Convertible Debt or a Priced Round – Entrepreneur and Investor Perspectives
Published in New Jersey Technology’s TechNews November 2015 edition
Raising capital is one of the entrepreneur’s most difficult and time-consuming activities. Not all money is the same and the structure of those early investment rounds could have an impact on future returns. Today, seed stage rounds provided by angels or early stage VCs usually come in the form of priced rounds or convertible note/convertible debt. These two vastly different types of securities are used for smaller rounds of financing at the early stage of a company’s life cycle.
Priced Round vs. Convertible Debt
A priced round is fairly straight forward and the investor receives a share of the equity based upon the pre-money and post-money valuation. With a priced round, investors may be entitled to both economic rights as well as other rights including dilution provisions and board representation. Seed stage equity investors typically request equity in the form of preferred stock rather than common stock. The preferred stock will have an agreed upon dividend rate and will usually include a liquidation preference, before the common stockholders get paid.
A convertible note is a debt instrument which will convert into equity at the time of the Series A funding round. Convertible notes are considered debt and therefore do not come with ownership rights, such as veto rights or board representation. In the case of a liquidation event, debt is considered to be senior to equity and therefore provides superior downside protection. If a company goes out of business and there is available cash, the convertible debtholders will get their money back even before the preferred stockholders.
Convertible debt typically carries an agreed upon interest rate, which is handled as payment-in-kind. The term of the convertible note term is usually 12- 18 months.
The terms of the convertible debt typically include a valuation cap for conversion purposes, as well as a conversion price at a discount to the Series A round. This allows the seed stage investor to convert their debt to equity at a better price than the Series A investor.
On the one hand, convertible debt has some advantages. Typically, the entrepreneur can close a convertible debt round much quicker, since the valuation discussion will not slow down the process. The entrepreneur can now defer the valuation issue to a later date and get back to the matter at hand of building the business. Second, since a convertible debt round can close in a matter of weeks rather than months, professional fees are considerably less. And lastly, convertible debt rounds do not involve the issuance of any stock to the investor, so the founder is not giving up any formal control in the business at this time.
While the convertible debt round has some advantages for the founder, there are also some drawbacks. If the founder does not make it to a Series A round, he might be forced to pay back the convertible debt with cash that might not be available. For the founder, another disadvantage of convertible debt is the possibility of less investor engagement. Investors with no board seat, less frequent updates from management and no consultative role in major decisions will certainly be less active in a company’s activities. Investor advice and business experience is often valuable.
For the investor in a convertible debt deal, most of the benefits do come at the time of conversion to equity. Since stock is not immediately issued with convertible debt, the investor does not immediately have to become a party to a shareholder agreement. Remember, that most deals have a valuation cap and are priced at a discount to the Series A investors. Therefore, if the company is not valued as highly as predicted, the convertible debt investor will wind up with a bigger equity piece upon conversion than he would have received in a priced round.
Clearly, there is no one right answer on whether to use convertible debt or a priced round. Every transaction is different. However, if entrepreneurs understand who their investors are and how much risk each party is willing to accept, the answers become more clear.