We field a lot of founder questions on convertible equity. Things like, “What is it?” and “Is it a good funding option for my startup?” Here’s a quick primer that will help you fill in the blanks as you think about your funding options. At its simplest, convertible equity is a form of financing that gives investors the right to preferred stock based on a specified triggering event.

What does that mean in practice? Read on to find out.

Convertible debt

More than two-thirds of startup founders use convertible debt in their seed round financings. Issuance is usually a short-term note that converts to equity (at a typical discount of 15-25%) at a later date, typically once the founders raise a specific threshold of Series A financing. The notes may or may not come with a cap (for seed stage deals, we see ceilings of $3M-6M). This ceiling on valuation is meant to make sure that early investors participate in any upside and get a minimum percentage of equity.

What makes convertible notes so popular?

Convertibles come with two big benefits:

  1. They allow founders and funders to postpone the valuation discussion; and,
  2. Their agreements can be drawn up much faster and at a much cheaper cost in legal fees versus equity deals.

Although there’s been some founder pushback on the typical 15-25% discount convertible debt comes with, this is really not a big drawback for founders who are executing well and hitting their targets. In those cases, startup valuation increases in later funding rounds and should easily exceed the amount of the discount.

The “problem” with convertible debt

Convertible notes have become controversial with some folks because they view their short maturity (12-24 months is typical) as potentially harmful if for example, founders can’t raise more funds in time or if they are not able to generate enough cash to repay the debt once it matures. There is disagreement on the impact of valuation caps too.

Enter convertible equity.

What is convertible equity?

It’s a newer security that enables early stage startups to obtain flexible financing. 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 main difference versus convertible notes is that convertible equity does not need to be repaid and doesn’t accumulate interest.

Why convertible equity is attractive

Convertible equity is designed to offer the same attractive features of convertible debt deals: delayed valuation discussion plus ease and speed in drafting agreements, but without the downsides of mandatory retirement at maturity and ongoing interest payments that can be set at Prime rate plus 2-4%. To see what this looks like in action, here’s a sample convertible security term sheet.

When would startups typically use it?

Convertible equity is used in the same situations that convertible debt is—for seed and/or bridge financings (short term borrowing designed to fill the gap in the runup to a pending liquidity event).

What variations are there?

Similar to convertible notes, convertible equity can be issued at a discount, come with caps on valuation, and/or be subject to mandatory conversion to equity if founders can’t lock in more funding within a set time frame. As an example, here is Y Combinator’s version of a simple agreement for future equity (SAFE), which gives investors the option to buy stock in a later financing round.

Convertible equity removes the fear of a debt default as a source of distraction for startup entrepreneurs struggling to gain traction. But of course there is no “one size fits all” funding option. Convertible equity simply does not have a long enough track record for anyone to be able to say with credibility how it will perform in the long run or what unforeseen issues might arise.

Ultimately, it comes down to setting milestones that are specific to and relevant for your business, then using them as guides to how much funding you need and when you’ll need it.

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Guest blogger David Ehrenberg is the founder and CEO of Early Growth Financial Services, an outsourced financial services firm that provides early-stage companies with accounting, finance, tax, valuation, and corporate governance services and support. He’s a financial expert and startup mentor, whose passion is helping businesses focus on what they do best. Follow David @EarlyGrowthFS.