July 25, 2023

Pre-IPO Converts: What Late-Stage Private Companies Should Know

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Cooley LLP

Our late-stage private company clients that are on the path to an IPO in the next 12to 24 months will often ask us for guidance on “pre-IPO converts.” This article explains what a pre-IPO convert is and describes some of the main considerations in this type of transaction.

What is a pre-IPO convert?

A pre-IPO convert is a debt instrument issued by a private company, typically as the last financing round before an IPO. While public company convertible bonds are fairly standardized debt securities, pre-IPO converts tend to have a variety of negotiable structures and features, which also make them more complex than a traditional equity financing or convertible note bridge round. The key feature of a pre-IPO convert is that, upon some future date or event, such as 2-3 years after issuance or upon an IPO which meets certain size and liquidity criteria, the debt becomes convertible at the option of the noteholder (or, in some cases, is mandatorily converted) into shares and/or cash based on the stock price at the time of the conversion event. Until the conversion event or maturity, the convertible note (or “convert”) is effectively a straight debt instrument. Some pre-IPO converts may be redeemed by the company in cash in limited circumstances (typically at a substantial premium). In addition, pre-IPO convert structures tend to provide for an increasing interest rate and decreasing conversion price as the time to IPO or other conversion event increases. Features, such as cash interest vs. PIK, incurrence covenants, information rights, boards seats, subsidiary guarantors, collateral, guaranteed minimum internal rate of returns, valuation cap, conversion price resets and registration rights are much more common in pre-IPO converts. While sizing and pricing for traditional public convertible bond offerings are primarily limited by a company’s market cap, the trading liquidity of its stock and the “stock borrow” in the market, pre-IPO convert sizing and pricing depends primarily on an investor’s willingness to deploy capital and the company’s need for capital and willingness to incur dilution.

What kind of investors are interested in pre-IPO converts?

Pre-IPO converts are partly made possible by the increased number and types of investors willing to participate in private capital raises today. For example, mutual funds and “crossover” investors, which have conventionally focused on public market investing, are participating increasingly in pre-IPO financings. Other key investors include hedge funds, private equity funds, family offices, sovereign wealth funds, strategic investors and special purpose vehicles. Many of these investors have experience investing in complex financial instruments and therefore provide companies with additional flexibility to raise money in multiple types of structures. Traditional VCs and many public investors aren’t typically the focus for these complex financial instruments, and their participation will depend in part on the structuring considerations for each deal.

What are the pros and cons for investors participating in a pre-IPO convert?

Convertible debt in general is attractive to investors because it combines the downside protection of a debt instrument with the potential upside of converting into stock that has appreciated. As compared to non-convertible debt, the downside of a convert is that the stock may not appreciate and the investor will receive a lower yield based on interest rate alone. Issuers often push for redemption features after the IPO or some other period, which typically means the issuer can force the investor to convert the note for a specified number of shares of stock at a certain price. Overall, a pre-IPO convert provides investors with more flexibility to negotiate structural features important to them.

Some investors may be focused on reducing downside risk and/or increasing upside participation, others may require a minimum fixed internal rate of return while others may be focused on a strategic investment and building a long-term business relationship with the issuer. Investors in a pre-IPO convert may also be able to negotiate for certain anti-dilution protections if the issuing company sells more securities below the conversion price of their convertible notes. It’s also possible that investors can negotiate for certain negative covenants (e.g., limitations on the incurrence of debt liens, etc.) to further protect their investment.

What are the pros and cons for companies considering a pre-IPO convert?

A pre-IPO convert can be an attractive financing option for a late-stage private company because it is cheaper than issuing non-convertible debt and it allows the company to assume a higher future valuation upon conversion than may be achievable in an equity raise, especially in a difficult funding environment. Not every pre-IPO convert remains outstanding post-IPO and whether conversion happens at a premium or discount to the IPO is a negotiated point. The benefits of the conversion feature also allow the company to pay a lower interest rate to the noteholder.

On the downside, the convertible note will dilute the company’s stock when converted (but potentially at a higher valuation than would be possible in an equity raise) and may have a potential impact on IPO demand if the convert is too large. In addition, pre-IPO converts typically have more structural complexity, increasing the cost and time to negotiate a successful transaction, with many of the features having a higher cost and/or limiting the company’s flexibility, especially if the company delays its IPO. Special attention should be paid to the company’s M&A strategy and operating plan when structuring a pre-IPO convert. Finally, while name-brand issuers can usually achieve a 5-year term, investors prefer shorter maturities for smaller issuers.

Is it right for every company?

The biggest caveat is that the company needs to be credibly on the path to an IPO in the next 12 to 24 months. This is important for both parties as the convert is first and foremost a debt instrument. If the IPO is delayed, then the convert starts to become more expensive and upon maturity the investor can request full repayment of their debt with interest (sometimes with a penalty if the IPO hasn’t occurred).

Inherent in a credible path to IPO, the company would typically be a “Unicorn” to qualify for more public company-like convertible note terms. This means that the company would likely be generating in excess of $100 million of annual recurring revenue.

What are the key considerations when negotiating a pre-IPO convert?

