"Converts," which look like debt and taste like equity, are becoming popular among certain types of entrepreneurs and angel investors
For Stella Ma and Amy Norman, the founders of children's entertainment startup Little Passports in San Francisco, raising seed capital from angel investors as a priced round wasn't working. After three months of pitching in the fall of 2008, the company, which sells educational toys and electronic games meant to inspire kids to learn about foreign cultures, had few suitors. Those willing to come on board were offering valuations only a mother could love. Ma and Norman, first-time entrepreneurs who had met while working together at eBay (EBAY), made do on their own—self-funding Little Passports' April 2009 launch, then approaching friends and family for capital. Their efforts gained momentum in August 2009, when a friend who happens to be a Silicon Valley venture capitalist offered to lead a $175,000 round as a convertible note. It closed that September with a handful of angels participating. Convertible notes (known as converts in the investing community) are loans that turn into stock in the event of an acquisition or significant funding event. Converts are typically used for companies that need quick cash, are hard to value early on, or require a small round of financing (usually no more than $500,000). Although the valuation of the startup is deferred until the triggering event, investors in converts usually get slightly better terms than the ones offered to subsequent investors in a priced round. Widely regarded as entrepreneur-friendly structures, converts don't place an immediate interest burden on cash flow; coupon payments to note holders are accrued, instead of paid out in intervals. Do Converts Hint at a New Direction?
Over the past few years converts have gained in popularity. According to a 2010 Angel Capital Assn. survey of more than half the trade group's 150 member angel groups (representing some 6,500 individual investors), 14 percent of respondents listed convertible notes as their general preferred deal type. On one hand this is surprising, given experienced angel investors' traditional distaste for the product, which they see as limiting the home-run potential of investments. Following a decade in which venture returns were crushed twice—first by the Internet bubble and then by the Great Recession—the uptick may indicate a new direction for early-stage funding. For Ma and Norman, it was the only deal structure that made sense. The legal fees for a capital infusion of merely a few hundred thousand dollars were likely to cost 15 percent to 30 percent of the entire raise, making a traditional priced round less attractive. Because converts are debt, they are negotiated with less back and forth on governance. By postponing discussions of valuations, board seats, and oversight clauses, the funding process goes faster, which also helps keep legal fees low. It cost Little Passports $10,000 in legal fees to structure its $175,000 round as a convert, vs. $25,000 to $50,000 for documentation associated with a priced round of preferred shares. For founders raising less than $500,000 at a time, the savings from converts are noteworthy. For investors, convertible notes come with the promise of greater safety. Holders of debt are higher up on the food chain than investors of all equity classes, including preferred shares. Notes also provide periodic coupon payments of 8 percent to 10 percent, although these payments are usually payment in kind—notes or shares—that accrue. To make these arrangements more attractive to those assuming early risk, it is not uncommon for the terms of a convert to include sweeteners such as a 20 percent to 30 percent price discount to Series A pricing and a valuation cap that allows note holders to get into a deal at a predetermined valuation range.
Tracy Zaccone and Steven Williams, partners at corporate law firm Paul, Weiss, Rifkind, Wharton & Garrison in New York, warn that entrepreneurs should keep terms similar to other deals taking place in the market. If terms granted to early investors are too onerous for later investors, venture capitalists will not want in. Investors should also bear in mind that the accrued interest payments common to these structures can cause tax complications down the road.Respected serial angel investors, including David Rose of New York Angels and Bill Payne of Tech Coast Angels, are vocal opponents of convertible notes. Punting the valuation decision robs early stage investors of upside if investments strike gold. For rocket-to-moon angel deals, I think they are right. Used Desks and a Foosball Table
Other negatives face investors. The lost upside is not offset by the safety of debt, and the downside protections offered by convertible notes are technical at best. Failed startups have little in terms of real assets. Should things go completely south, a note holder will have first dibs on gently used office furniture, unwanted technology, and if they're lucky, a foosball table or sock puppet mascot. The recent appeal of converts may have less to do with their technical structure and more to do with a desire among some investors to fund business models that are less speculative in nature. Investor flight to safety could spell opportunity for startups that pose fewer what-ifs and offer more predictable upside than an unproven technology, a website, and a dream. The trade-off isn't so much about capital structure as risk inherent in the business. Companies such as Little Passports require less cash and pose more challenging early-valuation discussions, all of which makes the use of converts more appropriate. Of the 50 or so angels that Ma and Norman approached, they say only one turned down the deal because of structure. They've raised a total of $575,000, all as convertible debt, including $250,000 from Golden Seeds, a prominent angel group that traditionally prefers priced rounds. For investors broadening their investment palate, converts can be a far better bet than equity alternatives for all involved.