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Convertible Equity

Convertible equity is an entrepreneur-friendly investment vehicle that attempts to bring to the entrepreneur the advantages of convertible debt without the downsides for the entrepreneur, specifically interest and maturity dates. The convertible equity instrument the investor is buying will convert to actual equity (stock ownership) at the subsequent financing round, with some potential rewards for the investor for investing early. Those rewards are similar to the rewards for convertible debt, such as a valuation cap and/or a discount.

The amount of the equity the investor is entitled to receive is determined in the same way as a convertible note. The investor usually (but not always) converts at a discount to the next round’s price or at the valuation cap if that would result in a better price. As with convertible notes, the company avoids pricing its equity, which can be helpful when hiring employees.

Convertible equity is expressly defined as not being debt, so it does not bear interest. Nor does it have a maturity date.

Convertible equity is similar to convertible debt in that the documentation is simple—and therefore much cheaper—compared to a priced round, and so it is appropriate for earlier, smaller investment rounds, which can be anywhere from $50K to several hundred thousand dollars in size.

founder Convertible equity is an attempt to address the problems with convertible debt from the company’s perspective. Convertible notes bear interest, which is often small in amount but creates additional complexity; and convertible notes come due (that is, they have a maturity date). Companies would rather not have to confront interest rates and maturity dates if such issues could be avoided.

Convertible equity is a relatively new investment instrument in the angel investment world. You can access several different types of convertible equity term sheets on the web, including Y Combinator’s SAFE ( Simple Agreement for Future Equity), and 500 Startups’ KISS (Keep It Simple Security). The Founder Institute has also published a form of convertible equity instrument.*

Entrepreneur Perspective on Convertible Equity

founderThe convertible equity deal structure is intended to give the startup the benefits of the simplicity and low legal costs of the convertible note format, without the downsides of debt.

For one thing, having large amounts of debt on the balance sheet can be a turnoff for suppliers and potential partners the company may seek as they grow; convertible equity helps companies avoid this red flag.

Additionally, the maturity date attached to convertible debt can cause stress and distraction for a startup because it puts a deadline on when the company has to raise a qualified financing. There are a host of other provisions that may kick in if there is no qualified financing before the note matures; and at a minimum the company will have to do the legal work to extend the note.

This ticking clock problem is exacerbated if the company has issued a series of convertible notes over the course of months, each with a different maturity date. Calculating the conversion of the accumulated interest into stock at the time of financing can also be complicated, and the interest itself is dilutive to the founders, so there are benefits to eliminating the interest associated with convertible notes. (Like convertible debt, convertible equity can still contain a discount and valuation cap.)

Investor Perspective on Convertible Equity

The convertible equity financing structure is currently being promoted by several incubators and accelerators, including Y Combinator—if you want to invest in one of those companies, you will likely have to accept a convertible equity deal structure.

From an investor’s point of view, you might prefer convertible debt rather than convertible equity, because:

  • Convertible debt sits on top of equity; if the business fails, debt gets paid first.

  • Convertible debt is debt; it exists within a known and well understood legal category. Convertible equity is nebulous, where investors must accept equity of an unknown amount.

  • Convertible debt can bear interest, yielding a bigger payday for investors.

  • Convertible debt has a maturity date, meaning investors know when the loan is expected to be paid back.

  • If the company doesn’t achieve a qualified financing, you can probably demand a loan’s repayment and not be forced to accept stock in the company.

important Convertible equity is entrepreneur-friendly, but with discounts and valuation caps, you can still be rewarded for your early participation. As an angel investor who comes in early when there is significantly more risk, you have the right to demand a benefit relative to investors who come in later when the company has made more progress. Those benefits are the discount on the price per share relative to later investors, and the valuation cap. You should negotiate hard for those, because if the company’s value increased dramatically from the time you invested to the time they raise a priced round, you deserve to benefit from that increase because you took the early risk.

Terms of Convertible Equity

Convertible equity deals do not have interest or maturity dates, but may contain any of the following terms described in the section on convertible debt:

  • mandatory conversion

  • optional conversion

  • change of control provision

  • conversion discount

  • valuation cap

  • amendment provision

The following topics discussed in Advanced Topics on Convertible Debt may also apply to convertible equity deals:

  • liquidation preference overhang

  • calculating the number of shares to be issued at the cap

  • most favored nations clause

  • pro rata rights

Common Stock

As an angel investor, from time to time you might be asked to invest in common stock.

Common stock is stock that entitles the holder to receive whatever remains of the assets of a company after payment of all debt and all preferred stock priority liquidation preferences. Common stock does not usually have any of the special rights, preferences, and privileges of preferred stock (although it is possible to create a class of common that does, such as a class of common stock that has multiple votes per share, or is non-voting, or that has protective provisions).

When a corporation is initially organized, typically only common stock is issued to the founders and set aside for issuance under the company’s stock option or equity incentive plan for service providers. (However, sometimes founders will issue themselves a special class of common stock with 10 or 100 votes per share and protective provisions.)

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