Over the past few years, financing for early stage companies has increasingly taken the form of convertible debt. Some estimates suggest that these notes are used in more than 2/3rds of startup seed rounds. Moreover, these notes may be collectively responsible for saddling thousands of startups with billions of dollars of debt. Ironically, very few players in the startup world anticipate these notes being repaid, but a number of founders and investors have expressed concern that these securities can potentially trigger significant consequences for a startup. Yet despite these shortcomings, convertible debt continues to enjoy prominence as a financing instrument primarily due to its expedient and affordable nature. Frustrated with the failure of the startup community to address this ailment, Adeo Ressi of the Founder Institute contacted Yokum Taku at Wilson Sonsini Goodrich & Rosati to try to create an alternative to convertible debt. In 2012, they proposed convertible equity as an alternative to debt financing. This alternative offers startups a new way to finance their company with the benefits of a convertible note while simultaneously eschewing some of its key drawbacks.
What is Convertible Debt?
Before exploring the benefits of convertible equity, it’s critical to understand why convertible debt is an attractive financing option for startups. Convertible debt is structured as a loan to the company by an investor that converts to equity in the company upon some future triggering event. Usually, this conversion occurs upon a “qualified financing,” in which the company raises a minimum, predetermined amount of cash in a Series financing. Sometimes convertible noteholders will negotiate valuation caps or discount rates to reward the investor for their risk in investing at such early stages. In this sense, convertible debt is meant to mirror traditional equity financing in many ways.
The allure of convertible debt primarily rests in how quickly these notes can be consummated without significant attendant legal fees. The entirety of a convertible note and its accompanying terms may be encompassed in a mere few pages. Moreover, convertible notes do not set a valuation on a company and can be negotiated independently with individual investors (i.e. a “rolling round”). As such, the legal costs are a fraction of the costs associated with a full equity financing.
What’s Wrong with Debt?
There are at least four issues with convertible debt that should give both founders and investors pause:
- Maturation: First, convertible notes have a maturity date. Notes generally mature within one or two years of the loan’s issuance. In the best cases, when a startup fails to meet the note terms and cannot raise adequate funds in a qualified financing, the entrepreneurs must return to investors in order to renegotiate the loan terms. In a worst-case scenario however, investors can demand repayment of the loan. If even one investor demands repayment, it can trigger catastrophic effects for the startup that has to use much-needed funds to repay an investor. Finally, certain state laws require individuals to register as lenders if they extend loans for more than a year, imposing potential greater costs on the investors as well.
- Interest: As a debt instrument, convertible notes also have an interest rate. While the interest is generally converted to equity upon a qualified financing, some have questioned whether levying interest rates on startups are appropriate from an optics perspective if the investors are genuinely acting as investors and not lenders. Additionally, managing various interest rates across different investors can be challenging and take away valuable product development time.
- Insolvency: Former lawyer turned investor, Jason Mendelson, also highlights a potential consequence of convertible debt that has not received much attention in the media. Since convertible notes are debt, companies should recognize them as liabilities. Yet, because convertible debt usually converts to equity, few people actually recognize it as a liability on their balance sheets and financials. When properly recognized as a liability however, convertible debt may incidentally put many startups into insolvency immediately upon receipt, since few seed stage companies have any assets of significant value to offset these liabilities. In some states, courts impose additional duties and personal liability on directors towards creditors when a company is insolvent.
- Creditworthiness: Finally, closely related to the insolvency issue is how convertible debt may impact startups creditworthiness. Again, because convertible debt is a liability, startups may have problems receiving credit lines or borrowing from traditional institutions if their balance sheets appear to be saddled with significant liabilities.
Convertible equity is a type of security that seeks to remedy the aforementioned issues attendant with convertible notes. Generally speaking, convertible equity is a contractual arrangement wherein the investor agrees to contribute money to the startup in exchange for some future equity upon a qualified financing. Convertible equity functions similarly to convertible notes but eliminates two critical features of convertible debt: maturity dates and interest rates. The effect of eliminating these two aspects of convertible debt are best seen by considering the same factors that hamstring convertible debt:
- Maturation: By eliminating the repayment feature, the threat of an investor demanding repayment and derailing the startup disappears. Investors no longer risk becoming lenders under most state law regimes, and founders can focus on developing products and services.
- Interest: Without interest, startups don’t have to spend time managing complex financials and cap tables to keep track of various interest rates across noteholders. Philosophically, eliminating interest aligns these securities more closely with traditional equity financing as well, an initial inspiration for the creation of convertible debt.
- Insolvency: Convertible equity can likely be recognized as equity on a company’s balance sheet, eliminating the risk of insolvency and unintentionally heightened duties owed to creditors. According to its creators, there may even be tax benefits if the securities can be qualified as qualified small business stock.
- Creditworthiness: Finally, while it is unlikely that convertible equity can be used to significantly enhance a startups credit profile, it does not pose the same threat of harming a startup’s creditworthiness by saddling its balance sheets with liabilities.
Convertible equity can also be outfitted with most, if not all of the additional characteristics and rights of convertible debt such as valuation caps and discount rates. It can also include many of the rights offered in equity financing rounds, although negotiating these extensively would run up legal costs and mitigate any potential benefits for using convertible equity. Most importantly, because convertible equity is modeled after convertible debt, the deals can be completed just as quickly and cost effectively.
Is it right for you?
Despite emerging only three years ago, convertible equity shows signs of promise for many early stage ventures. There is at least one estimate that nearly 25% of recent early stage deals have used convertible equity, and in 2013 Y Combinator promulgated a set of convertible equity documents they dubbed the SAFE agreement (simple agreement for future equity). Yet, despite the increasing prominence of convertible equity, founders should still question whether pursuing this type of financing will be beneficial.
In making this choice, the considerations should be similar to those that arise when choosing between conventional equity financings and convertible debt. Is limiting the time expended raising funds important? Are you trying to minimize your legal fees? How sophisticated are your investors, and will they insist on negotiating for extensive rights as part of the financing? If expedience and cost are significant factors, convertible equity poses an attractive alternative to convertible debt for all of the above reasons.
The last hurdle startups may face is in convincing investors that are inexperienced with this form of financing that it’s a safe, viable alternative. As accelerators like Y Combinator move towards this model, more startups will find it easier to have this conversation with their investors, but convertible equity is still nascent. For this reason, startups in communities with more developed legal and VC practices such as those in Silicon Valley may find it easier to make the shift to convertible equity. With time however, I believe this form of financing will be more appropriate than convertible debt in many, if not most instances for early stage financings.