Convertible Rounds are Not Faster and Cheaper
In contrast to a pre-conception held by many entrepreneurs, convertible loans are not always preferable to equity investments
Are convertible rounds faster and less costly than equity rounds? Well, not anymore. For entrepreneurs trying to raise seed or pre-seed investments today, priced equity rounds can be done quickly and inexpensively while convertible rounds can turn into a nightmare.
In an equity investment investors get their shares of the startup at the date of the transaction, based on their investment and the agreed pre-money valuation. If the entrepreneurs opt for a convertible round, the money transferred to the company at the closing is considered either as a loan, bearing interest and having a maturity date as in any regular loan, or as a ‘down payment’ on future equity.
Y Combinator's SAFE agreements are probably the best-known example of this type of transaction. In both cases, the investment amount will eventually be converted into shares of the company, subject to certain agreed upon conversion scenarios.
One of the leading arguments in favor of convertible rounds is that they enable the founders to avoid the need to fix the company's valuation at the time of the closing. This is useful if the founders plan on achieving a significantly higher valuation at a near future funding round.
But there's no doubt that the most popular, almost automatic argument in favor of convertible rounds, is that they are a lot quicker than equity rounds and therefore cheaper. If no equity is issued at the closing, there is no need for lengthy negotiations over the rights granted to the investor as a shareholder. Issues like board composition, liquidation preference, information rights, anti-dilution and more are put on hold.
The above argument is so broadly accepted that, in my experience, it can in many cases tip the scale in favor of a convertible round. Admittedly, this usually happens in 'above average startups' with a strong founding team and great technology, since such startups naturally have a better chance of getting the investors' cooperation.
I would like to strongly oppose the myth of 'quick and cheap' convertible rounds. Here's why:
Even in the most straightforward convertible round, the investors usually get a handful of special rights which should be negotiated. As a common practice, the company will grant investors a considerable discount on the next round's price per share, and also agree to cap the valuation of the next round to reduce investors' exposure. On top of that, the company and the investors need to agree on the conversion scenarios which determine when the investment will be converted into shares.
Negotiating a convertible round can easily turn into a hassle. In many cases, structuring the abovementioned discounts, valuation caps and conversion scenarios can be proven to be at least as complicated, time-consuming and expensive as an equity round, if not more. On top of that, in my experience, it is very common for investors to insist on getting customary representations, information rights, and various other rights, regardless of the fact that it's a convertible round, all of which should also be negotiated.
On the other side, the fact is that as time passes, equity transaction binders are getting thinner. Investors and companies are cooperating in developing simpler investment mechanisms and the costs of doing business, including negotiating expenses, are dropping. Such processes are relevant to all business sectors in today's fast economy, but they are primarily true for companies in the online industry, having a much shorter life cycle than companies in other tech sectors.
So there it is, convertible rounds are not that simple while equity rounds are getting simpler. When deciding between the two, make sure you consider which is right for your startup's unique needs.
Adv. Zachi Zach is a lawyer and a mentor in the online industry, specializing in online gaming, adtech, ecommerce and other online related fields. Among others, Zachi serves as Of Counsel to the law firm of Pearl Cohen, an international law firm with offices in the US, Israel and the UK.
Zachi is also the author of The Online Startup blog: www.zachizach.com.