds allow businesses to access capital without immediately diluting ownership, while also providing investors with the opportunity to convert the loan into shares in the future. One of the most important elements of a convertible bond purchase agreement is the conversion condition, which stipulates when and how the debt can be converted into shares. This article will analyze in detail the aspects that businesses need to keep in mind when developing and negotiating transition conditions, from the practices from the contracts of BatteryXchange, Inc. and DoorDash[1], to help businesses optimize benefits and minimize risks.
1. Understand the nature of transition conditions
The conversion conditions in the convertible bond purchase contract define the events or criteria that trigger the conversion of debt (principal and interest) into shares of the company. These conditions typically include:
- Automatic conversion: Occurs when a company reaches a financial milestone, such as a qualified financing round.
- Optional conversion: Allows an investor or company to choose to convert debt into shares under specific circumstances, usually after the maturity date.
- Liquidity event: Applies when the company undergoes an IPO, merger, or asset sale.
In the contract of BatteryXchange, Inc. (2020), the automatic conversion condition is triggered when the company raises at least $1,000,000 in a qualifying funding round, with the conversion price based on a Valuation Cap of $ 3,500,000 or 80% of the lowest share price in the funding round.
DoorDash, Inc. contract (February 19, 2020, filed with the SEC) also mentions the possibility of convertibility, which, although not detailed in the previous information, could be similar to the conditions related to a funding round or IPO.
One caveat is that the transition conditions need to be carefully designed to balance the interests of the business and the investor, avoiding excessive dilution or unnecessary financial pressure.
2. Factors to note in transition conditions
a. Automatic conversion in eligible funding rounds
Typical regulation: Most convertible bond contracts, such as BatteryXchange's, stipulate that the bonds will automatically convert into shares when the company raises a minimum amount of capital (e.g., $1,000,000) in a qualifying funding round. Conversion prices are typically determined based on factors such as:
Discount rate: The investor receives shares at a price lower (e.g., 20% as in the BatteryXchange contract) compared to the share price in the funding round.
Valuation cap: A company's valuation cap to protect investors from overvaluation, such as BatteryXchange's $3,500,000 level.
Type of shares: It can be preferred shares with voting rights (like BatteryXchange's Series A1 for investors from $10,000) or non-voting (Series A2).
Some notes for businesses:
Minimum capital threshold: This threshold needs to be set reasonably. If it is too low (like $1,000,000), the company may be diluted prematurely; If it is too high, investors may be at risk of not being able to convert before the maturity date.
Discounts: The discount (15-30%) should be considered so as not to significantly reduce the value of the founder's shares. For example, BatteryXchange's 20% discount is common, but if the funding round valuation is high, this can lead to massive dilution.
Valuation cap: Should be set at a reasonable level based on the company's growth potential. A low valuation cap (such as $3,500,000) can attract investors but is detrimental if the company reaches a much higher valuation in the future.
Voting rights: The distinction between shares/non-voting rights (such as BatteryXchange) should be considered to avoid conflicts of interest between groups of investors.
For example, a Vietnamese technology startup such as Tiki can set the Qualified Financing threshold at 5,000,000 USD and the Valuation Cap at 20,000,000 USD to attract investors, but it is necessary to ensure that these conditions do not lose control of the founder. This is an issue that businesses should pay attention to when issuing bonds.
b. Voluntary conversion
Typical rule: If a qualifying funding round does not occur before the maturity date, investors may choose to convert the bonds into shares, usually with the consent of the company and the majority investors. In the BatteryXchange contract, voluntary conversion is allowed after the maturity date (24 months), with the conversion price based on the Valuation Cap.
Some notes for businesses:
Consent of the parties: Asking for the consent of the Majority Investors (as in the BatteryXchange contract) helps the company control the transition, but can cause delays if the investors do not agree.
Conversion price: It is necessary to clearly stipulate how to calculate the conversion price to avoid disputes. For example, BatteryXchange uses a Valuation Cap divided by the number of shares outstanding, which ensures transparency but needs to accurately predict the company's valuation.
Dilution risk: Voluntary conversion can lead to large dilution if the conversion price is low, especially during periods when the company has not yet achieved strong growth.
An example from a Vietnamese fintech company like MoMo can allow voluntary conversions at prices based on the most recent valuation, but it should be ensured that this does not reduce the control of the management.
c. Conversions during liquidity events
Typical regulation: In events such as IPOs, mergers, or sale transactions, bonds can be converted into shares or paid in cash. In the BatteryXchange contract, if a Sale Transaction occurs before the maturity date, the company must pay 2 times the original value (minus the amounts paid), instead of converting.
Some notes for businesses:
Cash or share payment: Businesses need to clearly determine whether investors will receive shares or cash in a liquidity event. 2x payment like BatteryXchange protects investors but creates great financial pressure.
