For some time now, convertible debt has been the poison of choice for seed financings by angel investors. Basically, these deals involve the investor providing capital in exchange for a note that automatically converts into equity at a future financing round, usually either at a discount to the price of the round, or with the addition of a warrant “kicker” for the investor. The principal advantages of convertible debt in the seed financing context are (i) the ability to punt on valuation, thus avoiding a likely contentious and sometimes even deal killing negotiation, and (ii) it is, compared to a more traditional equity transaction, much simpler and cheaper to paper. (Click here for a more detailed review of convertible debt in the seed financing context).
While the convertible debt structure is well-established, and has generally served angels and entrepreneurs alike pretty well, it does have its problematic aspects. First, as much as both parties may think of a convertible note as in substance equity, it is in fact a debt instrument. It has to be carried on the startups books as debt, which in many cases might render the startup technically insolvent. In addition, convertible notes almost always include a drop dead date, typically 12-18 months out, after which the holder of the note can demand payment. If the entrepreneur is not in a position to make the payment they give the note holder enormous leverage. There is also the matter of interest rates and payments, which adds a wrinkle to the accounting and the valuation issues. Finally, for those angels who lie awake at night worried about legal issues, in most states these transaction require that the angel be a licensed lender (I am not aware of a lot of enforcement activity in this area).
Recently, Adam Ressi of TheFunded.com and the Founder Institute teamed up with the folks at Wilson, Sonsini to devise a more entrepreneur-friendly alternative to convertible debt – convertible equity. Essentially, convertible equity is functionally equivalent to, and shares the advantages of, convertible debt, except there is no debt (and thus no liability on the balance sheet; no repayment obligation and no default-related control issues; no interest rate negotiations or accruals; and no need for the angel to be a licensed lender). What’s not to like?
Now I confess, there is a part of me that is thinking “if it isn’t broke, it doesn’t need fixing” and that the convertible debt seed financing vehicle doesn’t strike me as particularly broken. On the other hand, at least from the entrepreneur’s perspective, convertible equity looks like a modestly better deal – albeit at some expense to the investor. It is too early to say if convertible equity will ultimately emerge as a winning alternative to convertible debt. Stay tuned….© MICHAEL BEST & FRIEDRICH LLP