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.

On January 28, 2011, Yuri Milner and SV Angel announced that their Start Fund would offer all Y Combinator companies $150K in convertible debt.  Reactions are mixed, from “no big deal,” to “disrupting angel investing” to “you’d be crazy not to take this deal” to “facilitating a bubble” to “strategic perfection.”  TechCrunch reports that within 24 hours, 36 of the 43 companies had already signed the convertible debt documents.

I had a chance to review the terms of the convertible debt documents used in the transaction.

Below are the major points:

Interest rate:  higher of 2% or AFR (applicable federal rate).  (I think the intention to keep the interest rate as low as possible.  In the past, interest rates on convertible debt seemed to be in the 7% to 10% range, but I recently saw a VC fund offer $500K of convertible debt at a 3% interest rate.)

Maturity date:  two years or maturity date of other convertible notes.  (This also seems to be fairly company favorable as most convertible debt seems to have a one year term.)

Automatic conversion:  on a $1M equity financing with no conversion discount and no price cap, provided that the transaction documents provide for a right to purchase a pro rata share of future financings.  (I don’t know how to get a better deal than this.)

Optional equity conversion:  on other equity financings with no conversion discount and no price cap.  (Once again, I don’t know how to get a better deal than this.)

Optional maturity conversion: into Series AA Preferred Stock based on a $5M valuation.  The Series AA has a 1x non-participating liquidation preference, weighted-average anti-dilution, basic protective provisions (adverse changes to the Series AA, number of shares of Series AA, or merger/asset sale), right to maintain proportionate ownership, ROFR/Co-Sale rights and basic information rights.  (Please note that these are generally the terms of the Series AA Preferred Stock financing documents that Y Combinator previously published.)

Optional change of control/IPO conversion:  into common stock at the lesser of (A) fair market value (based on change of control or IPO), or (B) $5M valuation.

I can’t think a good reason to turn down this deal, unless a company is never planning to raise outside investment.  Congratulations to the Y Combinator companies that are benefiting from these terms.

Update:  In the second batch of YC companies, a “most favored nation” clause was added so that StartFund receives the benefit of terms negotiated by later convertible debt investors.

It’s been a while since I’ve written a substantive post.  (I started writing this post in September 2010, but only got around to finishing it.)

Convertible debt with a price cap seems to be the preferred structure for early-stage financings

Over the last 12 months, I’ve noticed a trend where early-stage startup companies raise seed financings of between $250K and $1M using a convertible note with a price cap.  In fact, it seems very rare to see a convertible note without a price cap these days, although it was fairly common to raise convertible debt without a price cap a couple of years ago.

Paul Graham has sparked some discussion on the topic in August 2010 when he tweeted “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.”

Seth Levine asks, “Has convertible debt won?”  Seth points out that “the convert cap reflects a premium to the current fair market value of the business. One super-angel I talked to told me that while a year ago these caps “approximated what I’d pay in equity” that they’re now “33% higher than what I’d normally agree to pay now.”

I have also heard that many of the companies in the YC batch that Paul Graham was referring to have been dictating convertible debt terms with price caps in the high single digit million range when pitching to angel investors.  This leads me to believe that there is a mini-bubble in the early stage financing universe.

Is a priced Series A financing a valid alternative?

A logical alternative to convertible debt is a priced Series A preferred stock financing. Mark Suster does a good job analyzing whether convertible debt is preferable to equity, and concludes that convertible debt is better. I’ve pondered the issue of convertible debt vs equity and come to the same conclusion.  Most commentators generally seem to be concluding that convertible debt with a price cap is better than a priced Series A round.

However, Ted Wang points out that Series Seed documents are better than capped convertible notes.  (I’ve used the Series Seed documents twice in the last six months and have managed to keep company-side legal fees under $15K on both of the deals, although I suspect that the documents for the “real” Series A financing will end up being more painful to draft as the Series Seed documents don’t scale well in later rounds.)  Fred Wilson, while he doesn’t endorse the Series Seed documents, says that Union Square Ventures has never participated in a convertible note deal.  Jason Mendelson points out that the use of debt fundamentally changes the fiduciary duties of managers and board members of the company, as executives and directors of “insolvent” companies face potential suits from various creditors.

Tweaking convertible debt so that common stock (instead of preferred stock) is issued for the conversion discount in order to limit liquidation preference overhang

Given that convertible debt with a price cap seems to be firmly entrenched these days as a typical structure for early-stage financings, I’ve pondered some methods to make the structure more favorable to companies.

