We field a lot of founder questions on convertible equity such as, “What is it?” and “Is it a good funding option for my startup?”
Here’s a quick primer that will help you make better decisions 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.
Convertibles Explained
Today, convertible securities include both debt and equity investment instruments. We take you through both, explain how they're different, and detail key takeaways for startup founders.
Convertible notes and convertible debt
More than two-thirds of startup founders use convertible debt in their seed round financing agreements. 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?
Convertible debt comes with two big benefits:
They allow founders and funders to postpone valuation; and,
The agreements can be drawn up much faster and at a much cheaper cost in legal fees compared to equity financing 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.
Convertible equity vs. convertible debt
The main difference between convertible debt and convertible equity is that convertible equity does not need to be repaid and doesn’t accumulate interest.
What are the advantages of convertible equity?
Convertible equity is designed to offer the same attractive features of convertible debt deals:
Delays valuation discussion
Ease and speed in drafting agreements
No mandatory retirement at maturity or 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 is convertible equity used in startup funding?
Convertible equity is used in the same situations that convertible debt is — for seed funding and/or bridge financing (short term borrowing designed to fill the gap in the runup to a pending liquidity event).
Different types of convertible equity
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, you may come across 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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Download The Startup Funding Playbook: A Practical Guide to Raising Capital for Sustainable Growth to learn more about debt financing for startups, including what you should watch out for, how to compare offers with different terms, and more.