26 Nov Convertible Notes: Balancing Risk and Reward
Mike, Ryan and Matt from Revenue Rocket discuss the use of convertible notes in business transactions, highlighting the benefits and considerations for sellers, including the ability to participate in the upside of the business while deferring risk. They talk through the importance of thorough due diligence, negotiating favorable terms, and seeking legal and M&A expertise when structuring such transactions. We’re also celebrating our 200th episode of the podcast and look forward to many more to come.
Key Points Covered
- Convertible notes provide sellers flexibility to participate in upside if the business performs well, while also offering some downside protection.
- Convertible notes involve a seller providing a loan to the buyer, with the option to convert the remaining balance to equity at a future trigger point.
- The conversion trigger is typically a date or milestone, after which the seller can choose to convert the note to equity rather than receive the remaining cash payout.
- Convertible notes are commonly used in IT services M&A to allow sellers to “have a second bite at the apple” if the combined business grows significantly.
- Thorough due diligence on the buyer’s financial stability and growth plans is critical for sellers considering a convertible note.
- Key negotiable terms for convertible notes include interest rate, payment schedule, and conversion triggers/parameters.
- Sellers should seek legal and M&A advisory expertise when structuring convertible notes to ensure favorable terms.
- The main benefits for sellers are reduced upfront risk and the ability to participate in future upside.
Episode Transcript
Mike Harvath 00:00
Music, Hello and welcome. This week’s Shoot the Moon podcast, broadcasting live and direct from Revenue Rocket world headquarters in Bloomington, Minnesota, as you know, if you tune in to our podcast, revenue rocket is the world premier growth strategy and M&A advisor for tech enabled services. Companies with me today are my partners, Ryan Barnett and Matt Lockhart. Welcome gentlemen.
Matt Lockhart 00:28
Thank you. Thank you, Mike and good to be back. Thanks for for covering the ship last week while I was out, sort of in hand with one of our recent podcasts too. So it’s a good break, and fired up and ready to go as we as we quickly move into winter here in at our world headquarters in Bloomington, Minnesota. Ryan, what’s happening?
Ryan Barnett 00:55
Yeah, it feels like ski seasons right around the corner. I think we’ll have to enact, hopefully we’ll enact a few powder day policy here in Minnesota and elsewhere around the country, but love it and excited for winter and getting through this year. Yeah. Topic today, again, we’re focused on M&A for IT services companies, and we help companies buy other IT firms. For IT services firms, and we help companies sell your firm in the times, right? And this podcast really gets both areas of this in what we would like to talk about are the use of convertible notes when talking in deal structure. And so without further ado Mike, I’d love for you to just get us started. What is a convertible note and how is it used in IT services?
Mike Harvath 01:45
Yeah, sure thing. Ryan, so you know, as you guys know, if you’ve tuned into a few of our podcasts and you know, follow M&A in the space, there’s always price or enterprise value for which a buyer is going to pay for a particular firm, and an acquisition scenario or a merger scenario, and then there’s terms. And terms really are how that price is paid, sort of the consideration of cash, what we’ll call seller financing or seller note, which is kind of where we’re going today, or equity rollover, or a variety of other sort of mechanisms for paying out consideration. And you know, a big, big part of of transaction terms typically involve what’s called a vendor take back note or a seller note are the same thing, and many of them, especially those that are used with a buyer that might be a early stage private equity firm, or someone that has as a buyer, or an acquirer that’s looking to go public at some point, involve what’s called a convertible note, or convertible VTB note, and convertible means that it’s convertible from just a normal loan that you’re as a seller going to give that buyer that involves interest and is paid at a certain schedule, to have the remaining balance at a particular trigger point in the future be convertible to equity and there’s lots of benefits for both parties, both buyers and sellers, to use vtbs or or notes in general seller financing and to have them be convertible. And we can unpack that further as we go through the podcast.
Ryan Barnett 03:40
So Mike, just understand this bit more. When you’re talking about convertible, you’re sort of a seller. Note, that is going to be a loan. The seller actually provides the loan. Is that correct? So the person who’s selling, the business is going to provide a loan to the buyer with a certain amount of interest rates. That Correct?