One issue that has bothered me is that the conversion discounts and price caps result in a company creating more liquidation preference than the amount of money that investors have invested.  For example, if the amount of money raised in the convertible debt financing is large (say $1M), and the conversion discount is 50% (or the price cap is 50% of the Series A valuation), then the company will end up issuing $2M (+ interest) of Series A preferred stock to investors that only paid $1M.  This Series A preferred stock will typically have a 1x liquidation preference, so $2M of liquidation preference overhang will be created as a result of the conversion discount/price cap.

Thus, a company is in a worse situation by using convertible debt with a price cap than if the company simply did a Series A financing at the price cap valuation instead of the convertible debt.

Please keep in mind that there are two principal economic features of preferred stock:  the liquidation preference, and the equity on an as-converted to common stock basis.  Convertible debt with a price cap preserves the investor’s “equity” ownership, but gives the investor extra liquidation preference.

In order to solve this problem, I have resorted to modifying the conversion discount formula in certain deals so that the conversion discount is paid in common stock.  In other words, the principal and interest on the convertible debt will convert into preferred stock with no discount, and the discount portion will converted into common stock valued at the preferred stock price. This is an attempt to make convertible debt with a price cap economically equivalent to a priced Series A financing.

One might note that this is not the exact economic equivalent, as the application of the anti-dilution formula on the preferred stock issued upon conversion of the debt will not be as favorable as if the convertible debt financing was originally done as preferred stock. However, many seed equity financings don’t provide for anti-dilution protection, as the valuations are low to begin with.

[Note: A better way to make convertible debt identical to a seed financing is to have the convertible debt convert into its own series of preferred stock.  In other words, the new investors would purchase Series A and the convertible debt would convert into Series A-1 with an aggregate liquidation preference equal to the principal and interest of the debt (and a liquidation preference per share lower than the Series A price per share).  However, most people don’t like the messiness of creating an extra series of preferred stock.]

[Please also note: It probably doesn’t make sense to entirely focus on the equivalent theme, as there are plenty of other ways that convertible debt and equity are different. For example, convertible debt has no voting rights, and typically don’t have protective provisions. However, seed investors don’t seem to mind the lack of these features.]

An example of a term sheet provision to provide for the conversion discount to be paid in common stock and the math involved is below.

Term sheet excerpt:

CONVERTIBILITY:        In the event the Company consummates, prior to the Maturity Date, an equity financing pursuant to which it sells shares of its preferred stock, which are expected to be Series A Preferred Stock (the “Preferred Stock”), with an aggregate sales price of not less than $[1,000,000], excluding any and all indebtedness under the Notes that is converted into Preferred Stock, and with the principal purpose of raising capital (a “Qualified Financing”), then all principal, together with all accrued but unpaid interest under the Notes, shall automatically convert into shares of the Preferred Stock and the Company’s Common Stock at the lesser of (i) 80% of the price per share paid by the other purchasers of Preferred Stock in the Qualified Financing and (ii) the price obtained by dividing $5,000,000 by the Company’s fully-diluted capitalization immediately prior to the Qualified Financing (the “Discounted Purchase Price”).  The total number of shares of stock that a holder of a Note shall be entitled to upon conversion of such holder’s Note shall be equal to the number obtained by dividing (i) all principal and accrued but unpaid interest under such Note by (ii) the Discounted Purchase Price (the “Total Number of Shares”).  The Total Number of Shares shall consist of Preferred Stock and Common Stock as follows (see also example on Exhibit A):

The number of shares of Preferred Stock shall be equal to the quotient obtained by dividing (i) all principal and unpaid interest under the Note by (ii) the same price per share paid by the other purchasers of the Preferred Stock in the Qualified Financing (such price, the “Undiscounted Purchase Price,” and such number of shares, the “Number of Preferred Stock”).

The number of shares of Common Stock shall be equal to (i) the Total Number of Shares minus (ii) the Number of Preferred Stock.

Example:

Assumptions:

Principal + Interest    $1,000,000
Discounted Purchase Price    $1.00
Undiscounted Purchase Price    $2.00

Total Number of Shares:

Principal + Interest ($1,000,000)        =    Total Number of
Discounted Purchase Price ($1.00)        Shares (1,000,000 shares)

Number of Preferred Stock:

Principal + Interest ($1,000,000)        =    Number of Preferred
Undiscounted Purchase Price ($2.00)        Stock (500,000 shares)

Number of Common Stock:

Total Number of Shares             –    Number of Preferred          =    Number of Common
Shares (1,000,000 shares)            Stock (500,000 shares)    Stock (500,000 shares)

I seem to be doing a lot of pre-Series A convertible bridge note financings these days. As I have written previously, I think that convertible notes with even large conversion price discounts (e.g. 50%) or warrant coverage are typically more company-favorable than a Series A financing where a valuation is set.  After completing a lot of convertible debt deals over the last year on behalf of both companies and investors, I have refined some of my thoughts about pre-Series A convertible debt terms.

