You’ve probably heard the term ‘convertible equity’, but what does it actually mean?
Convertible equity defined
Convertible equity was inspired by Sequoia Capital’s startup financing instruments.
This is a flexible form of finance. It’s especially suited to early-stage companies because it doesn’t hamstring them with debt. Instead, it gives investors the right to preferred shares or other benefits when a specified triggering event happens, such as a Series A round.
Key benefits for companies
Convertible equity enables a company to raise finance without having to put a value on the business. That’s ideal for an early-stage company that hasn’t had much time to develop a track record. This is useful because valuing a fast-growing startup or early-stage company can be pretty awkward in the early stages, with so little time to have built up a track record. Instead, a valuation can be delayed until a major financing event, such as a major funding round. By the time this event takes place, there may be more facts and figures to help establish a valuation.
Convertible equity is also relatively quick, cheap and easy to arrange, with minimal legal fees. This makes it ideal for bridge finance that carries high-growth businesses through to a planned major raise.
There are two other important advantages for companies:
- No repayment is required – so there are no worries about having to pay off a large debt (i.e. convertible loan).
- No interest is accumulated – so there’s no further burden on the company.
Key benefits for investors
- They can receive advantageous tax relief benefits from SEIS or EIS (if the company is eligible)
- As and when the company reaches the next funding round, the earlier investors will be rewarded for taking on earlier and bigger risk through the terms they received (discount and caps on valuation) in comparison to the latest investors
Convertible equity terms
When considering convertible equity, there will almost certainly be terms included that both entrepreneurs and investors need to be aware of, including:
- Discount – The lower valuation an investor will receive compared to investors in the next finance/follow-on round, as a reward for taking a higher risk by investing earlier, when the company was less established. So, the investors would receive more shares for the same amount invested.
- Caps on valuation – The maximum value at which convertible notes will be converted into equity in the company when the Series A round closes. So, if the valuation of the shares is higher than the cap, in effect, the discount increases.
A convertible equity in action
Let’s say a UK-based adtech company has already raised on a well-respected early-stage equity investment platform. Time has gone by since the company last raised, and now it wants to raise a further £300,000 before it has a Series A round, planned for six months from now.
- The adtech company decides to offer a convertible equity, as it appreciates the ability to raise a funding without a formal valuation, which may negatively impact its Series A conversations.
- The platform runs the convertible equity campaign.
- Investors fully funded the round, delighted that they will have their equity converted to shares in the next round of funding (Series A), and receive a 15% discount on the price of the shares based on the value of the company in that round. So, the investors receive more shares for their money than the series A investors.
Sound vaguely familiar? The above example is based loosely on the convertible equity campaign run by Adludio Labs on Seedrs.
Why some entrepreneurs choose a convertible note
As with convertible equity, convertible notes can be cheaper and quicker to issue than preferred stock as there’s usually less legal involvement needed.
And again, just like convertible equity, by issuing a convertible note, the company doesn’t have to come up with a value.
Committing an early-stage company to a large debt is thought by many to not be a great strategy. Also, the debt can come to maturity within just 12-24 months, which can be a huge burden for a startup.
After all, the company may well struggle to raise funds or generate enough cash-flow to pay it off. And what if another round of financing doesn’t happen for some unknown reason? The company would probably never recover and the investors would be left out of pocket, so no-one would benefit from the situation. And that’s why Seedrs offers equity, not debt in general, although we recognise debt is fine for some established businesses, we feel it’s not suitable for early-stage companies.
Please note that tax treatment depends on your individual circumstances and may be subject to change in the future. Seedrs does not provide legal, financial or tax advice of any kind, and nothing in this blog post constitutes such advice. If you have any questions with respect to legal, financial or tax matters relevant to your interactions with Seedrs or its affiliates, you should consult a professional adviser.