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Four Things Every Founder Should Know About Convertible Equity

February 10, 2016

I often get questions about convertible equity: “What is it?” and “Should I use it?” I would like to take an opportunity to answer some questions and fill in some of the blanks.

In short, convertible equity is a form of financing that gives investors the right to preferred stock once a triggering event occurs.

So what does that mean? Let’s start with some background…

Convertible debt

Convertible debt is a common feature of startup seed rounds, used in more than ⅔ of all financings. Issuance takes the form of a short-term note that converts to equity (usually at a discount of 15-20%) 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 $3M-6M 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:

1) They delay having to agree on a valuation, making arriving at terms more straightforward and less contentious—which means agreements can be drawn up very quickly and at a much cheaper cost in terms of legal fees relative to equity deals.

2) The typical discount of 15-20% is not a big drawback, since your startup valuation increases going into the next round should easily exceed that.

The “problem” with convertible debt

Convertible notes have become controversial in some corners because their short maturity (12-24 months is typical) could at best hamstring, or worse, deal a crippling blow to startups in the event founders aren’t able to raise funds or generate sufficient cash flows to pay off the debt at maturity. Valuation caps can be a huge source of frustration too.

Enter: convertible equity.

1. What is convertible equity?

It’s 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: they don’t require repayment and they don’t accumulate interest.

2. Why is convertible equity attractive?

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 2-4%.

Sample Convertible Security Term Sheet.

3. When would you use convertible equity?

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).

4. Are there variations to convertible equity?

Just as with convertible notes, convertible equity can be issued at a discount, include valuation caps that vary by investor, and/or be subject to mandatory conversion (to equity) if no financing event occurs within a set time frame. Take a look at Y Combinator’s version, 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 in determining how much and which type of funding will help you achieve your startup goals.

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