Convertible Debt: Worst Form Of Seed Financing — Except For All The Others

Antone Johnson , Founding Principal , Bottom Line Law Group

5 Sep 2012

How to finance a new seed-stage startup?  Equity?  Convertible debt?  Convertible equity?

As of August 2010, Paul Graham famously proclaimed, “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”  Yet in my little corner of Wonksville, Founder Institute CEO Adeo Ressi and Yoichiro “Yokum” Taku, a partner at my “alma mater” law firm Wilson Sonsini Goodrich & Rosati, created quite a stir this past week by announcing a new set of template deal documents dubbed “Convertible Equity.”  Ressi in particular seems to be passionate about removing the “debt” component from convertible debt seed financing transactions.  For a good summary with links to the documents, see Leena Rao’s post at TechCrunch.  The whole episode has reopened a broader discussion about the virtues and vices of each variety of seed financing, as exemplified by Mark Suster’s most recent post on the subject.

I won’t rehash all of the customary convertible note financing deal terms and points of negotiation here.  (For a comprehensive tutorial with sample term sheet, see my prior series here at Gust.)  To understand the form of “convertible security” proposed by FI and WSGR, start with a classic convertible note:  A loan made to the company that automatically converts upon the closing of a qualified financing event into the same class of securities issued to the investors in that priced equity round, but at a discount (say 20%) so the note holder gets more shares for his or her money.  Like any promissory note, it bears interest (usually at a nominal rate) and has a maturity date on which the loan must be repaid if it hasn’t been converted to stock (typically around 18 months).  There are other provisions covering various what-if scenarios, but those are the basics.

The new form of convertible security or “convertible equity” is essentially a convertible note containing most of the usual terms — except it’s been stripped of the features that would make it a loan.  It doesn’t bear interest or require repayment upon maturity.  (Technically, I would argue, it’s not a security either, but rather a contract entitling the holder to shares of stock whenever issued in the future.  In that sense it’s more like a warrant or option with a zero exercise price.)

How can this possibly make sense?  Turn the question on its head:  How could it make sense to lend money to a brand new, seed-stage company with no revenue, no products, and no collateral?  (You won’t see banks doing that.)  A convertible note financing is not a loan in the conventional sense.  Angel investors don’t expect to get repaid, nor do they really want to get repaid; the return on their investment, if the startup proves a success, will come in conversion to equity followed by an eventual liquidity event (sale or IPO of the company), with a return of at least 5x or 10x the initial investment if all goes well.

Structuring this kind of seed investment as a loan only makes sense because, as it turns out, a convertible note is a convenient “hack” to make it quicker, easier and cheaper to inject seed capital into an early stage startup while giving investors some protection (debt is ahead of equity in line in the event the company is liquidated).  Convertible debt is a venerable instrument, originally created to “bridge” a later-stage startup from one VC round to the next quickly and easily. (They are still occasionally referred to as “bridge notes.”)  Pressed into service for seed financing, it is, to some extent, a square peg fit into a round hole.

Nevertheless, if it ain’t broke, why fix it?  Convertible debt financing has its share of vocal critics, including Mark Suster, Seth Levine, Fred Wilson, and other highly respected commentators.  Yet startup lawyers and firms have cranked out thousands of convertible notes for startups over the past several years, particularly on the West Coast, without any signs of the apocalypse (yet).  Convertible equity strikes me largely as a solution in search of a problem.  Here is a quick rundown of the touted benefits:

• Convertible notes put a new company “in debt.”  This is inherently a bad thing.  Although that’s technically true, as described above, it’s misleading to view convertible notes as “debt” in the traditional sense.  (Interestingly, Ressi seems to contradict himself as he simultaneously argues that debt is a terrible thing looming over startups and founders, and that eliminating the debt component shouldn’t be a big deal to investors because they don’t expect the notes to be repaid anyway.)
• Convertible notes have a maturity date upon which the company can be forced into bankruptcy if it hasn’t closed a financing round.  Convertible equity eliminates that threat.  This is true in theory but extremely rare in practice.  Graham has flatly stated, “This has never once been a problem.”  The primary reason is that investors have every incentive to work with the startup to extent or renegotiate the terms of the notes, because that represents their best shot at seeing any return on their investment.  Unless the startup has been hoarding cash or investing it in hard assets in some unusual way, calling the notes won’t yield any proceeds to the investor.
• Convertible notes accrue interest from the date(s) they are issued.  This adds cost and administrative complexity, especially with multiple closings on different dates.  Convertible equity does away with interest altogether.  This is true, although interest is generally paid in stock upon conversion.  It’s typically simple interest, which is easy to calculate.
• Convertible notes appear as debt on the startup’s balance sheet.  For some purposes, such as dealing with banks, the appearance of a large amount of debt on the books could be a hinderance.  Also, certain tests apply under various laws that would deem a startup “insolvent” because of the debt it carries.  Among other things, that can create issues for directors and executive officers if the company goes under.  By contrast, convertible equity is only a contractual right to acquire stock in the future, like an option or warrant.
• Convertible equity may qualify for preferential tax treatment.  If successfully classified as equity for tax purposes, a “convertible security” issued early on could make for a longer holding period, thereby getting the best capital gains tax treatment, or ideally be classified as “qualified small business stock” excluded from federal tax altogether (if an exemption that expired in early 2012 is extended by Congress).

There are some other nuances, but those are the primary differences introduced with the concept of convertible equity.  Overall, in my view, it’s an evolutionary but not revolutionary change from convertible debt financing.  Advising investors, I would advocate for traditional convertible notes (with a valuation cap) over this new structure.  As Company counsel, I’d be open to switching to convertible equity, but frankly rank it lower on the list of priorities behind key terms such as conversion discount and valuation cap.  It’s also possible to make changes to a standard convertible note to achieve some of the same benefits.

We’ll continue the discussion in a future post looking more broadly at the question of doing a priced equity round vs. convertible debt (or its new cousin, convertible equity).  In the mean time, please feel free to post any questions in the comments.
This article is for general informational purposes only, not a substitute for professional legal advice. It does not result in the creation of an attorney-client relationship.

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