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Convertible Equity

Innovative. In the world of private equity and venture capital this term is usually reserved to describe the entrepreneur. These days however, its not just the entrepreneurs developing new ideas. The Founder Institute and law firm Wilson Sonsini have created a new “startup-friendly seed-financing” tool – convertible equity. [1]

Traditionally, convertible debt has been the chosen vehicle to fund startup businesses.[2] The pervasive use of convertible debt has uncovered its shortcomings. First, some states’ laws create unique liabilities for the directors of startups if creditors, who hold convertible debt, are not paid upon its maturity.[3] Also, accounting principles dictate that convertible debt must be recorded on the books as a liability.[4] This may result in some startups being technically deemed insolvent.[5] Also, debt on the books is a road-block if the startup seeks a line of credit from a supplier or to close a deal with a large corporation.[6]

The risk that investors may demand repayment is also now a greater concern than it was in the past. When the conversion period occurs, which may be in as little as a year after issuance, an investor has the right to call the debt. This may result in the startup filing for bankruptcy or putting the startup in a weak position to renegotiate financing terms.[7] Adeo Ressi, creator of the Founder Institute, notes that while this “isn’t traditionally a problem in tight-knit Silicon Valley circles, first-time investors may be more prone to go against tradition and enforce their legal rights.”[8] Further aggravating the situation is the fact that “the percentage of companies with convertible debt that successfully raise Series A funding is shrinking, due to an explosion in new angel financings and just moderate growth in venture funding.”[9]

How does convertible equity solve these problems? It solves, because convertible equity is basically “convertible debt without the debt.”[10] Investors still get a discount for purchased shares that are realized upon conversion.[11] However, startups do not carry the corresponding debt on their books.[12] An example of the documents used to draft a convertible equity agreement can be found at TechCrunch.

The Startup Company Lawyer blog outlines the four following advantages of using convertible equity as opposed to using convertible debt:

  1. Convertible debt may need to be repaid. The risk that an investor might demand repayment of a convertible note is eliminated with convertible equity.
  2. Convertible debt holders must be paid interest. Convertible debt must have interest at the applicable federal rate (AFR) published by the IRS or higher, or the IRS will deem that the lender should have received imputed interest at AFR. If convertible debt with a price cap is supposed to mimic the economics of equity, then removing interest seems logical. (Of course, one may argue that some preferred stock financings contain a feature called cumulative dividends that is similar to interest on debt, but I find the provision to be fairly unusual in typical West Coast venture financings.) In addition, when a financing occurs and the convertible debt converts, creating the spreadsheet to track interest on the notes to the penny, especially when notes have been issued on different days, ends up being a painful task — especially as the closing date of a financing may be delayed and the amount of interest increases, resulting in more shares being issued to note holders.
  3. Convertible equity is “equity” and probably can be characterized as qualified small business stock, which may have a tax benefit for investors.
  4. Convertible debt with a maturity date longer than one year creates problems for California-based investors due to licensing requirements under the California Finance Lenders Law. Making it equity removes this issue. [13]

However, convertible equity is not without its critics. Some concerns raised by skeptics are that investors may be reluctant to give up their position as a creditor of the company.[14] Investors would also lose a return on their investment in the form of paid principle and interest.[15] Will the loss of these benefits undermine convertible equity’s chance of being the financing vehicle of the future? Or will it go away as quickly as it came? Creators are optimistic believing “all it takes is one major player to adopt it.”[16] Deals made in the upcoming year should determine whether or not they are right.

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[1] Convertible Equity, a New Early-Stage Funding Concept, First Venture Legal (Oct. 2, 2012), http://www.firstventurelegal.com/convertible-equity-a-new-early-stage-funding-concept/.

[2] Id.

[3] What is Convertible Equity (or a Convertible Security)?, Startup Company Lawyer (Aug. 31, 2012) http://www.startupcompanylawyer.com/2012/08/31/what-is-convertible-equity-or-a-convertible-security/.

[4] Adeo Ressi Introduces ‘Convertible Equity’, Convertible Debt Without Debt, Forbes (Aug. 31, 2012) http://www.forbes.com/sites/jjcolao/2012/08/31/adeo-ressi-introduces-convertible-equity-convertible-debt-without-debt/ .

[5] Startup Company Lawyer, supra note 3.

[6] Forbes, supra note 4.

[7] Id.

[8] Id.

[9] Leena Rao, Convertible Equity, A Better Alternative To Convertible Debt?, Tech Crunch (Aug. 31, 2012) http://techcrunch.com/2012/08/31/thefunded-founder-institute-and-wilson-sonsini-debut-startup-friendly-seed-financing-vehicle-convertible-equity/ .

[10] Forbes, supra note 4.

[11] Id.

[12] Id.

[13] Startup Company Lawyer, supra note 3.

[14] First Venture Legal, supra note 1.

[15] Id.

[16] Startup Company Lawyer, supra note 3.

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Loretta Tracy

Vol. 3 Managing Editor

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