Is Convertible Equity Better Than Convertible Note and Preferred Stock?

Convertible equity has gained popularity in Silicon Valley after Y Combinator made its Simple Agreement for Future Equity (or "SAFE") available for free and used it for all of its startups. Since then, 500 Startups followed suit with its affectionately-named KISS document. The intent in creating the convertible equity was to provide a better tool--compared to the convertible note and preferred stock--to handle early-stage investments by angel investors.

The Problem with Convertible Notes

A convertible note is a loan given by an investor that converts into stock (usually preferred stock) upon a future financing (such as Series A) on the same terms that the venture capitalists get in the future financing, usually with a discount. As a starting point, the convertible note has significant advantages for both the investor and the company.

For the investor, it provides an opportunity to share in the upside of the company if the company is successful in raising professional investment. It does so by providing the investor preferred shares of the company's stock upon a financing. The shares can then be converted into cash upon an exit event--either an acquisition by a larger entity or an Initial Public Offering (or "IPO"). At the same time, the convertible note provides the angel investor with protection in the event that the company fails to raise any funds before it is acquired or before it fails. This is because the investor can call the loan by demanding repayment of the loan at the maturity date.

For the company, the convertible note allows for quick access to capital without having to negotiate financing terms such as percentage, price, and preferences over common stock holders (such as liquidation preference, anti-dilution provision, etc.). As a result, the company can focus on developing and improving its product without spending too much time and resources on efforts that could distract the company from that goal. Additionally, it allows the company to raise significant funds without having to value the company at the time of investment.

But convertible note's biggest downfall is the fact that it is a debt instrument. In any loan, the lender has the option to demand full repayment of the amount due (principal plus interest) upon its maturity date, regardless of the company's ability to pay. If the company does not have the ability to repay the loan, it can be forced into bankruptcy. While it is uncommon--and counter-productive--for an investor to force a company in which she is invested into bankruptcy, it is a possibility. But more important, the ability to demand payment is a great bargaining chip that puts control and power in the hands of the investor in a way that the company may not understand when it receives a check for hundreds of thousands of dollars. Having too much debt on its books can also cause other problems for the company.

Because its treatment as debt allows an investor to demand repayment upon maturity, the convertible note is more of an investor-friendly instrument.

There is also another small disadvantage of the convertible note: if the maturity date is more than one year from the date of the loan, California's Finance Lenders Law may require that the lender (i.e. the angel investor) obtain licensing.

These disadvantages were the driving force behind the creation of the convertible equity.

Convertible Equity

Convertible equity operates almost exactly as a convertible note, but with one important exception: it eliminates the debt aspect of the convertible note.

As with a convertible note, convertible equity allows an angel investor to infuse cash into a company without negotiating deal terms such as percentage, valuation, etc. And as is the case with a convertible note, convertible equity rewards the early-stage investor with stock upon a future financing (such as Series A) on the same terms that the venture capitalists get in the future financing, usually with a discount.

Because investors who receive convertible securities, whether notes or equity, are considered investors in the VC financing stage, convertible security is not a suitable instrument for friends and family that are not "accredited investors" under the securities laws. See our earlier article for more information.

However, unlike a convertible note, the company is under no obligation to repay the amount of the convertible equity investment because convertible equity is not a loan.

For this reason, convertible equity is a company-friendly instrument. Given Y Combinator's pledge to be on the side of the startup, it makes sense that it would support the expanded use of convertible equity.

Back to Preferred Stock Priced Rounds?

Initially, the convertible note was used as a bridge loan when a startup needed emergency cash in between VC rounds to get it to the next round. More recently, it became a tool of choice for early-stage investments to avoid the premature valuation of the startup and the transaction costs of priced rounds (i.e. Series A, B, C, etc.). These transaction costs include the legal costs with drafting, negotiating, and finalizing all the legal documents necessary in a priced round, which could run in the tens of thousands of dollars. The thinking was that, by using convertible notes, companies and investors would bear significantly reduced legal costs, and punt on all the expensive legal costs until a large VC round, when those costs would be unavoidable.

Most recently, the legal community has gotten creative by revisiting the past. In response to dissatisfaction from startups about convertible notes, and dissatisfaction from investors about convertible equity, a new set of preferred stock legal documents have emerged. The popular Series Seed documents and Y Combinator's Series AA documents are efforts to streamline and trim down the traditional VC legal documents to reduce the cost of completing a priced round, where the investor gives the startup cash in exchange for a set percentage of the company and specific preferences over founders and other common stock holders.

While these documents have contributed to streamlining the process and reducing legal fees, they do not address one of the biggest reasons for moving to convertible securities in the first place: premature valuation of a company's stock, especially before it has had enough time to fully demonstrate proof of concept, gets in the way of investment. It can also affect the company's ability to give cheap stock options to its early hires without significant tax consequences. If a company uses one of these documents, it is extremely important for it to understand what rights it is giving up, especially anti-dilution protections that may affect the company's ability to raise future funds.

While convertible notes, convertible equity, and streamlined preferred stock documents have trimmed the legal paperwork related to early-stage investments, they have not affected the importance of working with counsel to make sure that the company is protected.

Contact us to discuss if convertible securities are right for your startup.

DISCLAIMER: The information in this article is provided for informational purposes only and should not be construed or relied upon as legal advice. This article may constitute attorney advertising under applicable state laws.