Will investors receive projections that could potentially make them ineligible to participate in an IPO? Will investors be prohibited from purchasing or selling shares of your company if they receive projections?
Should you accept investor put options?
What prepayment / redemption options should you push for?
Should the anti-dilution provisions be different than those in your existing certificate of incorporation?
Does it matter if the shares can be settled in cash, stock or both?
What kinds of negative covenants (e.g., limitations on the incurrence of debt liens, etc.) may investors require and why is that different from a public company convertible note offering?
Should you offer all investors information rights or any other special rights?
Once closed, will you have to do quarterly valuations for accounting purposes? What are the other accounting implications?
If the debt doesn’t convert at IPO, how does that affect your disclosures to the SEC in your IPO and how does the SEC view these instruments?
Will the pre-IPO converts be DTC eligible (i.e., electronically tradeable) even if you are not a public company? Can you prevent competitors from acquiring the notes?
Do you need to offer minority protections to investors or does the lead investor control?
Can you continue to acquire companies and move assets around internally?
Will subsidiaries and companies you acquire be required to guaranty the debt, even for subsidiaries and companies outside of the US?

Public v. Pre-IPO Convert Comparison

	Typical Public Company Transaction	Typical Private Company Transaction
Principal Amount:	Typically, at least $100 million to ensure liquidity, plus greenshoe.	Any size.
Additional Securities:	Rarely issued with additional securities.	Occasionally issued with warrants.
Issue Price:	100%	Typically, 100% but sometimes issued with original issue discount (OID). Any warrants issued would contribute to OID equal to the fair market value of the warrants.
Ranking:	Senior unsecured, rarely senior secured.	Senior unsecured, occasionally senior secured.
Time to Completion:	Typically, 2 to 3 weeks	Typically, 1 to 3 months.
Maturity Date:	Typically, 5 or 7 years.	Any duration but typically 5 years or less.
Interest Rate:	Fixed rate, payable semi-annually in cash in arrears.	Floating or fixed rate, which may increase if IPO does not happen within set time period. Payable monthly, quarterly or semi-annually; Interest may be payable in-kind or in shares.
Typical Settlement Method Types:	Physical Settlement –Shares of the company’s stock; or Instrument X – Cash, shares of the company’s common stock or a combination of cash and shares of the company’s common stock, at the company’s election.	Prior to IPO –Shares of the company’s common stock, existing preferred stock and/or future round of preferred stock Upon IPO –Shares of the company’s common stock.
Conversion Price:	[20-35]% premium to the last reported sale price at pricing.	Typically, a discount to IPO price, which may increase if IPO does not occur within set time period; provided, however that some recent pre-IPO converts have provided for a premium to the IPO price.
Conversion Rate / Price Adjustment:	Subject to adjustments via specific formulas, including for stock splits, stock dividends, recapitalizations, reclassifications, subdivisions, or distributions payable in securities or assets of the company or any other person. Rarely include price-based anti-dilution adjustments.	If convertible prior to IPO, the conversion price may be subject to adjustments like those in the company’s preferred stock and may include price-based anti-dilution adjustments and adjustments for certain corporate events (e.g. spin-offs, subsidiary IPO).
Redemption:	Provisional Redemption – The company has a right to redeem the notes for cash right after Year 3 or Year 4 if the stock price exceeds 130% of the conversion price for a specified time period.	Rarely includes optional redemption features. Any redemption features typically include a substantial prepayment premium.
Fundamental Change / Change of Control:	If the company undergoes a “fundamental change” (includes a change of control, delisting or dissolution and subject to certain exclusions), the company is required to offer to repurchase the notes for cash at 100% of the principal amount plus accrued and unpaid interest.	Typically, results in an Event of Default and/or a mandatory prepayment of the notes, with or without a premium.
Make-Whole Fundamental Change / Change of Control.	If a Make-Whole Fundamental Change (to be defined as a Fundamental Change without certain exceptions therein) occurs, noteholders that convert will get additional shares based on a make-whole table tied to the stock price and effective date of the “Make-Whole Fundamental Change”. This feature is intended to compensate holders for the lost value of the embedded conversion option.	Noteholders may have an option to convert into merger consideration at a discount or subject to a capped valuation.
Certain Covenants:	Limited to financial reporting and conversion settlement	May also include limitations on the company’s ability and the ability of its subsidiaries to: (i) incur indebtedness, (ii) issue preferred stock, (iii) incur liens, (iv) make certain dividends and distributions on the company’s capital stock and/or (v) make certain asset sales.
Events of Default:	Limited set of Events of Default with respect to the company and its subsidiaries, including, among others: payment default, failure to convert, bankruptcy, a cross default and a judgment default.	More expansive list of Events of Default, which may include a change in control, material adverse effect, reps & warranties and other defaults more typical in secured credit facilities.
Concurrent Equity Derivatives:	Capped call or call spread is often entered into in order to synthetically increase the conversion rate / price for the notes	Never.
Transfer Restrictions:	None, other than transfers by affiliates. Transfers for Rule 144A and 4(a)(2) transactions subject to registration or an exemption from registration under the securities laws.	May include limitations on transfer other than among a noteholder’s affiliates.
Registration Rights:	Rarely include registration rights for Rule 144A or 4(a)(2) transactions. Designed to allow for resale under Rule 144 after six months.	May include registration rights in connection with IPO, subject to the same limitations that the company’s equity investors are subject to.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Attorney Advertising.