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Convertible equity is a form of early-stage bridge funding that allows a startup to sell to investors a form of equity security that in many ways resembles a convertible note in that it auto-converts into preferred stock at the time of a next qualified funding but without some of the issues of a note financing.
Specs
Pros
Pro Doesn't place the Startup in Debt
Convertible notes place a Startup in legal debt. This has three primary problems:
- When the Convertible notes maturity date is reached, investors can legally demand the debt be paid back which may force the company into bankruptcy.
- Being in debt can inhibit startups from gaining additional lines of credit.
- In some cases (depending on jurisdiction and on length of the loan term), angel investors are technically not able to legally provide debt to Startups without being licensed lenders.
Convertible equity does not have any of these downsides.
Pro No Complex Interest Terms
With convertible equity there is no interest paid on the round. This saves the entrepreneur equity and simplifies future fundraising.
The lack of complex interest terms is a significant advantage over convertible notes. From Startup Company Lawyer:
Convertible debt must have interest at the applicable federal rate (AFR) published by the IRS or higher, or the IRS will deem that the lender should have received imputed interest at AFR. If convertible debt with a price cap is supposed to mimic the economics of equity, then removing interest seems logical.
In addition, when a financing occurs and the convertible debt converts, creating the spreadsheet to track interest on the notes to the penny, especially when notes have been issued on different days, ends up being a painful task — especially as the closing date of a financing may be delayed and the amount of interest increases, resulting in more shares being issued to note holders.