August 3, 2020

Volume X, Number 216

August 03, 2020

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Convertible Equity: The Founder’s Alternative to Convertible Debt

Convertible debt (a loan that converts into equity upon the closing of a round of financing or other conversion event) has long been the preferred investment vehicle of early-stage investors, particularly angel investors, as a relatively easy and cheap form of investment. A typical convertible debt round, with simple and standard terms, can be closed in a number of days and cost the company as little as a few thousand dollars in legal fees.

The downside, of course, is that convertible debt is nevertheless still debt, with all of the problems of debt, including, most importantly, the looming maturity date, which is typically 12-18 months from the date of issuance. If the convertible note matures prior to a round of financing or other conversion event, the investor has the right to demand repayment and, assuming the company is unable to do so, the other rights of a creditor, including the right to force the company into bankruptcy.

One response to these concerns was the development of convertible notes which provided for the conversion of the debt upon maturity, at an agreed upon valuation, in the absence of a financing or other conversion event. A few years ago, and the Founder Institute introduced a "convertible equity" form of agreement meant to replace traditional convertible debt notes with a standard agreement for conversion upon maturity.

Today, some startup accelerator programs have adopted their own forms of "convertible equity" or "convertible security" agreements, in each case providing a means of investment without the downside of traditional convertible debt – namely, the "debt" part. In some cases, these agreements excise the idea of a maturity date entirely, instead providing for conversion upon certain specified events (e.g. financing, liquidation, or dissolution) or, if no conversion takes place, termination of the agreement entirely.

The evolution of convertible debt to convertible equity is an unqualified good for entrepreneurs. For the time being, however, adoption of convertible equity investing seems limited to a handful of startup accelerator programs, which have an interest in structuring founder-friendly deals, and have not been widely adopted by the investment angel community. In time, that too may likely evolve. 

© 2020 Varnum LLPNational Law Review, Volume V, Number 266


About this Author

Matthew Bower, Corporate formation attorney, Varnum

Matt is a partner on the Business and Corporate Services Practice Team, and participates in both the Startup and Emerging Companies and Intellectual Property Practice Teams. His practice focuses on corporate formation and organization, venture financings, joint ventures, mergers and acquisitions, corporate governance, securities law, and intellectual property protection and transactions. He works closely with startups, second stage and private companies on day-to-day issues and all manner of corporate and intellectual property transactions.

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