My last article—what do the different share classes mean for me and my startup?—generated a lot of interest and feedback for more information on the nature of startup financing terms in general: what’s toxic and what isn’t. We touched on aspects of equity in our take on toxic term sheets, but I think it’s worth going into a bit more detail on some of the clauses we didn’t cover. But first, we need to take a step back from equity altogether and talk about debt, because it’s one of the most popular forms of early startup financing and has its own toxicity pitfalls. We’ll return to equity terms in part three.
As it turns out in early-stage financing, debt-like instruments play a key role in financing. Let me break this down ELI5 style:
Debt: You give me money, and I pay you back and a bit more over time. The “bit more” bit is called interest.
Debt-like: You give me money, and sometime in the future we change what I owe you into equity.
So you see, “debt-like” isn’t debt at all. It’s equity by another name. Most of us call it convertible debt anyway. YC and 500 Startups have come up with alternatives, which serve the same purpose, called SAFE and KISS respectively. SAFEs, in particular, try to solve for one of the annoying bits of convertible notes, which is interest.
Interest
Converts are a handy way to raise capital one cheque at a time with no lead, or pricing, investor.
An essential element of debt is the interest rate it has. But as you will note from my ELI5 description of debt-like financing, interest isn’t even mentioned. So you would think that a typical convertible note wouldn’t have any! Unfortunately, securities and tax law treat zero coupon notes (debt with no interest) a bit differently than ordinary debt.
Fundamental here is the law is such that implied interest on a bond is subject to income tax. Very bad! That pretty much rules out zero coupon convertible notes. So investors are essentially forced to charge some form of interest. Bad, but not the worst thing in the world. If your equity is growing in value 100 percent+ a year, a convertible bond growing at six to seven percent isn’t a problem.
However, this interest has annoyed a lot of people over the year. Enter the simple agreement for future equity or SAFE. Basically, one of two primary purposes of SAFEs is to get around interest. It’s right there in the very second bullet point of the description:
“Because the money invested in a startup via a safe is not a loan, it will not accrue interest. This is particularly beneficial for startups, but also better embodies the intention of investors, who never meant to be lenders in the first place.”
It’s other main purpose is to keep things simple. We should all like that.
Discount
A feature almost every convertible note has is the concept of a discount at conversion. The idea being, the price per share will be set sometime in the future, and that the investors will benefit from having invested early by converting at a discount to that price.
The standard conversion rate is 20%. The range is anywhere from 30% to 5%, with either extreme being highly unusual.
Price
Convertible debt, SAFEs and KISS (I’ll lump them together going forward as “converts”) are a strange form of quasi-equity because you and your investor have not agreed on what the price per share of your equity is worth. Instead, you’ve decided to convert an amount that will be set in the future at a conversion event. This conversion event is typically an equity financing round. What makes this strange, and can lead to some severe toxicity, is that you don’t know how much of the company you sold. All you know is that it’s somewhere between zero percent and 100 percent of the company!
Caps
The current solution to this terrifying unknown is conversion caps. A cap is a limit on the minimum amount of the company an investor will get at the conversion event. A $1 million convert with a $9 million cap guarantees the investors will own 10 percent of the company before the new investment is taking into account.
It should be noted, however, that this cap does NOT stipulate the maximum amount the investor can get! You would think smart founders would spend time to set a lower cap on conversion, to protect their ownership of their company. I’ve never seen it done.
A strong cautionary note about converts: they typically convert into a junior class of the next round, mainly with the same rights as the next equity round.
Let me provide a quick example. The same company which raised $1 million in a convert with a cap of $9 million. As mentioned, the founders have guaranteed to the investors that they will at least own 10 percent of the company, pre-money. However, if things don’t go as planned and they end up converting their equity at $4.5 million, they actual sold 19 percent of the business! Halve that again to $2.25 million, and the investors get 30 percent of the company! To my knowledge, there is currently no downside price protection in converts for founders.
The notion of caps is intellectually strange to me. Converts are grounded in the thesis that you can’t or don’t want to, determine a price for the equity today. But a cap stipulates we can determine the value of the company in the future! Strange. Moving on.
There are times when this is a strong preference for converts. A typical use for convertible debt is when you are financing the company with a small amount in between more substantial equity raises and where there is high confidence of a future equity raise. These bridge financings are typically expected to convert in less than a year at a discount to the next round. They rarely contain caps and stay true to the concept that you can’t price the equity today accurately.
Converts are also popular with accelerator programs and founders looking to raise seed rounds through collecting many small cheques one at a time. Equity closes typically require most funds to be received simultaneously, which is less desirable for lots of quick closes. These party or club rounds are rarely priced or lead by any one investor, so a convertible piece of paper with no price or lead makes this easier.
Valuation
Another danger of converts is a misunderstanding of valuations in term of equity and debt. I’ve seen companies that have raised entirely via convertible and when negotiation their first equity round, believe that the pre-money valuation is only for the equity. Unless expressly stated as such, a pre-money valuation for a new round is the post-money of the last round which includes all equity and debt. If you want to know the value of the equity, it’s valuation minus debt (don’t forget the discount or cap!).
This confusion is why we are seeing some investors offer term sheets with post-money valuations. Unfortunately, this method comes with a new set of pitfalls. The biggest of which is that it unduly punishes the founders, and rewards the new investors, in the event of an oversubscription. An unfortunate misalignment of interest while fundraising.
Converts + Toxic Equity =
A strong cautionary note about converts: they typically convert into a junior class of the next round, mainly with the same rights as the next equity round. The going assumption, when raising converts, is the next equity round will be a plain pref series, as outlined in the previous article. However, sprinkle some plutonium into the next round, and the toxicity of your equity may more than double when you take into account conversions! Ouch!
Summary
Converts are a handy way to raise capital one cheque at a time with no lead, or pricing, investor. They are also useful when bridging two equity rounds, essentially allowing investors to pre-purchase shares in the next round at a discount. Converts, however, are not immune to toxicity and misuse!
