As leader of the American Bar Association’s subcommittee on Angel Venture Capital, Fox Rothschild is undertaking an ongoing analysis of early stage convertible notes and current market terms. Over a series of blog installments, we will analyze the state of the market and present results of the subcommittee’s informal national survey of national trends in convertible note terms.
If you are an attorney, investor or entrepreneur actively involved in note offerings, please participate in the survey located at www.govote.at (code 27 94 49).
The increasing popularity of convertible debt deals in recent years has turned up the volume on a now raging debate: What is the preferred deal structure – convertible debt or priced equity rounds? It’s the angel equivalent of Beatles vs. Stones, in no small part because the answer is largely personal, and, for some, it isn’t an either/or choice at all.
First, the players:
Convertible debt is evidenced by short term notes, and is commonly used for financing rounds for early stage companies before or between priced equity rounds. The notes convert to equity when the startup completes its next funding round, typically within 12 to 24 months. A crucial distinction between convertible debt and priced equity rounds is that convertible debt allows the company to defer valuation until that next funding round. Convertible notes can include a variety of innovative terms, but all include an interest rate (often 4%-8% annually) and maturity date. Risk premiums are a key feature of convertible notes, so convertible notes may also include a valuation cap and a discount rate on the share price upon conversion.
Valuation caps protect early investors from dilution in the event that the company is able to leverage early investments into an outsized valuation in its next funding round. Without a valuation cap, early investors may be left with a piece of the pie that is too small to adequately reward the risk they incurred when they invested. Therefore, investors will negotiate a cap on the highest valuation at which the note will convert, regardless of the next round’s actual valuation.
Similarly, the discount rate compensates early investors for early investment risk. Discount rates are commonly 20%, but can range from 0% to 50% depending on the context. If equity is priced at $1 per share during the next round, a discount rate of 20% means that the note will convert at $0.80 per share. A $100,000 note will purchase 125,000 shares – a 25% premium.
Priced Equity Rounds
Priced equity rounds are the more common investment method. A key difference is, of course, that a priced equity round involves a valuation of the company. Investors commonly seek preferred stock, which may carry a 6% to 8% dividend and a liquidation preference at 1x their investment before the common shareholders participate in the proceeds of a sale of the company. The risk incurred by preferred investors is mitigated by anti-dilution protections and protective provisions, including the right for preferred shareholders to veto certain major actions (e.g., change of control, amendment to governance documents that adversely affect the preferred investors’ securities). Preferred investors may also have representation on a company’s board of directors or managers.
Which is Better?
The pros and cons of convertible debt vs. priced equity rounds is currently the subject of an intense debate. A recent survey of Angel Capital Association members published in Forbes (which was not a statistical sample) found the following:
- 82% of ACA members preferred priced rounds for initial investments; however
- 78% had participated in at least one convertible note in the prior 18 months; and
- 25% used convertible notes for over half of their first investment deals.
Those in favor of convertible debt may be drawn by a number of advantages. Structuring a convertible debt deal is significantly less expensive than a priced equity round. The discount rate and valuation cap can be valuable rewards for early investment. There are fewer convertible note terms to negotiate, and they are highly flexible and subject to frequent innovation, which helps investors and entrepreneurs align their interests and negotiate contingencies for the many scenarios possible in the uncertain early stage period.
However, investors have reasons to be wary of convertible debt. While priced equity rounds establish a company’s valuation, convertible debt includes inherent uncertainty. Furthermore, equity investors negotiate and determine the company’s valuation prior to investing; convertible debt holders without proper valuation cap protection are exposed to an oversized valuation in the next funding round. Priced equity rounds also include standard incentive-aligning mechanisms such as protective provisions and board representation that are not typically included with convertible debt rounds. Also, convertible debt holders may miss out on tax benefits that are commonplace for equity investors, and in fact, may incur unintended tax consequences on conversion to equity.
Additionally, as the survey above noted, some investors believe there is a time and place for bubblegum Beatles and surly Stones. The choice between convertible notes and priced equity rounds is not a zero-sum game; rather it is a choice of the investment approach that best suits the deal, investor and entrepreneur. Ultimately, whether and under what terms investors and entrepreneurs Come Together is a weighing of pros and cons; after all, no investment is perfect because (say it with me) You Can’t Always Get What You Want.