Here’s what an entrepreneur should consider when evaluating a convertible equity financing option.
In our work with clients, I’ve seen nearly every variety of fundraising vehicle in use. Lately though, I‘ve been getting more questions from clients about convertible equity. Some wonder whether it might even become a good replacement for convertible debt, which has become ubiquitous in seed stage startup fundings. So I figured I would fill in some blanks. In short, convertible equity is a form of financing that gives investors the right to preferred stock once a triggering event occurs.
Understanding Convertible Debt
Convertible debt is a common feature of startup seed rounds, used in more than two-thirds of all financings. Issuance takes the form of a short-term note that converts to equity (usually at a discount of 15-20 percent) at a later date, typically when a startup raises a minimum specified amount of Series A financing. Convertible notes may or may not include a cap on valuation (we see ceilings of three-to-six million in seed stage deals) that ensures early investors participate in any upside and are guaranteed a minimum percentage of equity.
Convertible notes are popular because of two perceived big benefits. First, they delay having to agree on a valuation, making arriving at terms more straightforward and less contentious. This means you can also draw up agreements very quickly and without as many legal fees as with equity deals. The typical discount of 15-20 percent is not a big drawback since your startup valuation increases going into the following round and could easily exceed that.
Convertible notes have become controversial in some corners because their short maturity (12-24 months is typical) could at best be a hindrance or worse, a crippling blow if founders aren’t able to raise funds or generate sufficient cash flow to pay off the debt at maturity. Valuation caps can be a huge source of frustration too: enter convertible equity.
Understanding Convertible Equity
Convertible equity is a newer security that enables early stage startups to obtain flexible financing while avoiding some of the drawbacks of convertible debt. Inspired by Sequoia Capital’s startup financing instruments, Yokum Taku of Wilson Sonsini and Adeo Ressi of Founder Institute and TheFunded came up with convertible equity. The securities are modeled on convertible notes, with two chief and important differences: there is no repayment requirement and they don’t accumulate interest.
Convertible equity aims to mimic the ease (by postponing the valuation discussion) and speed of drafting agreements that convertible debt offers, without the downsides of mandatory retirement at maturity and periodic interest payments. We typically see these set at prime plus two-to-four percent.
You would use it in the same situations where you’d consider convertible debt — namely for early stage startups raising seed financings and/or for bridge financing (short-term financing to carry you through to an expected liquidity event).
Variations of Convertible Equity
Just as with convertible notes, convertible equity can be issued at a discount, include valuation caps that vary by investor. They can be subject to mandatory conversion (to equity) if no financing event occurs within a set timeframe. Take a look at Y Combinator’s simple agreement for future equity (SAFE) which gives investors the option to buy stock during a future equity round.
Convertible equity definitely removes the worry over a debt default for entrepreneurs struggling to gain traction and generate cash flow. But there is no one-size-fits-all funding option. Right now the track record for convertible equity is just too short to determine how this newer financing option will perform in the long run or what unexpected issues might come up.
Ultimately, it comes down to setting milestones that make sense for your business, then using them to guide you to how much and which type of funding will help you achieve your startup goals.
The Young Entrepreneur Council (YEC) is an invite-only organization comprised of the world’s most promising young entrepreneurs. In partnership with Citi, YEC recently launched StartupCollective, a free virtual mentorship program that helps millions of entrepreneurs start and grow businesses.
Image credit: CC by John Liu.