Should I Raise My First Round of Funding Via Convertible Debt or Equity?
One of the first questions an entrepreneur must address when launching a technology startup is how the company will be funded during its early stages. For those who are not in a position to bootstrap, this question typically results in two possible answers: (a) raise money from private investors via a convertible debt financing; or (b) raise money from private investors via an equity financing. So what’s it going to be, debt or equity?
What are the Key Differences?
Convertible debt is debt, and equity is equity. However, if and when convertible debt gets converted into equity, it moves off of the debt side of the balance sheet, and becomes stockholder equity. If not converted into equity, convertible debt must be paid back to the investors, and unlike stockholders, convertible debt investors don’t get voting rights or statutory information rights prior to conversion into equity. Both methods allow a company to raise money efficiently, and investors who are experienced in making investments in early stage technology startups will generally be equally comfortable making investments in convertible debt or equity (although, for reasons I’ll discuss below, angel investors generally prefer to make convertible debt investments, and institutional venture capital investors generally prefer to make equity investments).
The Case for Convertible Debt
As a general rule, it is much cheaper to close a convertible debt financing than an equity financing. By way of example, it is not at all uncommon for a company raising its first funds after formation via an equity financing to pay legal fees and other costs in the range of $7,000 to $20,000, depending on how much negotiation and maneuvering is required to get the deal closed. On the other hand, companies raising their first funds after formation via convertible debt can usually accomplish such a financing with legal fees and costs somewhere in the $4,000 to $10,000 range, depending again on the amount of negotiation and maneuvering required to close the deal.
In addition to being cheaper, most companies find that raising their first angel financing via convertible debt is also much easier, as angel investors are comfortable with this structure. The reasons are that in a convertible debt financing there are less terms to negotiate and understand, thus less paperwork to review, which means that the angel’s legal fees for having their attorney review the financing documents will be minimal, and in many cases sophisticated angels who have made several convertible debt investments might feel comfortable reviewing the documents on their own. Further, because some of the most stickiest negotiating points (like valuation) are punted to the “qualified equity financing” that triggers the conversion of the notes, the angel can make the investment without having to spend a lot of resources making sure they aren’t buying at an inflated valuation. And finally, because convertible debt is real debt until converted into equity, the angel investor purchasing a convertible note gets the upside benefit of equity (if the company has success raising additional funds and the note is converted), but also has the downside protection of being a creditor on the top of the liquidation stack if the company fails.
The Case for Equity
The primary benefit of raising an equity round is that there is no requirement to ever repay the investment. Because of the associated costs of a priced equity financing, most technology startups raising their first funds will find the convertible debt route more appealing, but there are, however, some instances where the benefits of an initial equity round might outweigh the costs. This is especially the case when it is anticipated that the company will be revenue positive within a short period of time. One downside about convertible debt is that it essentially forces the company to have to raise more money in the future via an equity financing (which triggers conversion of the convertible notes). In the case of the typical technology startup, this is part of the plan. However, if the startup has the ability to generate revenue early on, it might not need to raise the additional financing, meaning that in such a case, the company would have to take on a dilutive equity financing round that it doesn’t need, or the convertible notes would have to paid off at maturity (or some other arrangement worked out with the convertible debt investors). There are workarounds for this, but many of them can lead to the company having to undergo an expensive transaction akin to an equity financing, without the resultant cash infusion of an equity financing to defray the costs. If the same company were to simply take in the funding via a preferred equity financing, it would avoid the necessity of having to raise more money in the future (which it might not need) or having to undergo a conversion or payoff transaction.
Because of its efficiency (and typically lower costs to close), many emerging technology startups find that raising their initial round of capital via a convertible debt financing is the preferred route. However, every situation is different, and you should consult sophisticated corporate counsel to determine whether it makes the most sense for your startup company to raise its initial funds via convertible debt or equity.