Observation 1 — Convertible debt is a bad deal for angel investors

I think many sophisticated angel investors realize that convertible bridge notes do not adequately compensate angel investors for the risk that they take in funding early-stage companies. For example, typical provisions in a company-friendly pre-Series A convertible bridge note financing may include a 20% conversion discount from the Series A price and a 2x return on a sale of company.

Assume the angel investor invests $500K. If the company eventually raises $50M in a Series A financing at a $100M valuation, a 20% discount from that price is not particularly attractive compensation for that investment risk, as the investor would only own about 0.4% of the company after the financing (assuming that the shares issued upon conversion of the bridge were not included in the pre-money fully-diluted share number). Similarly, if the company is sold for $100M, the investor would only receive 2x their investment back (plus interest), or a total of $1M, which would only be 1% of the sale price.

If the investor had invested $500K in a Series A Preferred Stock at a $4.5M premoney valuation, then the investor would own 10% of the company. If the company raises $50M in a Series B financing at a $100M valuation, the investor would own 6.67% of the company post-Series B financing.

Similarly, if the company was sold for $100M before another round of financing, the investor would receive 10%, or $10M.

Observation 2 – Angel investors realize convertible debt is a bad deal so they demand price protection provisions (i.e. a price cap)

Due to the economic results described above, many sophisticated angel investors refuse to do convertible note bridge financings unless the conversion price on the debt is capped.  In other words, an investor may request that the conversion price is the lower of (i) a 20% discount from the Series A price, or (ii) the price per share determined if the valuation was $[X]M.  Typically, the valuation might be some reasonable projection of the valuation range in the eventual Series A financing.  The valuation is typically higher than what would be set if the investor and the company negotiated a valuation at the time of the convertible debt financing, but lower that the expected Series A valuation if the company achieved their objectives.

Similarly, in the event of a sale of company before a Series A financing, a sophisticated angel investor may request that they receive the better of (i) 2x their investment back (plus interest), or (ii) the return if they had invested their money at an $[X]M valuation.

In any event, I think that convertible debt financings are still easier to complete than a Series A financing, so a convertible note with a cap achieves the investor’s objective without the complexity of a Series A financing.

Under the California Finance Lenders Law (the “CFLL”), a person engaged “in the business of a finance lender or broker” within California generally must obtain a license from the California Department of Corporations.  The law provides a number of exemptions from this requirement, including exemptions available for small business investment companies and persons that limit their lending activities to no more than one loan in any 12-month period.

However, the licensing requirements of the CFLL are not triggered by a qualified bridge loan (“QBL”), which is defined as a “commercial bridge loan” made by a “venture capital company” to an “operating company.”  Thus, a venture capital fund that made only QBLs would not be required to obtain a license under the CFLL.  However, a fund that makes other types of loans should be subject to licensing requirements only if those loans cause the fund to be engaged in the business of a finance lender or broker.

In general, a “commercial bridge loan” is any loan that: 

1.         Has a principal amount of $5,000 or more;

2.         The proceeds of which are intended to be used by the borrower other than for personal, family or household purposes;

3.         Matures in one year or less;

4.         Is made in connection with, or in contemplation of, an equity investment in the borrower;

5.         Is secured, if at all, solely by the borrower’s business assets (but not by real property); and

6.         Is subject to the implied covenant of good faith and fair dealing arising under Section 1655 of the California Civil Code.

A venture capital fund generally will be a “venture capital company” if it: 

1.         Engages primarily in the business of promoting economic, business, or industrial development through “venture capital investments” or the provision of financial or management assistance to operating companies;

2.         At all times maintains at least 50 percent of its assets in venture capital investments or commitments to make venture capital investments;

3.         Maintains or, assuming consummation of the equity investment to which a commercial bridge loan relates, will maintain a material equity interest in the borrower;

4.         Approves each loan made to an operating company through the fund’s board of directors, executive committee, or similar policy body, based on a reasonable belief that the loan is appropriate for the operating company after reasonable inquiry concerning the operating company’s financing objectives and financial situation; and

5.         Complies, when making the loan, with all applicable federal and state securities laws.

A “venture capital investment” is “an acquisition of securities in an operating company that a person, an investment adviser of the person, or an affiliated person of either, has or obtains management rights to.”  The statute provides no definition of the term “management rights,” but the term is well defined in other places.  The first is the definition of “venture capital operating company” under the Employee Retirement Income Security Act of 1974 (“ERISA”).  The second is Rule 260.204.9 of the California Code of Regulations, which deals with the regulation of investment advisors.

