Convertible Equity – tipping the balance further in favor of founders

Matt Bartus —  September 5, 2012 — 7 Comments

Recently Yokum Taku of WSGR announced, together with and Founder Institute, a new set of standard forms for an investment security called “Convertible Equity.”  The open sourced standard form documents can be found here:  term sheet, purchase agreement and convertible security. The release received a fair amount of attention in Techcrunch, among other publications, and in my Twitter feed.

First, kudos to Yokum, TheFunded and Founder Institute for attempting to further the causes of document standardization, lowering friction in fundraising and achieving greater balance between the forms of investment known as convertible debt and equity.  This is something that all of us in the startup ecosystem strive for, even, ahem, the lawyers.

Since then, many of us in the startup community have been asked by clients and others about this form of investment structure, and I thought I would make my thoughts known publicly.

Many of the questions I have received center around “how does this differ from convertible debt and why is it better?”  As I review the terms of the convertible equity, they are remarkably similar to convertible debt. The stated benefits of convertible equity over convertible debt seem to focus around the following primary issues:

  • No accruing interest
  • No maturity date for repayment of debt

Starting with the interest accrual, this is certainly a feature that, if removed, is more beneficial to founders because interest equals dilution (unless repaid in cash). Accrued interest at the time of conversion effectively increases the conversion discount on convertible debt (in other words, a 20% discount rate with a 5% interest rate will have, roughly, a 25% discount after one year). It also compensates investors for risk. On the flip side, market interest rates are currently very low, and startups that are issuing capped convertible notes are generally negotiating the lowest possible interest rate (use the minimum rate AFR rate if possible, which hovers around 1%) because the investor can be compensated for risk by using an appropriate valuation cap and conversion discount. So, while it’s certainly more founder-favorable to remove, this is a small “problem” at most.

The bigger problem that convertible equity purports to solve is the “maturity date” problem, where it is posited that startups face a day of reckoning when their debt comes due if they have not raised a round of financing by the maturity date (which is often 12-24 months from the inception of the debt). Again, it’s decidedly more founder-friendly to not have to negotiate with your investors at maturity about whether repayment is due. Additionally, if the intention is for the “debt” never to be repaid (as would be the case with equity), founders could solve the same problem by requesting note maturity far past any possible success horizon (say, 3 years).

However, in my experience, the “maturity date” problem is rarely an issue in practice. First, most seed-round companies that have raised debt face a binary outcome: they either raise additional funding (and thus the debt is converted) or they fail to raise funding and shut down. In the unusual middle case where a company doesn’t raise funding but is still bouncing along when the debt comes due, I have rarely seen investors demand repayment and put a company into default. In most cases the repayment date is extended by the investors or some other mutually agreeable outcome is achieved. (As a side note, there is an argument that repayment at maturity is actually founder-favorable, rather than a negative, because if the company succeeds without having to raise money, the debt can be repaid in cash without diluting the founders. Unfortunately this is best judged in hindsight.)

In fact, it is a fairly common term of convertible debt that the debt can be converted (either optionally or mandatorily) at maturity into equity of the company at a pre-defined valuation, and indeed this term is included in the convertible equity as well (as an option). If a mandatory conversion into equity (either common stock or a new series of preferred stock) is included in a company’s convertible debt documents, there is no “forced repayment” issue any longer. Companies that include a “conversion at maturity” feature typically consider using a pre-defined valuation that is at or below the valuation cap to be used to determine the conversion price in connection with a financing.

Another founder-friendly feature that was not expressly discussed (and is possibly an oversight) is the removal of the concept of a liquidation preference. To recap, a liquidation preference is a basic (and accepted) protection of investors that provides that, if the company is liquidated, the investor gets its money out first (which is the case in preferred stock, in the form of a liquidation preference, or in debt, by virtue of the fact that debt is a senior security and is repaid before equity). For example, assume the company raises $500K of convertible equity and after spending $250K decides (for whatever reason) to shut down and liquidate. In a company that had raised typical preferred stock or convertible debt, the remaining $250K in cash would be returned to investors. With the current iteration of convertible equity, that money would go to the common stock holders (the founders). I think this oversight will need to be corrected for investors to embrace this structure.

