Convertible debt is perhaps currently the most popular form of early stage financing for startups, to the tune of tens of billions of dollars in convertible debt currently held by tens of thousands of startups. However, the sheer size of convertible debt in the US startup ecosystem has led to criticism of convertible debt as a financing vehicle.
The criticism goes that the growth in convertible debt has outpaced the growth in Series A financing; as a result, not every startup that has taken on convertible debt will be able to achieve a Series A round and trigger an automatic conversion to Series A equity, at least not within the maturity date of the note, which will result in the startup having to pay the note and its interest or convince the note holder to extend the maturity date. Otherwise, the startup would have to default on its debt.
In response, the Founder Institute and law firm Wilson Sonsini have developed a new form of early-stage startup financing called convertible equity — it is intended to retain all the ease of convertible debt by being simple to draft and deferring the questions about valuation until the Series A round.
In convertible equity, at the expiration of the agreement (what would be the maturity date in a debt deal) or in the event of a sale of the company with no Series A financing having occurred, instead of being converted into Series A preferred shares the investment is converted into common stock at the valuation cap — essentially, the investment converts as if a Series A round had occurred at the valuation cap, but converts into common stock as opposed preferred stock.
I’ve heard of convertible debt deals where instead of principle and interest coming due on the maturity date or upon a sale of the company; however, here it appears that the investment is not debt, since no interest accrues, and can be considered equity rather than debt from the outset, since the investment will convert into equity no matter what happens. In addition, according to some analysts, convertible equity may be eligible for qualified small business stock exemptions.
The concerns I have with convertible equity is that investors may be reluctant to adopt it, since they don’t receive the added benefit of accrued interest. Additionally, they also lose the security of being a creditor of the company, or that they will at least receive a return on their investment in the form of being paid principle and interest in cash in the event that no Series A financing is received. However, convertible equity solves the issue of holding debt, and for investors that may be open to it it is an option that startups should consider.