Fundraising: Convertible Debt vs. Equity


(Scott Cadora) #1

So we’re preparing for an angel round of fundraising and have spoken with several folks about the best capital structure. Of course equity is the classic standby but I understand that 500 Startups and other early stage investors on the West Coast now prefer convertible debt. The reasoning is that it is easier to implement and avoids trying to determine a valuation at such an early stage, which in most cases is just blind guessing.

I’d love to hear your feedback on this matter.


#2

Hi @ScottCadora,

I’m in the same situation, some insights about convertible debt vs equity will be great.

Bart.


(Andrew Chen) #3

Do you have any specific questions about it? Can you give more context? These kinds of questions are always hard to answer in the abstract.

It’s true that most rounds <$1M are done as notes or even newer, SAFEs these days.


(Stephen Willis) #4

It really depends on the interest % on the convertible note and if you can afford it. I myself would opt for no debt and just give straight equity.



(Andrew Chen) #5

Disagree. The interest % has nothing to do with it. Usually it’s fixed at 2% or 5%, and generally isn’t a term people debate about. The bigger reason why people do notes versus equity is covered here:

http://venturehacks.com/articles/debt-or-equity
http://venturehacks.com/articles/debt-benefits


(Stephen Willis) #6

True, that is based on the bigger picture. My answer was based on my preference and the fear of having any debt:)


(Scott Cadora) #7

Andrew,

So we’re looking to raise $250K to $500K, depending upon valuation & terms. Obviously more $ gives us a longer runway but at what cost. We’re going to use the funding to further develop our technology and begin marketing & sales. But our discussions on valuation have been all over the map. A friend who is a 500 Startup member suggested that we consider doing convertible debt as a way to avoid the valuation matter.

I’ll take a look at the VentureHacks articles - thanks for sharing them. But I welcome any further insights you can offer about the SAFE’s.


(Matt) #8

I am also looking to fundraise. It seems to me that SAFE’s are the best option for seed fundraising: https://www.ycombinator.com/documents/

Like a convertible note but without the debt. I’m not sure if all investors outside of CA would agree (i’m in MA)

I don’t fully understand which type is best for which situation though. I am trying to decide what terms to offer for a friends and family round (30-40K). Im thinking the MFN clause (no cap, no discount) makes the most sense for me. My original 40K investor won’t convert until my valuation is set at the Angel/Seed Round (750-1M). My question is what happens if that seed round is also done using a convertible note? Does the conversion wait until the next round of equity “series _” funding?


(Stephen Willis) #9

@andrewchen This is off topic on the thread, but if you have 3 minutes, would you mind looking at my pitch deck and giving me your opinion on it if it is structured right…


(Scott Cadora) #10

I think that should be a permanent thread as probably all of us would like someone to review our pitch decks. But in respect of Andrew’s valuable time (and to ensure only quality decks are submitted), perhaps it should be a fee based review. I’ll defer to Andrew for his opinion of course, but I’d certainly find value in such a review.


Can you review my pitch deck? Yes. Post here
(Scott Cadora) #11

Andrew - Those are both great articles on convertible debt for a seed round investment. Thanks for sharing them.

Y Combinator also has a good section on their site about SAFE investments as an alternative to debt. https://www.ycombinator.com/documents/


(Scott Cadora) #12

Oops - Looks like someone else found the Y-Combinator documents as well. Jinx Chartreuse. Thanks for the post.

I actually just discussed SAFE’s with our attorney and he said that SAFE investments are popular in California but still are considered as unusual to many angel investors outside of the Golden State. But if you can get an angel to agree to take a SAFE, he said that they are the most entrepreneur friendly investment vehicle to use. But convertible debt or SEED’s may be more familiar to angel or seed level investors.


(Andrew Chen) #13

These days in the valley, I’d say that 90% of rounds that are <$1M are convertible notes these days. Above that, it’s more likely to be equity. At >$3M, then it’s almost always equity.

The reason is mainly that note rounds are much much easier to put together. Simpler terms. Not much to negotiate. Versus equity rounds have complicated terms, like board seats, protective provisions, liquidation preferences, etc., etc. There’s been some efforts, like Series Seed, which are meant to simplify equity investing to the point where they are competitive to debt rounds. But in general it’s become commonplace to use notes.


(Andrew Chen) #14

SAFEs are being pioneered by YC, so it’s really a Bay Area thing. I don’t think investors in LA use it much, for instance.

Generally, something like the following is true for a <$1M round:
SAFE < note < equity

Above >$2M, then you probably go equity.


#15

Jason Lemkin offers an interesting view point of this matter in a recent article in SaaStr:

http://www.saastr.com/an-insiders-guide-to-convertible-debt-vs-equity/

Bart.


(Andrew Chen) #16

I respect Jason’s opinion, but in most cases, for the hot companies (like out of YC or whatever), they ask for whatever terms they want and they usually get them. While it’s great as an investor to express a preference for what you want, the reality is that you get what you get most of the time.


(Peter Adams) #17

I’m jumping in this conversation a little late, but hopefully some of this will be useful to others. Your question has spurred on a great conversation. I’d add one more factor that hasn’t been discussed in this thread and that is that the 100% capital gains tax breaks for angel investors are not available for convertible note holders. Why would you choose something that gave you a guaranteed 20% lower return on investment? More on that and other reasons to avoid convertible debt can be found in this post ==> http://www.rockiesventureclub.org/frontpage-article/ten-reasons-not-to-use-convertible-notes/