Mike Harvath 03:57
Yeah, that’s correct. So we can just paint a very simple picture. You know, it’s not atypical for, let’s say, a private equity buyer to facilitate through sort of a debt and equity third party debt and equity Provider A structure something like this. Let’s say half of the transaction value is paid in cash at closing. 25% is an equity role of into the new entity. And 25% is, you know, a note or a vendor take back note or seller note. Sometimes those are bucketed in a third, a third, a third. But you know, not atypical for it to be a half cash and then 25% note, 25% equity roll, you can actually create it to be 100% equity roll with this conversion for portion on the note, on the seller note. And you know, the you. Of course, all the parties like to see a seller, kind of putting their money where their mouth is, with a note, you are a secured creditor to the business. You are in a partnership. This is, you know, usually used pursuant to a sell, in sort of scenario where you’re going to be sticking around, running your business with a new capital partner. You know, you’re taking some chips off the table with that half cash sort of scenario. And then you know, know that you got another 25% that’s guaranteed through the note that could be convertible equity if things are going swimmingly. And then you have, you know, your 25% equity portion rollover, if you will. And so, you know, it’s a way for folks to de risk the transaction of the seller, because you will get 75% at the strike price of the deal, guaranteed to you with half now and 25% paid out in the note if you don’t convert it, and if it’s determined based on the conversion trigger that you know the business is growing, you know really well, and there’s been other acquisitions made, and you’re in alignment and definitely want to participate in more equity, you can then convert your note to equity, and your liquidity event will happen sometime in the future With the, you know, infamous second bite at the apple, or if someone goes public, we’ve talked to more firms, and both in the US and Canada, have plans to facilitate, you know, roll ups that will go public again. There was a time when that was out of favor. Now there seems to be more of those being, you know, predictive, or worked on, if you will, or working on a few of those, on behalf of several clients. But I don’t want to underestimate or under, under emphasize the fact that, you know, there certainly is a lot of private equity firms that are in the space and and are participating, and oftentimes will use this seller note, or convertible seller note, as an instrument in their transactions.
Matt Lockhart 07:11
You know, one of the things that you said, Mike, that I think is, is just absolutely, you know, critical is, is the idea that you know, through this new partnership, right? There is a one plus one equals 345, opportunity, right? And as a seller, if you are are looking at you know the partnership and the acquirer is looking for some flexibility in terms of of achieving the overall enterprise value. You know, you got to go into it with that positive mindset that you know, together you’re going to win. And and then you know, there’s shared upside for, you know, for all parties, right? And so, you know, you use the term guarantee, well, you know, some sellers are like, Well, is it guaranteed? Well? And you say, well, it’s as guaranteed as the, you know, just like as a lender would be looking at the, you know, stability of that, of that note. But, you know, worrying about the downside sort of puts in the in the wrong frame of mind altogether, you know, with the idea of getting into this partnership that is going to, you know, create greater success.
Ryan Barnett 08:38
Yeah, that’s a great, great start to this discussion. Mike, there’s, there was one question I had here. Can you just explain you mentioned the word conversion trigger, and explain what is a conversion trigger in the grander scheme of things here?
Mike Harvath 08:55
Yeah, usually it’s a date and time. So it’s not atypical for these notes to be, either be a quarterly or annually. And you just think of it, if you have a loan and you’re going to loan your buyer money, it’s usually going to be at an interest rate that’s above market, due to the risk of, like, what you could borrow money from a bank at just how it goes. It’s the typical to see, you know, these types of deals at, you know, 7-8 percent interest in some cases, and oftentimes, a conversion trigger comes with some sort of cliff or pending payment that’s due on the note, and you have to make a decision as to, you know, do you take the payment or do you convert the value of the outstanding note to equity? And, you know, sometimes that can happen. I mean, every deal is different, so I don’t want to, you know, generalize too much, but you know, it could be after a year or two years or three years. It could happen. And if there’s been milestone payments paid on the note, certainly that reduces the amount of available equity, available for the for the for the conversion. Or sometimes there’s, you know, what’s called a bullet payment or a balloon payment. And as that payment is, is, you know is going to be coming due, you’ll have to make a decision on whether you convert the remaining value of that note to equity. So, you know, when we talk about conversion triggers, there’s they’re either specifically called out at dates and times, or there’s a logical time when they would be called out based on when payments or milestones might be made in the note payment.
