Using “Convertible Equity” instead of Convertible Debt

As I’ve discussed, an option for startups to raise money is to do a convertible debt financing.   In this sort of a transaction, the investor gives the company a loan evidenced by a convertible promissory note.  The note is convertible upon a later financing round into the same type of securities that the financing round’s investors receive, and the note holder gets a discount on the per share purchase price.   The benefits of this are that it is generally much quicker and straightforward than a typical seed/angel round and the company and investor do not have to have the awkward and difficult conversation regarding valuation of the company.  The detriment to this type of transaction is that the company’s balance sheet is saddled with debt, and if the company does not raise another round of investment before the term of the convertible promissory note comes due, then the investor can essentially bankrupt the company if the investor does not want to extend the due date.  Also, there are a good amount of investors that do not like investing through a convertible note, as one of the important terms – how much of the company the investor will own – is up in the air.

Recently, and the Founder Institute annouced the introduction of a new concept called “Convertible Equity”.  The concept and draft documents, were put together by Yokum Taku or Wilson Sonsini and a top accounting firm. TechCrunch has a good write up on it.

The form documents are available for free download here.

From a quick review of the documents it seems to be a great compromise.  There would be no more maturity date or interest due.  The startup will not have any debt on its books, and the investors would have the opportunity to qualify for the exclusion available on gains for holding “qualified small business stock”.  It will still leave open how much of the company the investor actually owns, however, but that can probably be resolved using a valuation cap or some similar mechanism that can be drafted into the convertible equity documents.

The documents appear to automatically convert into shares of the company stock upon a change in control or qualified investment.  There doesn’t appear to be an option for the investors to decide to convert at will or in any other circumstance, although certain provisions can be added for different situations.

This would be great if it gets adopted in the startup community, but like anything, it may take awhile.  I know I will be recommending it as an alternative to convertible debt.