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Convertible or Equity

April 11, 2022

In Europe, most early-stage financings are done as direct equity investments, whereas investments done as a convertible note are quite common in the US. A convertible note grants the investor a right to equity in the future, rather than simply receiving equity immediately. The amount of equity that the investor gets is dependent on future funding rounds that the company does.

Why do some prefer a convertible? Because it is hard to value the startup at the beginning. In the future, the company has metrics that a valuation can be based on, so the company is much easier to value. Instead of figuring out a valuation now, a necessity for an equity investment, the can is kicked down the road. The next time, the convertible note is converted to equity at the valuation set at that point in time, but with a discount typically between 15 and 30%, to account for the additional risk that the early investor takes as well as the time factor. In addition to not needing a valuation, the paperwork is much simpler for a convertible. Founder time is scarce and time spent negotiating rounds is time away from building the company - keeping that to a minimum is in everyone's best interest (except for the lawyers who get paid less).

Two very nice things. My view, though, is that there are valid counter-arguments to both of these points.

Making the valuation dependent on a future round effectively means limiting the upside for investors, and having an uncapped upside is crucial when investing in startups. What if the company does extraordinarily well right after the round closes and proceeds with raising the next round at a ludicrous valuation only to have a great exit a few years later? The investors didn't know that the company would do extraordinarily well after the investment. Most of the investments that early-stage investors make don't do well, because that's statically how outcomes look for that kind of investment. So it is critical to the investment model to protect the upside of the ones that do. And yet, as an investor you only got a 20-30% better deal than the investors who invested after you and they had much less risk when they decided to invest. On the other hand, if the company doesn't do well and shuts down, they don't get any money back. They participate fully in the downside. Their cash has been used on financing operations and growth and if things don't fly the residual value is often zero.

Of course, that shouldn't bother you too much as a founder. Usually though, the investors know about this and ask for the convertible agreement to include a cap. The cap is a maximum valuation that the investors can be converted at. It effectively means that the investors get to keep their unlimited upside because once the valuation exceeds the cap, the discount that the early investors enjoy increases. If no subsequent round happens, conversion happens at a pre-set valuation (typically very low). This makes the convertible more similar to equity, but not the same. These two valuations are something that must be agreed upon at the time of investment - they cannot be postponed until later. It becomes awfully similar to valuing the company, which was precisely what the intention was to avoid. You also have an additional financial instrument in the capital structure, which is equity-like but not quite equity, and keeping track of how the cap table will look in various scenarios is much more complicated than if the startup had simply issued equity.

Admittedly, the paperwork is simpler with a convertible note than with equity. However, the difference tends to get smaller when the investor is a VC or a larger investor. With equity rounds, you often update or replace the Shareholders' Agreement, which governs control of the company that the new investors get, among other things. Just because the round is a convertible doesn't mean that the investors don't want any control. Often, many of the clauses that govern control move to other documents and have to be negotiated anyway.

To sum up, the choice is a matter of how to share the pie and who gets to decide what, as always with financing. If you have investors who accept giving up part of the upside and are OK with not having control, congratulations - a convertible is the way to go. If the investors want to modify the convertible agreement to include a cap and control, which they often do, the difference between the two becomes much smaller, while simultaneously making things more complicated.