In general, a borrower is an “operating company” if it: 

1.         Engages (directly or through subsidiaries) in the production or sale, or the research or development, of a product or service other than the management or investment of capital;

2.         Uses all of the bridge loan proceeds for the operations of its business; and

3.         Approves the bridge loan through its board of directors, executive committee, or similar policy board, based on a reasonable belief that the loan is appropriate for the borrower after reasonable inquiry concerning the borrower’s financing objectives and financial situation.

The advantages of a conversion discount versus warrant coverage depend on math and modeling.

In the example of 20% conversion discount versus 25% warrant coverage, the formulas below apply.

The value of investment with the 20% conversion discount = {[Investment amount] / [0.8 * Series A price]} * [exit value of Series A]

In other words, the above formula represents: how many shares of Series A do you get after the discount * the exit value of Series A per share.

The value of the investment with 25% warrant coverage = {[Investment amount / Series A price] * [0.25] * [exit value of Series A – Series A warrant exercise price]} + {[Investment amount / Series A price] * [exit value of Series A]}

In other words, the above formula represents: the exit value of the Series A warrant shares (taking into account the warrant exercise price) + the exit value of the Series A shares issued upon conversion of the note.

If Series A price (and Series A warrant exercise price) = $1.00, then the 20% conversion discount will always be slightly more valuable than 25% warrant coverage. (This is simple algebra to solve for the above equation.)

There is a reason why I think corporate attorneys need strong math skills. I hope someone will check the above math and concur or correct me.

In deals where investors don’t have counsel, the term sheet usually says that each party will bear its own legal fees and expenses. It wouldn’t be unusual for investors to not engage counsel in an early stage convertible note financing with friends and family. If one of the investors wants to have the documents reviewed by counsel, those fees typically are paid by the company, which is customary in any VC financing. The amount of fees to investor counsel can be as low as $2500 for a quick look at documents and no due diligence in a seed stage deal, to over $15K, depending on the amount of diligence and the complexity of the documents. Investor’s counsel may conduct UCC searches and extensive due diligence, especially if the note is secured. In complex deals, investor’s counsel fees may exceed $50K to $100K. Investor counsel fees payable by the company are typically capped, with the investors responsible for any excess over the cap.

Company counsel fees could be under $10K if there is no negotiation on terms and a single investor to over $30K if there is extensive due diligence and complexity. Company counsel fees on convertible loans may exceed $100K for later stage companies or extremely complicated deals. Company counsel fees are higher than investor’s counsel fees because company counsel drafts documents (on the West Coast) and needs to solve diligence issues. In addition, there is typically some deferred corporate housekeeping that needs to be done by company counsel before the financing.

In the event a company needs to amend or waive a provision in the notes, absent a provision that says that the note can be amended or waived with the consent of holders of a majority in interest of the notes, the company has to get every single investor to agree to the amendment or waiver. This ends up being difficult as a practical matter if certain investors are unavailable or refuse to sign an amendment or waiver. Typical situations where a company may want to amend or waive a provision of the note might include extension of the maturity date, changing the terms of the automatic conversion on a qualified equity financing, etc. Majority is measured by the principal amount of the notes. The majority trigger may be set higher to two-thirds or seventy-five percent depending on the situation.

Some investors are perfectly willing to purchase notes without receiving particularly extensive representations and warranties from the company. Other investors want the same level of detailed representations and warranties as a typical VC Series A financing. Generally, I think that if there is a bridge loan after a Series A financing, the investors should receive the same level of representations and warranties that the previous Series A investors received. This means that the company probably needs to prepare a detailed schedule of exceptions or disclosure schedule to disclose things required by the representations and warranties. Representations and warranties in seed stage bridge financings generally will be less extensive than in VC Series A financings, which probably reflects the fact that representations and warranties for an early stage company are not necessarily meaningful because there is very little to disclose. In addition, as a practical matter, the recourse for a breach of representations and warranties generally is a claim against the company for damages. Making a claim for damages against an early stage company without any money may be futile.

A security agreement creates a security interest in certain company assets. This allows the investor to take certain actions upon non-payment of the loan. The investor (or a collateral agent acting for the investors) may take possession of and sell the collateral and apply the proceeds to the repay the debt. If the proceeds of the sale exceed the amount of the debt, the company is entitled to the excess.

In order for the rights of the investor to become enforceable against third parties with respect to the collateral, the holder must “perfect” the security interest. Perfection is typically achieved by filing a document called a UCC financing statement with the secretary of state where the corporation is located. The investor will not be able to enforce its rights in the collateral against third parties, such as other creditors who claim a security interest in the same collateral or a trustee in bankruptcy, without “perfecting” the security interest.

Security interests are rare in seed stage convertible note bridge financings and not particularly common in bridge loans for venture backed companies, unless the loan is particularly risky, such as in connection with a bridge to a sale of company when the company is running out of money.