Convertible Equity–An Idea Whose Time Has Come
In my last company, Advanced Diamond Technologies, there was a time between equity financing rounds when we needed bridge financing. This is very common among young companies. I don’t recall now the circumstances under which we needed to raise money quickly, but it has always been the accepted wisdom that if you need to raise money quickly, use a Convertible Note.
A Convertible Note is a loan to the company made by investors. In our case we tapped existing investors. To avoid the transaction costs of an equity financing, and to avoid the need to negotiate a valuation on the company with the equity investors, a Convertible Note essentially says the following:
- We (the investors) will loan you the money
- You will pay us back when you do your next equity financing
- At that time, when the valuation of the company is determined by new investors, we will convert what you owe us (plus interest) into shares of the company at the negotiated price less a discount (to account for the fact that we’re investing now, not then).
- And if you don’t raise new money during a specific time frame [this is highly situational and could be anywhere from 90 days to two years], we get our money back plus interest. In other words, we can demand repayment and foreclose on your or take over your company if you aren’t able to repay. At the very least, we will extract a huge pound of flesh when converting the debt you owe us into shares of your company.
This worst case scenario rarely happens, but it could. Live long enough and you will hear stories of companies that got screwed by unscrupulous investors over this kind of structure. What’s more, I have never seen any company who issues a Convertible Note properly account for it on its balance sheet (it is a liability). It goes without saying that if you have to borrow money to stay alive, then you are insolvent. And if you are insolvent, you will probably have other problems (with your landlord, licensor, trading partners, etc.). But no one accounts for it as debt because no one thinks of it as debt.
On top of that, if you are eligible for an SBIR supplement from the National Science Foundation, Convertible Notes are prohibited from qualifying as matching investments (because there is a chance the investors will ask for their money back).
Some creative people like Adeo Ressi at the Founder Institute and Yoichiro (Tokum) Taku at Wilson Sonsini Goodrich & Rosati [please let me know if I’ve failed to acknowledge anyone else and I will correct it] got together to solve this problem. They created a new kind of security called a Convertible Equity Security. It has many of the same constructs as a Convertible Note, but without the debt part. A Convertible Equity Security essentially says:
- We (the investors) will buy equity in your company and we will pay you now
- But we don’t know how many shares we are actually buying. That will be determined when you do a future round of financing and the valuation will be determined then. We will get a discount to that price to account for the fact that we are investing earlier.
- If you never raise more money, by the time the Security matures, we will convert our equity at a pre-determined valuation (probably fairly low). If your valuation skyrockets or you get acquired without raising more money, there will be a cap on the valuation we will pay.
- No matter what, we can’t foreclose on you. The only uncertainty is the percentage of the company we get for our money. In return, you get money now and a very simple transaction structure.
Since this is unambiguously an equity purchase, the new dollars sit on your balance sheet as equity which avoids a whole host of other liquidity problems. This structure really doesn’t deprive the investors of the outcome they hoped for with a Convertible Note since no one except unscrupulous investors hopes that the company will be unable to repay.
At GlucoSentient, last week we used the Convertible Equity Security and closed a small round with two Midwest-based venture firms, Illinois Ventures and Serra Ventures. We did this in part to qualify for a Phase IB supplement from NSF for our Phase I SBIR. While NSF hasn’t issued us the grant yet, this vehicle should meet their statutory requirements (because it unambiguously is not debt and the investors cannot claw back their investment).
I was on a panel last week in Skokie, Illinois sponsored by the Midwest Research University Network. After I mentioned the Convertible Equity Security the place was abuzz with questions about this structure. I believe from the immediate response I received from investors, attorneys, entrepreneurs and tech transfer folks alike that this financial instrument is going to take off like wildfire. Since no one else was aware of any other companies in the Midwest having used a Convertible Equity Security, we decreed that we were the first. I’d like to acknowledge our investors for their willingness to be pioneers with us.
I’ve posted the documents we used to the little Box widget on the right hand side of the home page of this blog (http://beliefwithoutevidence.com/). Please comment and let me know what your experience is like.
- What is convertible equity (or a convertible security)? (startupcompanylawyer.com)
- The Truth About Convertible Debt at Startups and The Hidden Terms You Didn’t Understand (bothsidesofthetable.com)
- TheFunded, Founder Institute And Wilson Sonsini Debut Startup-Friendly Seed-Financing Vehicle, Convertible Equity (techcrunch.com)
- Investors Weigh In With Convertible Note Caveats for Start-Ups (blogs.wsj.com)
Great post. I always get confused about the different types of funding vehicles for early stage companies and I appreciate they way you can simplify everything. Keep up the good work.
Like it; I’m structuring a raise at the moment and outstanding convertible debt is scary for the investors as it leaves an operational cash flow hit / foreclosure risk on the cards if there isn’t a Series A before the note matures. This alternative makes a lot of sense – IF you’ve who’s prepared to swap debt’s downside protection for some sort of discounted equity participation.
[…] written before about the merits of convertible equity for the startup. Recently, I heard about companies that took convertible notes as bridge loans, so […]