Most of the discussion around convertible equity seems to be focused on business terms, but there are situations where convertible equity may be preferable to convertible debt for tax reasons. For example:

  • When there are original issue discount (OID) issues (which can result in phantom income for lenders);
  • When there may be cancellation of debt issues for the issuer if the debt ends up being forgiven; or
  • To avoid withholding tax issues where the lenders are foreign (or limited partners in a fund that is foreign).

However, convertible debt may at times qualify as equity rather than debt for tax purposes if the terms of the convertible debt instrument and other circumstances indicate that the investment has more equity characteristics than debt characteristics under the applicable tax law test. In these cases, if the parties include language in the legal documents agreeing to treat the investment as equity for tax purposes rather than debt, these tax arguments for preferring convertible equity to convertible debt may not apply.

In summary, convertible equity seems to be an instrument that attempts to tip the scales in the founders’ favor.  It remains to be seen whether convertible equity is widely accepted by investors, and whether the changes in terms are sufficiently meaningful to warrant a re-inventing of the convertible debt wheel.

  • Andrew

    Maturity date issues are non-issues, as Matt points out. Most (all) convertible debt at the seed stage is unsecured, and the lenders rarely (never) force repayment if a subsequent financing event does not occur. The convertible debt structure is one of convenience and not substance. I do not see the need for yet another seed stage investment structure, especially when convertible debt (and not a traditional round of financing, even if abbreviated) has proven to create more issues than it solves. Convertible equity is no different IMHO. Companies should spend more time focused on where the money comes from – is it value add money or cats and dogs money – and less on flavor of the month structures that don’t really mean anything in the grand scheme of things. If presented with a convertible equity structure from someone who can’t help you at all and a traditional financing structure with market terms from someone that can help your business, suggest you take the latter (twice on Sundays).

  • William Carleton

    Matt, thanks for calling out the (de facto) liquidation preference issue. Even if the convertible security gives the holder the option to convert into common stock prior to any liquidation, the investor is then sharing pro rata with the founders, which won’t seem fair to the extent that cash being distributed came from the investor.

    • Matt Bartus

      Yes, I agree. As currently written, if the convertible equity is treated like a warrant as Yokum suggested, the investor would get nothing, which cannot be the result. Even if they got part of the proceeds as you mentioned, that still seems inconsistent with the normal way of doing things.

  • joewallin

    Really good article Matt. The question I have is this–if you don’t specify an optional or default conversion, and there is no fund raise and thus no mandatory conversion–it strikes me that the investor is in limbo land. They don’t own debt–which has a firmly defined set of characteristics in the legal firmament. Instead, they have some equity–but is unclear how much–since no default conversion is specified (sure, there is a cap, but that is not the default conversion). It is not a warrant–so it can’t be exercised. Instead, the instrument just continues to float…It seems to me that this is clearly worse for investors…and I am not sure it really avoids a lot of the issues that prompted its creation in the first place. Sure, the companies won’t have to face the threat of a legal action to enforce the debt. That is good. But the company will still have to sit down with the investor and figure out where the investor fits on the cap table. Would appreciate your thoughts.

    • Matt Bartus

      Joe, all good points, and as I pointed out, I do think this is clearly more favorable to founders (and removes some important protections for investors). I suppose this would just be treated as a contribution to the capital of the company with no attendant rights, and the company would need to work with the investor to figure out what they had. So it does leave the investor somewhat in limbo under certain circumstances.

      • joewallin

        Matt, I haven’t done the research…but under corporate law, if the rights of the investor are not defined…perhaps it would be treated similar to debt (on top of equity) in any event? It would be a great research project for someone….Anyway, thanks for the great post.

  • Kendall Thiessen

    Great overview. I have had several clients ask about this “new structure” and have been more than a little surprised at the coverage for what seems to be just a removal of options for the investor to get back their $$. Overall, I think it is very founder friendly doc but is effectively just the same old convertible note minus a repayment option. I am not clear why any sophisticated investor would use it unless they were part of the friends and family round. Seems like more hype than reality but perhaps I am just being cynical.