Ryan Barnett 10:47
Gotcha so something like a next funding round, or a an IPO, for example, that might be a trigger date that that also triggers that note, converting that fair to say?
Mike Harvath 11:01
That’s fair to say!
Ryan Barnett 11:03
Alright, yeah, interesting. So if I’m hearing this right so far, it gives sellers a way to participate, if things are going really well, to participate in equity by converting, or if things are stable, or you just want a more kind of steady as it goes portion you’re going to essentially keep that note, perhaps for a longer time, and maybe perhaps a less risky approach. However, the return may not be as good for the for the seller as well. Okay, so, so why? Why are convertible notes used in the IT services world? What’s, what’s specific about our world, and how does a convertible note compare to traditional equity or debt in terms of risk and reward for the for a buyer and seller?
Mike Harvath 12:02
Well, I’ll weigh in here. Certainly, traditional debt is a situation where, you know, oftentimes that initial payment that’s done in a leverage, what’s called a leverage buyout, is are getting leverage so that initial cash payment could come from some debt that the buyer carries and ultimately pays you out. And oftentimes that’s the most favorable deal terms versus a seller note or BTB. Usually those interest rates are higher than what’s available in the general open market. And so obviously getting cash to close reduces risk and increases certainty. And so it’s not completely out of the question that you know, a buyer could also get a larger loan at a lower interest rate and pay well. However, with that said, there’s certain financial instruments where the that financier wants to see a note being carried and paid by the buyer to the seller in a certain way, with a, you know, an indela Proof conversion rights, etc. So, you know that that’s just how those instruments are built. Certainly, that comes with some risk, right? You know, you risk that your buyer is going to be solvent, right? Because you’re a secured creditor. If they go out of business or file for bankruptcy, then you know you’re gonna have to get in line with the rest of the of the debtors, if you will, to get paid out. So that’s always a potential risk when you’re doing a seller note. And you know, if you convert to equity, let’s say things are going great, you know, at the time of conversion trigger, and then things go not so great, certainly your value. And that equity goes down, could go down versus taking the value of the note. Those are all things that you know you have to sort of keep in mind and and be cognizant of same situation with a with an equity role, you know, an equity role, you’re kind of filling in, if you will. You’re saying, Hey, I’m going to, I’m going to trade a portion of my equity for your equity, and your thesis around building value into that equity. And I’m think that we’re going to get somewhere together that we can’t get apart. So we’re going to make that bet. And that’s why, you know, convertible notes are so interesting, because once you have more visibility that that’s actually being delivered and the plan is being met, you know, there’s a big impetus to do that conversion. You can also kind of punch your tax liability on that appreciating asset, because you’re not really accepting the game. When your note gets paid out, you know you’re going to be an essence. That’s you know you’re going to be creating a tax event. But if you turn it into a conversion. Uh, to equity. You know you’re not taking those gains yet. You’re letting them grow. Kind of reinvesting them to grow is probably one way to think about it, and to appreciate for a future liquidity event or an opportunity for you to call some of that equity depending on what your stockholders agreement looks like. So there’s certainly opportunities and benefits to doing a conversion. But, you know, hopefully we painted the picture that any of these instruments, you know, they all come with some level of risk, and you just have to determine, you know, where that risk profile is for you based on the valuation and and ultimately, how much of that transaction you want guaranteed.
Ryan Barnett 15:46
All very, very helpful. Mike is there when you’re negotiating a convertible note, what levers do the buyers and sellers have to pull and what what terms do typically negotiate around to make this favorable for most parties, or at least ensure fairness or alignment between buyers and sellers.
