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.

Background

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.

The problem

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.

The solution

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.

Form of Convertible Security Term Sheet

Form of Convertible Securities Purchase Agreement

Form of Convertible Security

The release of the documents was covered by Techcrunch, Venturebeat, Forbes and Fortune, as well as the Wall Street Journal.

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.

Conclusion

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.

Comments

  • http://www.facebook.com/profile.php?id=617014934 Steven Echtman

    How does this convertible equity vs. convertible debt potentially affect ESOP stock option strike prices?
    I can imagine that without the debt component, a convertible equity deal could be viewed as a funding event that impacts valuation and option pricing at time of closing.

  • mileslasater

    Thanks for the post!  A few questions:

    1.  I’ve seen convertible notes that contain a provision for the company to repay the note in equity.  What’s the advantage of convertible equity compared to that situation?2.  Also, I would wonder about blue sky laws for convertible equity – do they apply differently?

  • http://500startups.com/ Dave McClure

    good stuff yokum.

    I suggested on Quora that a minimum 2X return provision is a reasonable trade off in exchange for giving up interest. this would also satisfy investors somewhat in the case of an early exit or “acqui-hire” deal.

    Q: so does this security convey info rights & pro-rata rights? that’s usually the other items we ask for in conv notes or normal seed rounds (info rights let investors know how the company is doing, and pro-rata rights guaranteed the investor can continue to invest in the future to maintain their ownership).

  • http://www.startupcompanylawyer.com Yokum

    1. A company option to force conversion into equity is another
    alternative to removing the potential for investors to demand repayment.

    2. Both convertible debt and convertible equity are “securities” — so blue sky laws apply the same in both cases.

  • http://www.startupcompanylawyer.com Yokum

     @davemcclure:disqus – In response to your Quora comment, I tweaked the form of term sheet to provide for some alternative language.  Like I said in the body of the post, I’m not particularly wedded to any particular form — I just want the repayment and interest provision to be eliminated.  I agree that the better of 2x money back or conversion at the price cap in a change of control is a fairly common term in typical Silicon Valley convertible debt.

    On info and pro rata rights, my general attitude is that if an investor wants it (and no one else asks or cares) — we can provide it in a side letter.  Once again, I wouldn’t object to those things — the provisions that 500S typically asks for are reasonable requests in my opinions.

  • http://wac6.com/ William Carleton

    Interesting structure. Do you see a need to define the features of the convertible security in the charter – authorizing and defining a class other than common – or is the idea that the “change of control” definition is going to catch a range of “deemed liquidation events” on the downside?

  • http://www.startupcompanylawyer.com Yokum

    The concept is that the convertible security is a contract — like a warrant. I am considering including an optional conversion into common stock at the price cap upon a true liquidation.

  • http://www.startupcompanylawyer.com Yokum

    According to a 409A valuation firm, they really don’t look at the debt element of a convertible note to reach a valuation conclusion.  So I don’t think that there would be any effect from a 409A valuation perspective.

  • http://wac6.com/ William Carleton

    Gotcha. Thanks.

  • http://bottomlinelawgroup.com/ Antone Johnson

    Great post as usual, Yokum.  I appreciated your links and recap of some others’ best writing on the subject, as the last time it seems to have been broadly debated was around the time of PG’s infamous tweet a couple years ago.  A couple follow-up questions:

    - Did 2011 empirically turn out to be “the year of the startup default?”  I haven’t seen that in my own practice.

    - Have you seen many investors or their counsel raise the CFLL issue?  I read about it on your blog when you first wrote on the subject (good catch), but frankly I’ve never had an investor flag it as a concern, with notes maturing >12 months as the norm.

    - I’m no tax guy, but I’ve heard there are situations in which preferred stock will be viewed by the IRS as functionally closer to debt than equity.  Is there any risk that this type of convertible security could be viewed “in substance” as debt such that the AFR would need to be paid (or face adverse tax consequences)?

    FWIW, nearly all of the seed-stage financing deals I’ve done in the past couple years were structured as convertible notes (or, in some accelerator deals, a convertible security).  ”Semi-preferred” equity instruments such as Series Seed are ingenious inventions, but so far I haven’t had one cross my desk.  This may be mostly a function of deal size (<$1MM).  I think the mere concept of issuing any series of preferred stock at such an early stage gives many entrepreneurs pause, and lightweight though they may be, there's a reasonable concern over a "slippery slope" of investor rights that will creep in once Preferred is on the table.When I talk through the various scenarios with founders, for the most part they seem unconcerned with the prospect of having the notes come due, viewing that scenario as a total failure already:  If the company (1) hasn't raised an eligible financing round, (2) hasn't somehow generated cash to repay the notes, yet (3) most importantly, its prospects look so dim, and investors' confidence in the founders is so low that the CEO can't negotiate an extension with the majority holders, what's left?  (Granted Jason Mendelson's point about insolvency is a good one.)  Nevertheless, removing the whole concept of "debt" coming due can relieve some psychological pressure and eliminating interest is a welcome simplification.

  • GlennES

    Yokum:

    Thanks for the post.

    A couple of questions:

    1.  What is the rationale for the split between preferred and common on conversion?  Why not all preferred?

    2.  Why is the conversion on a sale at the valuation cap as opposed to the lesser of the actual price per share and the valuation cap?  I know a sale at less than the valuation cap is farfetched, but I lived through the burst of the tech bubble and saw the market turn 180 degrees almost overnight.

    3.  I understand that the valuation cap in convertible debt does not count as a pricing for tax purposes.  Is that the same for the convertible equity?

    Thanks.

  • Steve Rosard

    Yokum, if the security is a contract and not capital stock, does it lose capital gain treatment on a change of control? 

  • http://twitter.com/ryangeftmangold Ryan Geftman-Gold

    Hi Yokum and everyone,

    This is a timely discussion for me — I’ve been trying to think through convertible structures over the past week.

    (Caveat:  I’m not a lawyer and I’d categorize my understanding of convertible structures as “For Dummies”)

    Entrepreneurs seem to be attracted to convertible equity and convertible debt because they perception (not sure if this is right or not) that those vehicles are quicker and less expensive… and, more importantly, because they allow an early-stage company to raise money at a time when there’s not necessarily a good means to put a valuation on the company.

    From an investor’s point of view, someone who’s putting money into an early-stage company needs to be rewarded for the risk he’s taking, right?  To that end, don’t you need to look at the risk difference between a seed convertible structure investment and a first qualified round, Series A investment… and just figure out a way to compensate for that difference? It certainly could be challenging to figure out what should go into that analysis and what the thresholds should be (e.g., difference between the percentage of times seed investors don’t make their investment plus 15% and the percentage of times Series A investors don’t make their investment plus 15%)… but isn’t that the core question here?

    If so, my gut tells me that a discount on the first qualified round, Series A investment AND a cap AND additional rights that Dave McClure and Antone Johnson and others have touched on is too much reward for the added risk seed investors are taking over and above the risks taken by Series A investors.

    Am I thinking about this properly?

    Thanks,
    Ryan

  • Guest

    Can you please explain how this differs from a call option? Thank you.