Startups typically raise capital by issuing convertible preferred stock or convertible debt. Find answers to frequently asked questions about these financing arrangements.
Published Date:
Oct 24, 2018
UpdatedDate:
September 2, 2023
Convertible preferred stock and convertible debt arrangements are widely used in startup financing. Nearly all VC-led funding rounds (from Series A on) are completed via preferred stock agreements. During seed financing, however, many startups use convertible debt as an alternative to preferred stock. Many angel investors and founders have strong opinions about using one form of financing over the other, but neither type of security is inherently superior.
Learning how both financial instruments work and their potential effect on your company is essential preparation for raising funding. (For more information on seed financing and equity rounds see our article entitled The Stages of Startup Financing.) This article provides an overview of convertible preferred stock and convertible debt while addressing common questions related to these securities along the way.
General Context
Why do investors use convertible preferred stock and convertible debt instead of common stock?
Startup investors shoulder significant risk by financing new, unproven businesses. While they hope that their portfolio companies will grow and provide large returns, investors strive to implement protections that reduce risk in case a startup performs poorly. Both preferred stock and convertible debt provide investors with additional protections beyond those available to common stockholders.
In the event of a liquidation, preferred stockholders and convertible debtholders are entitled to recoup the full amount of their investment before common stockholders receive any of the proceeds. This is commonly referred to as having seniority1 over common stockholders (who are usually the startup’s founders and employees).
Convertible Preferred Stock
Description
Convertible preferred stock represents ownership of a company, comparable to common stock, but with additional investor protections (preferential treatment). Some of these protections include higher seniority, restrictions on common stock sales, and anti-dilution provisions. Preferred stock issued to startup investors is almost always convertible, meaning that it can be converted into common stock at a future date.
To issue convertible preferred stock, a company and its investor(s) must draft a preferred stock agreement, which outlines both the economics of the investment and the new investor’s rights in the company. In conjunction with the preferred stock arrangement, founders and investors negotiate the pre-money valuation2, the amount of capital to be raised, the size of the stock option pool3, and the number of shares to be issued. Following a preferred stock deal, all shareholders have an accurate view of their ownership percentage and an estimate for the value of their stake.
Although preferred shares issued by public companies rarely provide voting rights4, most preferred shares issued by startups not only provide voting rights but also include other favorable rights associated with corporate governance. Most lead investors5 in an equity round receive at least one seat on the startup’s board of directors. Special provisions also require management to receive explicit approval from the board for certain actions like hiring a new top executive or raising debt.
Startups usually issue different classes of convertible preferred stock with each new funding round (Series A Preferred, Series B Preferred, etc.). Each class of stock will feature different investor rights based on the negotiations between management and the incoming investors.
Is conversion to common stock mandatory?
Preferred stockholders typically receive both optional and mandatory conversion rights. With the optional conversion right, investors can convert their preferred shares into common stock at any time. Optional conversion typically occurs during a new funding round or an acquisition that alters the economic relationship between preferred and common stock.
Most preferred stock deals also include a mandatory conversion to common stock if the company undergoes a qualified initial public offering (IPO). The automatic conversion clause typically establishes minimum thresholds for the IPO’s (a) price per share and (b) amount of company proceeds before the conversion is triggered.
When does the preferred stock convert to common stock?
Preferred stockholders generally convert their shares to common stock in two situations: (1) a qualified IPO (see prior question) or (2) when conversion results in an economically superior outcome for the preferred shareholders. The second scenario occurs when conversion to common stock would lead to increased value for the investor in the event of a liquidation or acquisition.
How many shares of common stock do investors receive upon conversion?
Convertible preferred stock agreements usually specify that the conversion ratio from preferred to common shares will be on a 1:1 basis, as calculated at the time of issuance. (Note that each agreement is unique and may have a different conversion ratio.) If the company raises additional financing, provides stock dividends, or issues a stock split, the conversion ratio will be adjusted to reflect the economic relationship of the original agreement.
What are the advantages of issuing convertible preferred stock during seed financing?
- Certainty about Valuation – Preferred stock arrangements attach a valuation to the overall company and each share price, providing clarity about how much the startup is worth. Convertible debt arrangements do not attach a valuation to the startup, causing the company’s various stakeholders to have differing opinions about the company’s value.
- Certainty about Ownership – After a preferred stock deal, all investors understand the exact structure of the cap table6. In convertible debt arrangements, the structure of the cap table may be unclear until an equity round has been completed and the debt has converted to equity.
- Preparation for Future Fundraising – Participating in preferred stock negotiations while raising seed financing can prepare you for later financing rounds where the stakes are even higher. Negotiating the valuation for an equity round and setting up the terms of a deal require judgement, skill, and diplomacy. You will not develop these skills as fully in a convertible debt deal because decisions about the most contentious points are deferred until a Series A round.
- Investor Preferences – Some angel investors will only invest in preferred stock deals. Issuing preferred stock instead of convertible debt may be your only means of attracting certain investors.
What are the key provisions within a convertible preferred stock arrangement?