IPO impact: If the company is preparing for an IPO (like DoorDash in December 2020), it is important to ensure that the transition conditions do not complicate the process of issuing public shares.
Priority rights: Terms that need to clarify the order of payment priority between bond investors and other stakeholders (such as senior creditors).
DoorDash may have stipulated that bonds convert into preferred shares before the IPO, which helps investors benefit from the stock price skyrocketing after going public.
d. Handling of fractional shares and interest rates
Typical provisions: The contract should clearly state how the fractional shares will be handled upon conversion. In the BatteryXchange contract, the company can pay cash or issue an additional share to compensate for the fraction, while also paying the accrued interest.
A few notes for businesses:
Transparency: Regulations on fractional shares need to be clear to avoid disputes. The payment of cash or the issuance of additional shares needs to be agreed in advance.
Accumulated interest rate: Businesses need to carefully calculate the accumulated interest rate (such as 4% in the BatteryXchange contract) to ensure that it does not significantly increase financial obligations when converting.
Source: Government News
3. Legal and financial risks involved
a. Legal risks
Compliance with securities laws: The BatteryXchange contract emphasizes that the bonds have not been registered under the Securities Act of 1933 (USA), [2]which requires investors to comply with transfer restrictions. Vietnamese enterprises need to ensure that the contract complies with the Securities Law of Vietnam and international regulations if there are foreign investors.
Disputes: Mandatory arbitration clauses help reduce dispute resolution costs, but enterprises need to choose an arbitration venue that is convenient and ensures fairness and ease of enforcement of the award for the parties.
b. Financial risks
Equity Dilution: Transition conditions such as a low Valuation Cap or a high discount can lead to a large dilution. For example, BatteryXchange's $3,500,000 Valuation Cap could be detrimental if the company reaches a much higher valuation in the future.
Payment pressure: If a qualified funding round is not achieved, the business may have to repay the principal and interest, as stipulated in the BatteryXchange contract.
Administrative costs: The requirement to provide periodic financial statements can be burdensome for startups with limited resources.
4. Transition condition management strategy
a. Negotiate valuation cap and discount
Businesses need to predict the growth potential to set a reasonable Valuation Cap. A valuation cap that is too low (such as BatteryXchange's $3,500,000) can attract investors but reduce the founder's ownership.
The discount needs to be negotiated to balance the benefits. For example, BatteryXchange's 20% level is standard, but businesses can consider a lower level (10-15%) if they have a competitive advantage.
b. Flexibility in transition conditions
The contract should allow for adjustment of the conversion conditions with the consent of the Majority Investors, as in the BatteryXchange contract (Section 11.6). This is similar to DoorDash's Section 10(d), which allows for the updating of the investor list.
Businesses can include a Most Favored Nation (MFN) clause to ensure existing investors receive the best conditions if the company issues new bonds.
c. Prepare for financial milestones
Businesses need to make a plan to achieve a qualified funding round before the maturity date. For example, BatteryXchange sets a threshold of $1,000,000, which is suitable for early-stage startups, but needs to ensure the ability to achieve this goal.
If preparing for an IPO, businesses need to ensure that the transition conditions do not complicate the issuance process, as was the case with DoorDash before the IPO in 2020.
5. Lessons from practical contracts
a. BatteryXchange, Inc.
The contract has clear conversion conditions, with a Valuation Cap and discounts that protect investors, and differentiate shares with or without voting rights to favor large investors. However, a low Valuation Cap (3,500,000 USD) can cause major dilution, and the requirement to pay 2 times in the Sale Transaction creates financial pressure.
b. DoorDash, Inc.
The contract is designed to support the IPO, with the flexibility to update the investor list (Section 10(d)). Transition conditions may have been optimized to take advantage of high pricing when listed. However, the details of the transition conditions are not clear in the previous document, but may be more complicated due to the sheer size of DoorDash.
c. Startup Vietnam
Startups such as Tiki or MoMo often use convertible bonds to raise capital from venture capital funds. However, many companies face difficulties due to failing to anticipate dilution risks or failing to achieve qualified funding rounds, leading to pressure to repay debts.
The conversion conditions in the convertible bond purchase contract are the core factors that determine the success of this financial instrument. Technology businesses need to pay attention to funding round thresholds, valuation caps, price reductions, and conditions during liquidity events to balance the benefits between companies and investors. Lessons from BatteryXchange and DoorDash show the importance of designing transition conditions that are clear, flexible, and aligned with long-term strategies. Vietnamese businesses need to work with legal and financial advisors to ensure contracts are compliant and optimize benefits. By managing transition conditions well, businesses can use convertible bonds as leverage to drive growth and achieve significant financial milestones.
