Convertible Debt Vs. Convertible Equity Throw Down: Which Form Prevails For Early-Stage Fundraising?May 19, 2016 Guest Contributor
This article is co-authored with Eliot Cotton of Vinson & Elkins.
Convertible debt has emerged as one of the most common forms of early-stage financing over the past decade for both angel investments as well as institutional rounds. A convertible debt round is generally less complicated and less expensive than a “priced round” and can usually be negotiated relatively quickly. It was designed to defer the negotiation of more complex terms until a later preferred equity round. More recently however, we have seen an increase in the complexity of convertible debt rounds as investors insert more sophisticated conversion scenarios.
As a response, a few innovations have emerged to improve and simplify the process and provide an even playing field to founders. Y Combinator created the SAFE (Simple Agreement for Future Equity) and 500 Startups introduced the KISS (Keep it Simple Security) – the latter having both a convertible debt and a convertible equity feature.
The purpose behind, and the value created by, each of these documents is essentially the same – simplify and reduce the cost of the early-stage investment process by reducing the terms that are open for negotiation.
Below is a brief list of pros and cons, comparing the benefits of the Y Combinator SAFE against traditional convertible debt notes, which in each case are presented from the founder’s perspective.
SAFE – Advantages
- Conversion to Equity: Both convertible debt notes (Notes) and SAFEs require conversion in the next priced preferred equity round. Notes typically contemplate a minimum threshold that must be raised in the next round for conversion to occur. SAFEs, on the other hand, do not typically stipulate any such amount and the instrument will convert at the next capital raise with a fixed valuation, regardless of the round’s size. This benefits the founders by reducing the possibility that the investor’s investment will have an overinflated increase in value (because of the discount or valuation cap) between the issuance of the SAFE and its conversion into equity.
- No “debt terms” – Maturity & Interest Rate: There are no maturity dates in SAFEs, which eliminates the countdown timer for when the company must pay back the debt (if another round is not raised in time). Some Notes allow the Note to convert into common stock at the maturity date if the company can’t pay back the loan, but the Note holder often retains considerable leverage at these inflection points, including a threat of insolvency and other security measures. Additionally, SAFEs do not have interest rates, which eliminates an extra expense from the company’s balance sheet.
- Liquidation Preference Overhang is eliminated: The SAFE takes away the “liquidation preference” premium that Note holders receive when they convert into a new priced equity round under a valuation cap, by creating a new class of shares – “Safe Preferred Stock”. Safe Preferred Stock has the same rights and preferences as the investors receive in the new round, but the liquidation preference, conversion price and dividend rate are adjusted to reflect the actual money invested.
SAFE – Disadvantages
- Familiarity: Investors are often creatures of habit and want to invest through instruments they know and are comfortable with. While more investors are familiarizing themselves with the SAFE, many still prefer convertible notes.
- LLC v. Corporation: SAFEs are intended to be used for corporations, not for LLCs. Since Notes are debt, they can easily be added to a company’s balance sheet, regardless of the company’s formation type. SAFEs, as a security interest, are not clearly aligned with the LLC structure and would need further adjustments and negotiations to be appropriate.
SAFE – Unique Twists
- MFN (Most Favored Nation) Provision: One of the provisions introduced with the SAFE (and also the KISS documents) is an “MFN” feature. Basically, if an investor invests through a SAFE, and later investors receive SAFEs with more preferential terms, the original investor’s SAFE will, at the investor’s request, be amended to match the new, better terms.
- Payback priority? Where does a SAFE sit on dissolution?: Upon a liquidation of the company, a SAFE would in principle get its investment repaid after debt, but before any of the company’s equity shareholders. In such a situation, the SAFE investors would have the option to convert their investment into common stock or receive a cash repayment of their investment amount. Conversely, a Note holder would, in principle, be paid back prior to any SAFE holders and ahead of anyone holding capital stock. The issue of how a SAFE would be treated in a bankruptcy/insolvency situation has been the subject of significant legal discussion, and is likely a matter to be fully resolved in the future. Investor Perspectives – losing the maturity date checkpoint/leverage: With respect to SAFEs, investors often pushback on the absence of the “traditional” debt provisions, such as the lack of a maturity date. Founders appreciate that they don’t have to go through the painful and time-consuming process of extending the maturity date, possibly annually (as maturity date extensions were typically affected on an annual basis). For founders this can be a frustrating process of herding cats and, sometimes, re-opening negotiation points that most founders would rather stay closed. Some investors have approached the maturity date as a sort of “reckoning” –where everyone takes stock of the company and figures out next steps (e.g. extend, convert or call it a day). Of course, there is nothing preventing founders and investors from having this discussion with SAFEs, but in this case there is no legal leverage to force a specific outcome.
Clearly, from the company’s perspective, SAFEs are the better option. If an early-stage company has the leverage to use a SAFE, and its form of organization allows them to do so, using a SAFE could save them time during the negotiations and a massive headache at the time of conversion. However, for investors that can add serious value to your company, be careful not to be too stringent. At the end of the day, it is important to build a strong team of investors that can carry you from where you are to where you want to be.