Convertible debt is pretty much what it sounds like: debt that can convert to equity. A convertible debt financing is similar to a traditional loan in that the company borrows money (often from angel investors, but sometimes from friends and family or even VCs) and commits to repay it with interest by the end of the term of the loan. Unlike a traditional loan, however, the entire principal and accrued interest will convert to equity at the option of the lender or automatically upon the occurrence of certain events. For example, if the company raises a round of venture financing the outstanding principal and interest usually automatically converts into equity of the same type as is being sold to the VCs. By tying conversion to a financing, the debt holders effectively piggy-back on the valuation determined by the equity investors.

A convertible debt financing is often called a “bridge” financing because it provides a company with the capital it needs to continue operations until the next round of venture financing. To compensate the convertible debt investor for the added risk of investing earlier, the conversion to equity is typically at a discount to the price being paid by the VCs (around 20-40% is customary) or the company issues to the convertible debt investor a warrant to purchase additional shares of the equity into which the principal and interest on the loan converts in the financing.

Convertible debt offers several other advantages over an equity financing for a very early stage company, but the most significant is probably that a convertible debt financing is a much simpler transaction and therefore can usually be completed at a much lower cost than an equity financing. If you’re only raising a small amount, the cost savings can be critical.

NOTE: Even though convertible debt starts out as a loan, it is still considered a “security” and therefore all the normal securities laws apply, including restrictions on sales to non-accredited investors, so be sure to consult your lawyer.

The Securities and Exchange Commission requires that a company provide a PPM to all non-accredited investors in any financing relying on Rule 505 or 506 of Regulation D. The information required to be included in the PPM is similar to the information required to be disclosed when a company goes public, and therefore takes significant time to prepare and requires careful review by the company’s lawyers and accountants. Among the non-financial information required is: a description of the company’s products and/or services, suppliers, target market and competition; a discussion of potential risks involved in the company’s business and any investment in the company; biographical information about the company’s management; and a summary of the company’s capitalization structure before and immediately following the financing.

Given the cost involved in preparing a PPM, why would a company ever choose to provide one if it was not required to do so? Because a well-prepared PPM helps protect the company from liability by providing a written record of information investors were given about the company and the risks of the investment. On the flip side, a poorly drafted PPM may serve as evidence of information the company failed to disclose to an investor, so it is imperative that legal counsel be carefully involved in the preparation of the document.

Finally, please note that using a PPM does not free a company from the other requirements of applicable federal and state securities laws or regulations, so it is important to consult an attorney to ensure you are in compliance.

The three exemptions from registration encompassed by Regulation D are found in Rules 504, 505 and 506, while the remainder of the rules in Regulation D set forth further limitations applicable to offers and sales of securities pursuant to each of the three exemptions (we plan to delve into some of these limitations at a later date). The most important aspects of each exemption are summarized below, but please note that the summaries do not purport to cover all aspects of Rules 504, 505 and 506, and should not be considered legal advice. Legal counsel should always be consulted in advance of an issuance of securities.

Rule 504: Rule 504 offers a broad exemption from federal registration for offerings of not more than $1 million over a 12-month period. Unlike Rules 505 and 506, Rule 504 does not impose any restrictions on the use of general advertising and solicitation to promote the offering, or the number or sophistication of investors, and the issuer is not required to provide any disclosure materials regarding the offering to potential investors (though it is often advisable to do so). Securities offerings made under Rule 504 remain subject to state securities laws (also referred to as “Blue Sky” laws), which may impose additional restrictions and requirements. Issuers relying on Rule 504 must either register or qualify for an exemption from registration in each state in which securities are offered.

