SUB CATEGORIES OF Funding Your Startup

Convertible Debt (also called Convertible Notes) is a loan by an investor to a startup with a maturity of nine months to two years. Convertible Debt accrues interest and must be repaid at some time in the future or converted into equity securities of the startup. Convertible Debt is more often either never repaid, in the case of a failed startup, or converted into equity securities, in the case of all other startups. Convertible Debt likely will only be repaid if the startup is sold before its next financing.

Convertible Debt is the most common form of seed financing for startups by a large margin. The other option for seed financings is priced equity, referred to as Series AA or Series Seed. Convertible Debt is the simplest form of seed financing documents and the cheapest to implement. Convertible Debt is also much faster between starting and closing than priced equity. Convertible Debt can be closed the day documents are started in some circumstances and almost always within a few weeks.

There are many advantage of Convertible Debt vs. priced equity, such as Series AA or Series Seed. One of the bigger ones is that the valuation negotiation is delayed until Series A. For early stage startups, valuation negotiations are difficult because the startups rarely have significant traction, which means there are no tangible metrics in which to base valuations. With Series AA and Series Seed, the startup must negotiate its valuation with investors.

Convertible Debt is most often used for seed financings that raise less than $1 million, what we call true angel rounds. If more than $1 million will be raised in a seed financing, priced equity agreements are probably more common because investors expect voting and other rights in connection with their investment.

Typical Terms of Convertible Debt

Discount

  • The discount is the percentage discount from the price of securities (usually Series A Preferred Stock) issued the next equity financing. The principal and interest on Convertible Debt converts into the securities issued in such next equity financing at the discounted price. The most common discount is 20%, but the discounts range from 10% to 25%.

Conversion price cap

  • The cap is the highest valuation in respect of which the Convertible Debt will convert. This means if the next financing valuation (reduced by the discount) is higher than the conversion price cap, the Convertible Debt will convert into the securities issued in the next equity financing at the conversion price cap. Convertible Debt terms usually allow holders to convert into Common Stock at any time at the same conversion price cap.

Automatic conversion triggering event

  • The triggering event that cause the principal and interest under the Convertible Debt to convert into securities issued in the next equity financing. The triggering event is usually the definition of the next equity financing, and is often based on the amount of capital raised in the next equity financing. Our rule of thumb is the amount raised in the next equity financing must be two to three times the principal amount raised under the Convertible Debt to cause an automatic conversion of the Convertible Debt into the securities issued in the next equity financing.

Convertible Debt vs. Series AA/Series Seed

  • Most startups at the angel and seed stage must choose between priced equity documents, such as Series Seed, and Convertible Debt documents. Here are some thoughts about the choice.
  • Convertible Debt financings are cheaper on average than Series Seed financings.
  • Convertible Debt financings are faster to close on average than Series Seed financings.
  • There is no valuation negotiation with Convertible Debt, other than the conversion price cap. Valuation negotiations are difficult for early stage investments.
  • Convertible Debt does not provide investors any voting rights until they convert their Convertible Debt into capital stock.
  • Convertible Debt documents are more flexible in allowing investors to subscribe over time in multiple closings, which is how capital is typically raised from individual angel investors.
  • With Series Seed, angel investors typically have the right to appoint one board member. With Convertible Debt, investors typically do not have a right to appoint one board member.