- Anti-dilution Provisions – Anti-dilution provisions protect investors from losing value in subsequent financing rounds by adjusting the price at which preferred stock converts to common stock.
- Liquidation Preferences – The liquidation preferences dictate how proceeds from a liquidation or acquisition will be distributed. The preferences normally come in two varieties: Participating Preferred and Non-Participating Preferred.
Convertible Debt
Description
Convertible debt arrangements allow investors to loan a startup money with debt that converts into equity at a future date. Like traditional loans, convertible debt agreements include a principal amount, an interest rate and a maturity date. Since many startups lack the funds to support cash interest payments, most convertible debt agreements allow the interest to accrue until the maturity date (or conversion date). When the startup raises an equity round, the principal amount and any accrued interest automatically convert into equity (normally preferred stock).
Although convertible debt agreements contain many debt-like features, startup investors view the debt instrument like an equity investment. Investors expect the debt to convert into equity as the startup grows and raises additional financing. The conversion option allows the convertible debtholders to participate in the startup’s upside while also retaining the protections associated with lenders.
What are the administrative requirements for issuing convertible debt?
Before closing a deal, investors will engage in due diligence, a review of various aspects of the company to certify that the information you have presented is accurate. Each investor will have a slightly different list of information requests, but most will, at a minimum, want to see important financial and legal records. Investors often require startups to have audited financial statements, but investors may be more lenient for very early-stage companies.
When does the debt convert into equity?
Most convertible debt deals are structured for the debt to automatically convert into equity upon the startup’s next round of financing. The legal agreements typically dictate that the triggering event must raise above a minimum threshold (often 1-2x the principal amount) to convert. The threshold ensures that the startup is well capitalized before convertible debtholders forego their lender protections.
What happens if the maturity date arrives and the company has not raised equity financing?
The company is obligated to meet its financial commitments by paying the accrued interest payments and principal amount to the debtholder when the maturity date arrives. Most startups, however, cannot afford to make these payments. Convertible debtholders could technically force a startup into bankruptcy for defaulting on its payment, but rarely do. Instead, the debtholders often extend the maturity date or convert the debt into equity in hopes of facilitating the long-term success of the startup.
Why don’t VC investors use convertible debt in equity funding rounds?
Convertible debt arrangements are rarely seen in middle- or late-stage financing arrangements because incoming investors desire additional control provisions (like board representation) and more precise ownership calculations (valuation estimates) that convertible debt does not provide.
What are the advantages of issuing convertible debt during seed financing?
- Speed – Raising capital in the form of preferred stock usually requires lengthy negotiations, consensus among multiple investing groups, and considerable due diligence. For companies that cannot wait several months for additional financing, convertible debt offers a simpler, faster way to obtain capital.
- Legal Costs – Preferred stock agreements involve extensive drafting of legal documents that outline investor rights. Convertible debt agreements are much cheaper to execute, allowing the startup to invest the cost savings back into the business.
- Flexibility of Additional Financing – Unlike preferred stock arrangements that issue a fixed number of shares, companies can raise multiple rounds of convertible debt under the same terms. Once the documents are drafted, the company can raise more convertible debt financing at little additional cost.
- Ease of Negotiations – Convertible debt arrangements do not explicitly assign a valuation to the startup. By using a convertible debt arrangement, management can postpone tricky negotiations about the startup’s valuation. This allows professional investors (usually VCs) to set the first valuation and avoids uncomfortable negotiations that could strain relationships with friends and family members participating in seed financing.
- Investor Influence – Under a convertible debt arrangement, incoming capital providers do not receive influence over management decision making. Unlike preferred stockholders, convertible debt holders do not receive a board seat and management does not need bondholder approval for key decisions.
What are the key provisions within a convertible stock arrangement?
- Conversion Discount – A conversion discount allows convertible debt shareholders to convert the debt into equity shares at a reduced price (“discount”) compared to the incoming investors in the subsequent funding round. The discount rewards seed investors for the additional investment risk related to the earlier timing of their investment.
- Valuation Cap – A valuation cap establishes a maximum initial value for the startup when determining the conversion rate from debt to equity. The cap ensures that convertible debtholders will convert to equity shares at a lower purchase price than the incoming investors.
Note that a convertible debt agreement can have both, either, or none of the two features described above. If both features are included, the agreement usually allows debtholders to convert at whichever price is lower to give the debtholders a better deal.
Conclusion
Preferred stock and convertible debt agreements are the foundational agreements that startup investors use to structure their investments. Each structure has pros and cons, and both are commonly used in seed financing. The terms of the arrangement, your startup’s needs, and the preferences of your potential investors should ultimately guide your decision as to the best form of financing for your company.
Summary Table
Resources Consulted
- Fred Wilson Blog: Preferred Stock
- Fred Wilson Blog: Convertible Debt
- Cooley: Primer on Convertible Debt
- YCombinator: A Guide to Seed Fundraising
- VentureBeat: Demystifying Venture Term Sheets
- TechCrunch: Everything You Ever Wanted to Know about Convertible Note Seed Financings
- Term Sheets and Valuations by Alex Wilmerding
