Startup Financing: Convertible Debt and Convertible Preferred Stock

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In startup financing, common arrangemens include convertible preferred stock and convertible debt. These financing arrangements are typical in seed capital and venture capital financing rounds. At the seed financing stage, convertible debt is more common. In venture capital rounds, from Series A financing onwards, the startup more often uses convertible preferred stock.

Convertible Debt

A convertible note is short-term debt that converts into equity under certain conditions. In a seed stage financing round, investors usually loan money to a startup. The debt will automatically convert into equity, usually preferred stock, when the startup progresses to a Series A round. Although the equity could take the form of common stock, most sophisticated investors would opt for shares of preferred stock instead.

Convertible notes are relatively fast and inexpensive to issue in startup financing. There is far less complexity as compared with an issuance of shares of preferred stock. The legal fees are smaller, given that the main document to draft is a note purchase agreement.

Startup Financing Certificate
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Preferred stock often comes with certain control rights. The startup usually heavily negotiates those terms with different investors. Convertible notes, on the other hand, rarely come with control rights. According to an analysis of seed financings by the law firm Fenwick & West, convertible noteholders won a board seat in only 4% of such financings, whereas preferred stockholders received a board seat in 70% of seed financing rounds.

Another draw of offering early investors convertible debt is the impact it has in attracting other prospective startup financing. Issuing convertible notes offers startups significant flexibility. They allow startups to offer different pricing to different investors.

Convertible Notes Make Startup Financing Quicker

Paul Graham, a venture capitalist who co-founded the seed round startup accelerator Y Combinator, states, “The reason startups have been using more convertible notes in angel rounds is that they make deals close faster. By making it easier for startups to give different prices to different investors, they help them break the sort of deadlock that happens when investors all wait to see who else is going to invest.”

Graham is referring to the conversion valuation cap, known more simply as the “cap.” In startup financing, the cap puts in place a ceiling on the conversion price of the debt into equity. This cap is analogous to a valuation in a priced financing round, or a round where the startup issues investors common or preferred stock. However, the cap can be different for different investors. In a priced round, by contrast, there is only one valuation for the startup.

Convertible Preferred Stock

Sophisticated early investors often push to receive preferred stock with special rights. Convertible preferred stock gives investors an ownership stake in the company, with added investor protections. These added investor protections included control rights, prevention of dilution, and a liquidation preference.

The control rights preferred stockholders receive typically come in the form of board seats and certain veto rights. Lead investors in a startup financing round often receive at least one board seat at the startup. These investors may also get veto rights or have special approval rights when it comes to hiring new executives or raising debt.

While the amount of money contributed to the startup dictates investor rights, different rounds of financing can also involve different investor rights. Thus, the rights that come with the convertible preferred stock issued in the Series A round can differ from the convertible preferred stock issued in the Series B round, and so on.

Convertible Preferred Stock Most Common for Startup Financing

Startup investors receiving preferred stock almost always receive convertible preferred stock. This simply means it is convertible to common stock at a future date. Most preferred stock deals involve a mandatory conversion to shares of common stock. This mandatory conversion typically triggers when the company undergoes an initial public offering (IPO). The preferred stock can also convert to common stock when it results in an economically superior outcome for the preferred shareholders. An economically superior outcome can arise in situations such as when the company undergoes a liquidation or acquisition.

In startup financing, the conversion ratio of preferred stock into common stock is typically 1:1. However, this ratio is adjusted to reflect the economic relationship in the original agreements with preferred shareholders.

In a convertible preferred stock agreement, which is entered into between the company and the preferred stockholder, there are a number of key provisions. First, there are usually anti-dilution provisions. Anti-dilution provisions provide for price adjustments so that investors in early rounds of financing do not lose significant value in subsequent rounds of financing. This can be achieved by modifying the price at which preferred stock converts to common stock.

Another common feature of a convertible preferred stock agreement is a liquidation preference. A liquidation preference outlines how the proceeds from a liquidation or acquisition will be allocated amongst shareholders if the company undergoes such as event. The seniority of the payment of proceeds will be specified. There are two main types of liquidation preferences—participating preferred and non-participating preferred.

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