The Equity Series Part 2 – Convertible Debt and Preferred Equity

In this second part of the Equity series, we will discuss issues relating to investors’ (seed, angel, and VC) equity, in particular issues relating to preferred equity and convertible debt.

While later stages of financing (in particular angel rounds of high-six and seven figure amounts, and VC rounds) often involve a more straightforward sale of equity to the investors, usually simply selling stock (typically preferred stock) in the company, there are issues to be cognizant of. First, when raising seed funding (particular from friends and family), entrepreneurs should be mindful of the issue of having too many seed investors. While getting the funding the company needs should be the primary concern, founders should also realize that having too many seed investors can make angel investors and VCs uncomfortable, and may present a logistical nightmare if the intention is to cash those seed investors out in angel or VC rounds to free up equity for later investors.

Equity given to investors often comes in the form of preferred stock, which usually carries a different set of rights and obligations from the basic common stock of the company which can help to maintain a balance of governance between founders and investors, who will likely want a degree of control over the company to help secure their investment. For example, preferred stock holders may be given the exclusive right to elect a certain number of board members, or may have a class majority voting requirement (essentially, veto power) over major transactions to be approved by shareholders.

Founders should always be mindful of the rights of preferred stock often held by angel investor and venture capitalists. Preferred stock may have rights such as rights to dividends, increasing liquidation values as time goes on in the event of the acquisition or dissolution or other termination of the venture, or right to require redemption of the stock at a future date. If the company lacks the resources to satisfy these obligations it can trigger a significant crisis.

However, early-stage ventures reluctant to start handing out equity so soon into their young existence may instead opt for convertible debt to secure financing. It is difficult to come to a mutually agreed-upon valuation of a venture in business less than a year or two, so convertible debt postpones the issue until a solid valuation can be calculated. It should be noted that convertible debt is a security and therefore securities laws must be considered before a venture issues convertible debt.

Convertible debt can pay a coupon rate or yield and the face value of the note upon maturity like a regular corporate bond, but it is usually converted into preferred stock (because that is where the real money is made) at a predetermined value or formula for determining value upon the happening of a particular event, typically a Series A financing round.

Of course, convertible debt can run into an issue where the best laid plans of mice and men go awry. This can happen if, for instance, the company is acquired prior to the conversion triggering event, or if the note’s maturity date arrives before the triggering event. It is important to remember that while the end goal is equity, convertible debt is just that — debt — and must be treated as such unless and until the note is converted. For that reason, while it is tempting to simply pay off the loan in the event the startup is acquired or the note matures before the conversion event, that won’t please the note holders, who were expecting a bigger return than simple interest. However, there can be other options — while attempting to convert the note into preferred shares outside of a VC financing round may be impractical or undesired, the notes can nonetheless be converted into common stock if the note holder is willing to forego preferred shareholder rights, or the note holders can be paid a premium on top of or in addition to the value and interest of the note to essentially ‘make the deal worthwhile’ for them.