Is Convertible Equity, A Better Alternative To Convertible Debt?

Can Convertible Equity, be a startup-friendly seed-financing vehicle intended to replace Convertible Debt? I asked an entrepreneur why he chose to raise finance using convertible debt and not equity,

“That was a really tough decision, the benefit of raising a convertible debt is, there’s really flexibility in terms of deal structuring. It is easier when you go to your next round of funding to structure the deal and go through discussions one-time instead of doing that with two different set of people, once with the angels and again with the VC’s. Therefore, there is flexibility there in the structuring and there is also time to close in a very little legal back and forth, which is very stuck document, and it makes it really fast. This is the benefits.

The drawbacks and what would have been good about equity is, there is no shares to our investors that they will own a percentage in the company even though that is both our desire and their desire. So, it’s somewhat of a strange structuring because it really doesn’t give both people what they want out of the arrangement really enough and that’s why we chose convertible debt”

My next question was how you set investor expectation as you were going through the process.

“That was a tough one, we lose a lot of investors because they didn’t want to do convertible debt, they really wanted to do equity deal so we did lose some on the way”

Whether you are an entrepreneur or an angel investor, the topic of convertible debt vs. equity impacts you. For the most part, startups favor convertible debt and angels prefer equity, but which one is the right choice for your startup?

A convertible debt is a hybrid, part debt and part equity, where it functions as debt, until some point in the future, when it may convert to equity at some predefined terms. Convertible debt is typically secured from the same angel investors and venture capitalists that fund equity deals and is usually used for smaller rounds of financing at the early stages of a company’s life.

Here is a basic overview of how convertible debt work:

• An angel investor invests $200,000 in a startup as a convertible debt.
• The terms of the debt are a 20% discount and automatic conversion after a qualified financing of $1,000,000.
• When the next round of funding occurs at $2,000,000, the investor’s debt will automatically convert to equity.

In this scenario, let’s assume the shares were priced at $1.00. Since there is a 20% discount, the investor can use that $200,000 investment to purchase shares at the discount rate of $.80 each, instead of the $1.00 price that other participants in the current funding round will have to pay. That gives the initial investor 250,000 shares for the price of 200,000, which is a 25% return — not bad.

On the other hand, convertible equity is a form of financing that gives investors the right to preferred stock based on a specified triggering event.

While a convertible debt might be a little confusing to calculate, equity is a breeze. The startup is assigned a pre-money valuation and a share price is determined. When you invest, you know exactly what the terms are and how many shares you will own in that round.

Here’s how it works:

• The startup has a pre-money valuation of $1,000,000 with 1,000,000 shares outstanding. This puts the share price at $1 per share.
• An angel investor makes an investment of $200,000 and receives 200,000 shares.
• The post-money valuation is $1,200,000 and the new investor owns 16.6% of the company.

Convertible equity removes the fear of a debt default as a source of distraction for startup entrepreneurs struggling to gain traction. But of course there is no “one size fits all” funding option. Convertible equity simply does not have a long enough track record for anyone to be able to say with credibility how it will perform in the long run or what unforeseen issues might arise.

Ultimately, it comes down to setting milestones that are specific to and relevant for your business, then using them as guides to how much funding you need and when you’ll need it.