Mike Harvath 16:10
Well, you know, obviously there’s, there’s a term of the note. You know, the buyer has to be prepared to pay that note out within the term. And usually those terms are very fairly short, say, less than three years. Where, you know, more traditional debt is, you know, maybe it’s a longer term amortization. Could be as long as 10 years in some cases. And so, you know, one you got to have the cash flow to be able to pay that out, which I think is a super important consideration for the buyer in particular, and indirectly, the stock, because you know, you want to make sure you actually get paid based on the terms that you agreed to on the note. Certainly, there’s interest rate. There’s when the payments are made, whether those are quarterly or annually or monthly. We’ve seen all three. And then there’s, you know, conversion provisions, right, which you know, are there caps on the value of the conversion? Are there, what are the timing considerations of when you have to make the decision to convert or not convert? There’s probably half a dozen other levers there that you know you could pull, as you’re thinking about, you know, a convertible note, and every transaction is different. Every you know, every buyer has sort of different motivations, and sellers do as well. So, you know, we won’t get in too far into the weeds on what all those different data points are. But you know, certainly m&a advisor, like revenue rocket, can help get that negotiated effectively, as can, you know, probably your lawyer, who’s done a lot of, hopefully a lot of M&A work, and has seen a lot of convertible notes in their day,
Matt Lockhart 17:51
You know, Mike, I was thinking, you know, it wasn’t one of the transactions that we, we helped with included This, if I recall, it was actually on the Canadian Toronto Stock Exchange. But the seller chose, you know, this path he was selling in. He was engaged, right? He, I think he, he stayed on as the CEO. And it was, it was absolutely the very best thing for him to do, right? And, and he really won, probably won more in the second bite than he did in in the first bite of the of the transaction, right? So, you know, it, it, it can be a really good deal for sellers.
Mike Harvath 18:41
Yeah, it can be a great deal for sales, I think, but understanding and having alignment around what is the expected sort of liquidity event on that equity is super important. Is super important, not only for your equity role, the portion that you’re going to roll over anyway, but it’s also super important in the context of any, you know, convert that you would make, because you may convert up to, you know, 50% of the transaction value, if, depending on how you level the conversion and how the deal was originally structured. And, you know, that’s a, that’s a material deal, and you’re going to delay, sort of, you know, that payout you’re going to invest it to grow in the combined organization. And I guess you have to determine, you know, when is, you know, is that a credible sort of use of your funds? And you know, is it something that you really want to do and and doesn’t make sense based on your role, and you know what, how you’re, you know, looking at your overall return on your deal as well. Now private equity oftentimes will have a prescribed exit strategy, one that, hey, we’re going to go do. This, and then we’re going to exit here when we get to these milestones. And I think understanding that and being alignment with your buyer, if you’re a seller and vice versa, is super critical. You don’t have any missing misalignment here, particularly if you’re going to convert what, what essentially is a guaranteed financial instrument where you’re going to get paid out seller loan, a seller note or or this VTB note to something that’s not guaranteed, which is the equity of the of the combined business and and you’ll be much more invested, obviously, in that situation, should you convert?
Ryan Barnett 20:45
I think the critical thing for sellers to understand, if you’re going through a situation here, and you’re part of this, you’re going to be a key component to hitting those numbers. And so the risk is somewhat on you performing to what you can execute and what you promised execute well on your forecast. And so I think there’s if you can, in some ways, betting on yourself and betting on the market, and the combined entity of working working together, I guess, with this convertible notes, and in the way that they’re almost combined with equity, or they’re combined with equity, in many cases, Mike, or maybe this is Matt, too. How much due diligence is needed from a seller to really understand the buyer in that scenario? Well,
Matt Lockhart 21:35
I’ll start out Mike, but you know, yes, certainly due diligence in the in the historical financial success and stability of the firm, understanding you know what other you know creditors may be involved. And so it is. It’s absolutely critical to do the appropriate level of due diligence. Think about how a bank will do its diligence on on you when you’re looking for a loan, right? And and so kind of need to think in that same mindset.
Mike Harvath 22:13
Yeah, I would agree. I would agree. Certainly, reciprocal diligence is important. You have to trust the party that you’re going to go to into business with, right? You have to trust their vision, and you have to look at, you know, track record of execution and how well they run their current holdings, and all those things should play into your consideration to determine, you know, whether or not you’re going to roll, you’re going to roll equity you begin with. But also, in particular, when you’re contemplating a conversion, or, you know, focusing on moving, essentially debt to equity through a conversion.
