Equity or Convertible Debt, What’s Right for Your Company?
Many of our clients that are looking to raise a seed-round financing have heard from friends or advisors that convertible debt is definitely the way to go. We often recommend equity rather than convertible debt, and we explain why below. Convertible equity (a twist on convertible debt), if done right, can be a good deal for both investors and entrepreneurs. The important thing is that everyone involved understands the difference between convertible debt (or convertible equity) and equity. It’s in that spirit that we authored this post.
Understanding the basics
Before you can understand the pros and cons, you need to make sure that you understand the basic features of convertible debt and equity.
Investors get preferred stock. The preferred stock has all sorts of contractual rights including a liquidation preference and terms for conversion to common stock. To calculate the price of the purchased stock, the company is given a pre-money valuation. “Pre-money” means the valuation of the company immediately prior to receiving funds from investors. For example, if there’s an $8mm pre-money valuation and investors contribute $2mm the investors will have a 20% interest in a $10mm (post-money) company.
There’s two different varieties of convertible debt–traditional convertible debt, and something called convertible equity.
With convertible debt, the price of the stock is not calculated at the time of investment. Investors have rights to interest, and the conversion price is not determined until the company receives a “follow on,” or subsequent round of financing. If the company does not receive a follow on round of financing before the debt matures, the investors can call in the debt, which may result in a bankruptcy for the corporation.
The convertible debt usually has a price cap. A price cap works like this: if there’s a $20mm price cap and the follow on investors value the company at $50mm, the convertible debt holders’ interest will convert at a $20mm valuation–meaning they will get a greater interest in the company than they would have if their investment was converted at the $50mm price.
Convertible debt holders also get a discount, meaning that they’ll pay a certain percentage less than the new investors no matter what. For example, if the follow-on round values the company at $5mm and there’s a 20% discount, the debt holders’ interest will convert at a valuation of $4mm.
With convertible equity (also sometimes called convertible securities) the investors don’t have the right to call in the debt. Rather, if time passes and there’s no follow-on round, the investors’ interests convert to common rather than preferred stock.
Pros & Cons of Convertible Debt
Dispelling the myths. It is often said (less often now, however) that convertible debt is cheaper, faster, and enables the company to easily price different investors at different prices. But, if this was ever true, it is no longer true. The terms of equity deals have largely become standardized, which means they can be done quickly and more cost effectively. Also, pricing different investors at different prices can lead to a complex, unwieldy, and burdensome capitalization structure.
The Benefits of Convertible Debt
Pro: you can delay the initial valuation. While this leads to other issues, delaying the valuation has its benefits: initial investors don’t have to spend the time and effort trying to precisely value the company; and if there’s no hard price on the seed round, the company will not have a down-round in the “Series A” round.
Pro: lack of control provisions–for whatever reason investors don’t usually get veto rights on a sale or future financing in convertible debt deals.
Pro: lack of board seat–again, for whatever reason, it is customary for equity investors to get board rights, but convertible debt holders typically do not have any right to a board seat.
The Problems with Convertible Debt
Con: with traditional convertible debt, investors can call in the debt upon maturity and may have the power to bankrupt your company or force your start-up to move forward with a Series A round before it’s ready.
Con: many of the worst, most anti-entrepreneur terms that have been phased out of equity deals are implicit in convertible debt deals.
- Convertible debt with a cap acts like a full ratchet. “Full ratchet” is a term from equity deals that allows investors’ interests to multiply automatically if stock is later sold at a lower price. If an investors buys a 20% interest at a $10mm valuation and the company later sells stock at a $5mm valuation, the amount of stock the original investor has automatically doubles. Entrepreneurs didn’t think this was fair, and many investors agreed. Thus, you won’t find full ratchets in many equity deals anymore. But the “full ratchet” effect happens in convertible debt when the follow-on investor values the company at a lower price. If the company’s value drops by half between the seed round and the Series A, the convertible debt holder automatically gets twice as many shares.
- Convertible debt holders get a discount on top of the full ratchet. If the company’s value drops in half between the rounds, the convertible debt holders actually get more than twice what they would have received at the initial valuation because of the 10-30% discount they usually receive.
- Convertible debt holders can get a multiple liquidation preference. Most seed stage VC’s doing equity deals don’t even ask for multiple liquidation preferences, but convertible debt holders often get these preferences implicitly. For example: I give you a $1mm convertible note at a $9mm pre-money cap. Worst case scenario for me, I get a 10% interest in your company. You raise $6mm at a $24mm pre-money valuation, my stock converts into that security. Since I only paid $10mm post-money, I’m going to get three times as many shares to make up for the price difference. While my $1mm is only 10% of the company, it has nearly $3mm in liquidation preferences. That’s effectively a 3x liquidation preference.
Con: uncertainty—delaying the pricing adds uncertainty to the deal. You have to know the valuation to know whether or not it’s a good deal for either party. If there’s a cap, the investors knows the floor on how much stock he or she will receive. But there’s usually no ceiling–unless it’s structured as a convertible equity deal, there’s no lower-end cap, and the entrepreneur doesn’t know how much stock he or she might be giving up to the convertible debt holder.
Con: complexity—there are more moving parts to a convertible debt deal. You have to describe (1) when the price will be calculated, (2) how the price will be calculated, and (3) terms for interest and repayment of interest. You don’t have corresponding terms in an equity deal.
You don’t just have to take our word for it. Many respected VC’s and attorneys have shared their thoughts on this issue. For more reading on this topic, see:
Mark Suster, “The Truth About Convertible Debt at Startups and the Hidden Terms You Didn’t Understand” Both Sides of the Table, September 5th, 2012 https://www.bothsidesofthetable.com/2012/09/05/the-truth-about-convertible-debt-at-startups-and-the-hidden-terms-you-didnt-understand/
Yokum Taku, “What is Convertible Equity (or a Convertible Security)” Startup Company Lawyer, August 21st, 2012 https://www.startupcompanylawyer.com/2012/08/31/what-is-convertible-equity-or-a-convertible-security/
Yokum Taku, “Is Convertible Debt with a Price Cap Really the Best Financing Structure?” Startup Company Lawyer, January 9th, 2011
David Rose, “How Does Convertible Debt Work?” Gust Blog, September 6th, 2012
William Carleton, “Convertible Notes Without the Notes” Counselor @ Law, September 4th, 2012
Ted Wang, “Version 2.0 and Why Series Seed Documents Are Better than Capped Convertible Notes” SeriesSeed.com September 2nd, 2010
Dan Shapiro, “A Cap is not a Valuation” DanShapiro.com Septemeber 12th, 2012
Fred Wilson, “Convertible Debt” AVC September 8th, 2012