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Debt Equity Combinations

Convertible Debentures

Since most risk investors wish to have an equity interest, convertible debentures offer investors a senior security with preferences on liquidation, payment of interest and other rights senior to common and preferred shares, while offering the investor the right to convert such debentures into common shares at his or her election at a time when the conversion equity security is more valuable than the principal amount of the convertible debentures. Convertible debentures are the ideal structure for angel investments with the following provisions - the convertible debentures would compulsory convert into a qualifying venture capital round, with a discount, and a default provision allowing the debentures to be converted into common or series A preferred at a multiple of earnings or revenues, with a floor and/or a cap for the valuation amount, at maturity or upon a liquidity event. Such a structure would tend to protect the angel investors from being crammed down as they would be if they held a simple series A preferred invested at a higher valuation.

Debentures With Warrants

Debentures with detachable warrants offer the same election to the holder, except that the warrants may have a longer term than the debentures so that investor could obtain repayment of the debentures but continue to hold warrants to purchase common shares after the maturity of the debentures. If the warrants are coterminous with the debentures, there is no real difference in such a security as compared with convertible debentures unless the debentures with warrants are prepaid before the warrants expire.

Tax Considerations

Debentures generally carry the same tax characteristics as other debt, unless the instrument as a whole represents an equity investment rather than true debt. In determining whether a hybrid security is true debt, Revenue Canada normally looks at such things as the intent of the parties, whether there is a common identity between the creditor and shareholders, whether and to what extent the creditor participates in the management of the startup, the ability of the startup to obtain funds from outside sources, the debt-equity ratio, risk, formality of the arrangement, whether the obligation is subordinate to or preferred over other creditors, voting power, whether the instrument provides a fixed rate of interest, whether there is any contingency on the obligation to repay, the likely source of the interest payments, whether there is a fixed maturity date, whether there is a redemption feature, whether the holder has any input, and whether the instrument was issued in connection with the organization of the startup. If the instrument is determined to be debt, the holder's conversion of the instrument into common shares under a conversion privilege is treated as a non-taxable event. A debt instrument that is a contingent debt instrument is subject to a special set of regulations.