Ryan Barnett 22:53
The last question of guy here got a bunch of them, but I try to narrow it down to some ones that are important. And this is curiosity. I really don’t know this answer. If you’re going to with a firm that has has this approach, I think there’s a case in which they are likely to do multiple acquisitions. And if that’s the case, is there any concern of dilution of another company participating in that equity pool? And does that seller, using this convertible seller node, does that help, perhaps, defer any of to the dilution or or am I completely on the wrong path? My question. Help me understand this? Well, certainly,
Mike Harvath 23:38
There is going to be some some some dilution. If you, if you call equity, you’re actually diluting the other shareholders, right? So, you know, I guess technically, you argue. I mean, you’re not going to be diluted because you’re already holding share. So if you’re going to convert equity or convert debt to equity, I suppose you know, your own holdings would get somewhat diluted, but you’re getting more shares in the context of transactions or roll ups that occur unless they’re occurring where you’re it’s a very small concern. The dilution of the types of note values that we’re talking about isn’t super material. There is dilution, but it’s not in the context of building, let’s say, $100 million firm, or a $200 million firm to either go public or go through some sort of, you know, second stage liquidity event. You know, the types and size of notes that we’re talking about likely are not material enough to move the needle in a big way for dilution. So it’s almost not a meaningful consideration. It’s also depending on how the structure of the buyer has set up the equity, how much equity is in Treasury, and if those shares. Them from Treasury versus get reallocated. How they get reallocated all will determine whether there’s dilution or not. There may not be dilution, depending on what shares are held in Treasury and by whom it just, you know, there’s, there’s some moving parts here. I would say, in a worst case scenario where it’s like a we want more equity, and, you know, we’re going to essentially buy equity, which is what you’re doing with a with a note conversion. Most likely, the person that has set up this company has been sophisticated enough to put those shares into Treasury, and they would come out of Treasury and not have a meaningful impact on dilution.
Ryan Barnett 25:43
Great. That helps a lot. Mike, appreciate it, and thank you so much for this podcast. I’ve learned quite a bit here. It’s a tool, as I said, to hear that it’s a it helps defer risks on with that for a seller, in which you can can make the right choice at the right time. And if things are going the right direction, you can, you can execute things that will really take the next bite into the apple. And so there you get tremendous upside with with reducing a bit of risk on the on the front side, you got to do your homework as a buyer or another printer of a seller. So you’re, going to be taking a look as a seller to the buyer, just a deeper look, there you’ll be. You’ve got terms that you can negotiate, things like the interest rate and the time the the event that may happen. Those are all negotiable items. And then ultimately, your lawyer is going to be crafting a big, part in crafting an agreement. And look for advisors that have are familiar with this, and both legal and M&A experience and putting these deals together seems like a huge amount of upside here, and a great opportunity for sellers, if this is something that is an option. Yeah, did I get that right? Matt And Mike, anything want to add to that?
Matt Lockhart 27:06
Yeah, I’ll just, you know, reinforce that as as you are selling in, and if it’s your first time on on our podcast, a first off. Thank you for joining, and welcome when we use the term selling in, that means that you’re going to be a partner moving forward and help drive the future success of the organization. If you’re selling in, you’re doing it because you and your new partner are going to do better together. And so if this is an appropriate piece of overall structure you’re doing, that’s it’s great and and you, to Ryan’s point, have some flexibility in future decisions. So, good podcast today. Mike,
Ryan Barnett 27:54
yeah, well, Mike, before you jump in, I do have a quick announcement, and it’s interesting to me. Any idea what podcast number this is,
Mike Harvath 28:06
I’m going to guess 200
Ryan Barnett 28:11
right on the nose. This was episode 200 congrats to everyone who’s been with us for multiple years doing this. One of the joys of working at Revenue Rocket is that we have been able to share what we’ve learned, and this podcast is truly a way for us to get back to people who have listened. So thank you to all the listeners, customers, partners and Mike, especially you, Mike and Matt, who have really made this a something that’s special for house and I congrats to your 200th Shoot the Moon episode.
Matt Lockhart 28:46
Alright, let’s go do a couple more.
Mike Harvath 28:51
Let’s go looking forward to that 500th podcast in our future. So anyway, thanks guys with that, we’ll tie ribbon on it for this week’s Shoot the Moon podcast. Hopefully you found value, and if you have questions or things you’d like to have us address in the podcast, please shoot us a note at info@revenuerocket.com, otherwise, feel free to tune in next week. We’ll unpack other kind of relevant and what we think anyway are interesting topics to the world of M&A and growth strategy and IT services companies make it a great week.
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