What is convertible equity (or a convertible security)?
August 31, 2012
Quick answer: convertible equity (or a convertible security) is convertible debt without the repayment feature at maturity or interest.
Over the past few years, convertible debt has emerged as a quick and inexpensive method for startup companies to raise money from angel investors and early stage venture funds. Paul Graham sparked some commentary by declaring in a tweet in August 2010 that “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.” In response, Seth Levine wrote a very thoughtful post on convertible debt versus equity. Other folks, such as Mark Suster, have also written about whether convertible debt is preferable to equity.
Fred Wilson has been openly critical of convertible debt, and prefers priced equity rounds. Manu Kumar has also indicated that he prefers priced equity rounds to convertible debt. Ted Wang believes that the “reason that capped convertible debt is the current market leader is that entrepreneurs have been conditioned over time to believe that convertible debt is (a) faster (b) cheaper and (c) better for them than equity investment.” As a result, Ted introduced the Series Seed preferred stock documents as an alternative to convertible debt for early stage investments.
One major concern about convertible debt is that it eventually needs to be repaid if another round of financing doesn’t occur. Originally, the concept of convertible debt was part of the VC playbook in order to “bridge” companies that needed financing in between round of equity financing — such as between Series A and Series B — in order to get to the next milestone to raise financing or sell the company. This is why convertible debt is sometimes referred to as a “bridge loan.” If the company didn’t raise a round of financing, the convertible debt would convert into the last round of financing (i.e. Series A) or have to be repaid.
However, most typical convertible debt issued by startups have a maturity date of typically one year or later from the time of issuance. At the maturity date, there is a risk that investors may demand repayment. As a result of this risk, some people like Adeo Ressi, have declared that 2011 will be the “year of the startup default.” The theory is that the number of seed stage Series A deals led by venture capital firms is decreasing, meaning that it will be difficult for startups to raise a new round of financing. In fact, Paul Graham wrote a letter to Y Combinator companies warning them that the performance of the Facebook IPO may hurt the market for early stage startups. There are likely thousands of startup companies (especially coming from incubators or accelerators) that have raised money using convertible debt — and many of these companies may default on payment.
On the other hand, some people, like Paul Graham, think that “this has never once been a problem.” However, I believe that YC realizes that having debt outstanding that may need to be repaid is not a good situation for founders. In fact, the form of convertible debt documents that YC recommends that their companies use has been recently revised to include a provision that forces a conversion of the debt into a pre-negotiated Series AA preferred stock upon the consent of a majority in interest of the convertible note holders.
One other related issue pointed out by Jason Mendelson is that convertible debt means that the company may be technically insolvent, and officers and directors may have enhanced duties to creditors (such as landlords), as some states may impose personal liability on directors for decisions that resulted in creditors not being paid.
In response to the concern that rogue investors might bankrupt companies by asking to be repaid when their debt is due and a lot of prodding by Adeo Ressi, I decided to modify convertible debt documents to remove the concept of repayment at maturity date and to remove interest.
These documents are available at the links below.
Please note that I am not necessarily advocating a particular form of document. There are some features in the sample documents that I like — such as the conversion discount being paid in common stock — that are in the form of convertible debt documents used by YC. There are probably other features like optional conversion into common stock or a pre-negotiated preferred stock after a certain time frame that may be appealing to some companies and investors. The main point is to re-think convertible debt so that it doesn’t have a repayment feature or interest.
Why convertible equity is better than convertible debt
1. Convertible debt may need to be repaid. The risk that an investor might demand repayment of a convertible note is eliminated with the convertible security.
2. Convertible debt holders must be paid interest. Convertible debt must have interest at the applicable federal rate (AFR) published by the IRS or higher, or the IRS will deem that the lender should have received imputed interest at AFR. If convertible debt with a price cap is supposed to mimic the economics of equity, then removing interest seems logical. (Of course, one may argue that some preferred stock financings contain a feature called cumulative dividends that is similar to interest on debt, but I find the provision to be fairly unusual in typical West Coast venture financings.) In addition, when a financing occurs and the convertible debt converts, creating the spreadsheet to track interest on the notes to the penny, especially when notes have been issued on different days, ends up being a painful task — especially as the closing date of a financing may be delayed and the amount of interest increases, resulting in more shares being issued to note holders.
3. Convertible equity is “equity” and probably can be characterized as qualified small business stock, which may have a tax benefit for investors.
4. Convertible debt with a maturity date longer than one year creates problems for California-based investors due to licensing requirements under the California Finance Lenders Law. Making it equity removes this issue.
Why convertible equity is better than preferred stock
1. All of the arguments that people make for convertible debt as superior to priced equity rounds are generally applicable. I don’t necessarily agree with all of them, but I think the primary argument is simplicity of documents and legal cost. Paul Graham also suggests that convertible debt is superior because it allows a company to easily provide different terms for different investors — for example, early investors may receive a lower price cap.
2. There are certain features that are commonly accepted in preferred stock financings that do not necessarily exist in typical convertible debt financings. For example, the Series Seed documents contain limited protective provisions, a right of first offer on future financings, a board seat, and information rights. The YC Series AA documents contain similar provisions. I’m not sure that founders really prefer to do convertible debt in order to avoid giving away these rights. I simply believe that angel investors don’t really think to ask for board seats and other rights (such as vetos on a sale of company, etc.) as they don’t care — or they trust the founders to do the right thing. I have seen convertible debt deals where extremely sophisticated early-stage investors load up convertible debt with protective provisions, pro rata rights, board seats, etc.
At the end of the day, I can’t think of a good reason not to shift early stage seed financings toward “convertible equity” away from “convertible debt.” I’d love to get feedback as to what people think.