Rule 505: Rule 505 permits an issuer to offer and sell up to $5 million of securities to an unlimited number of accredited investors and up to 35 non-accredited investors. The issuer must furnish detailed information about the company’s business and finances to non-accredited investors, as required by Rule 502(b)(2). Rule 505 also prohibits the use of general advertising or solicitation to promote the offering; either the issuer or an agent of the issuer (officer, director, employee or intermediary such as a placement agent) must have had a “substantive and pre-existing relationship” with any prospective investor. As with Rule 504, Rule 505 offerings are subject to state Blue Sky laws, which may impose additional restrictions and requirements and must be considered on a state-by-state basis.

Rule 506: Rule 506 permits an issuer to offer and sell an unlimited amount of securities to an unlimited number of accredited investors and up to 35 non-accredited investors, but unlike offerings under Rule 505, any non-accredited investor must have “such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.” As with offerings under Rule 505, in a Rule 506 offering the issuer must furnish non-accredited investors with detailed information about the company’s business and finances (required by Rule 502(b)(2)) and the Issuer is prohibited from using general advertising or solicitation to promote the offering. Unlike offerings under Rules 504 and 505, however, offerings that meet the requirements of Rule 506 are exempt from state Blue Sky laws pursuant to the National Securities Markets Improvements Act of 1996, though states may still require issuers to provide notice of the offering to state securities regulators.

To understand the importance of accredited investors, it is necessary to first understand that a primary goal of the U.S. securities laws is to reduce the possibility that ordinary people will lose their shirts by investing in dodgy companies. This is accomplished in part by requiring that companies provide to potential investors – even to friends and family of a company’s principals – detailed information about the company’s operations and finances, as well as the risks inherent in the company’s business. This information must be provided in a written document (called a private placement memorandum or “PPM”) that can take significant time to prepare and generally requires careful review by the company’s lawyers and accountants. Complying with the disclosure requirements would therefore be cost-prohibitive for companies seeking to raise small amounts from outside investors if not for the fact that the SEC relaxes the disclosure requirements in limited circumstances, including when companies sell only to accredited investors.

A person or entity is “accredited” if he/she/it falls within one of the categories of investors set forth in the definition of “accredited investor” found in Rule 501 of Regulation D, which was adopted pursuant to the Securities Act of 1933. These categories attempt to get at whether an investor has sufficient knowledge and skill to evaluate the risks of a potential investment. For a natural person to be accredited, he or she must be a director, officer or general partner of the issuer or must have, at the time of purchasing securities, either (a) individual net worth, or joint net worth with the person’s spouse, in excess of $1,000,000 or (b) individual income in excess of $200,000 in each of the two most recent years or joint income with the person’s spouse in excess of $300,000 in each of those years and a reasonable expectation of reaching the same income level in the current year.  [UPDATE: The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law July 21, 2010, provides that individuals may not include the value of their residence in determining  if their net worth exceeds the $1,000,000 threshold for being an accredited investor and requires that the SEC periodically review and update the net worth and income thresholds for accredited investors.]

Because accredited investors are considered better able to fend for themselves, Regulation D permits companies to sell to an unlimited number of accredited investors without requiring that they furnish the information that must be provided to non-accredited investors; provided that the company is available to answer questions from potential investors and provide to them, upon request, the same kind of information that would have to be provided to non-accredited investors, and that the offering also complies with the other applicable restrictions on the scope and manner of the offering. This can save a company thousands of dollars in legal and accounting fees, as well as the time necessary to prepare a PPM. We should point out that the rules of Regulation D allow companies to offer and sell securities to anyone, including friends and family, if applicable restrictions are met; however, if you want the cost savings afforded by streamlined disclosure requirements, then before offering securities to your Aunt Bertha, you’ll want to make sure she’s accredited.

One note of caution: in determining what information to provide to potential investors, it is important to remember that even when offering securities only to accredited investors pursuant to Rule 506, a company is still obligated to comply with the SEC’s anti-fraud rules (we’ll discuss these in a future post), which generally make it illegal to make a misstatement or omission of a material fact in connection with an offering of securities, as well as with any applicable state securities laws. Your legal adviser can help guide you through the intricacies federal and state securities laws.