The document discusses convertible debt, which is debt issued by a startup to an investor that converts to equity under certain conditions. Convertible debt is commonly used in startup investing as it allows the investor to ultimately own equity while simplifying and speeding up negotiations. However, convertible debt without a price cap can be risky for investors if the startup raises money at a high valuation. Price caps were introduced to address this, setting a maximum price the debt can convert at, but founders sometimes resist them. In summary, convertible debt can be a good option but alternatives like simplified preferred stock terms also exist.

1. C O N V E R T I B L E D E B T

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AGENDA
WHAT?
CONVERTIBLE DEBT
PARAMETERS
TYPICAL TERMS
WHY?
TROUBLE IN PARADISE
PRICE CAPS
SUMMARY

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CONVERTIBLE DEBT
Paul Graham (Y Combinator) tweeted in 2011:
“Convertible notes have won. Every investment so
far in this YC batch (and there have been a lot) has
been done on a convertible note.”

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WHAT?
• Debt (typically a promissory note) issued by an investor to a startup…
… where the principal and accrued interest convert into equity under certain
conditions
• Used when the investor’s intention is ultimately to own equity, rather than
to earn a return through interest payments

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PARAMETERS
• $ amount
• Interest rate
• Conversion upon next financing
• Minimum trigger amount
• Discount or warrants
• Optional: price cap
• Conversion price if no next financing
• Conversion on exit before financing or maturity
• Merger premium (multiple)
• Maturity date and repayment terms
• Secured? Against what?
• Board rights
• Information rights
• Pre-emptive rights on next financings
• Right of First Refusal
• Co-sale rights
• Protective provisions
• Fancy stuff, e.g. discounts that increase over time

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TYPICAL TERMS
• Conversion into Series A preferred
• Median conversion discount: 20%
• Median interest: 5.5%
• Median maturity: 18 months
• Merger premium: 2x (Fenwick and West, 2012)
• Secured against company IP
• No board set

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TYPICAL TERMS - DETAILS
Fenwick and West, Seed Finance Survey 2012
http://www.fenwick.com/publications/Pages
/Seed-Finance-Survey-
2012.aspx?WT.mc_id=2012.SEED_BK_email

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WHY?
• Punts on negotiation over valuation and many pref share terms
• Simplifies legals
• Simplifies and speeds up negotiation over terms
• Lower transaction costs
• Some angels will even do them without legal counsel
• Avoids taking on liabilities of Directors and Shareholders (because
you aren’t one)
• As a creditor, near the front of the line in case of adverse liquidation
(after employees)

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TROUBLE IN PARADISE
• Can be a bad deal for angels
• Does a 20% discount
sufficiently compensate
for a year or two of
additional risk vs. the
Series A investors?
• Series A investors will
generally veto higher
discounts, may sometimes
resist even 20%
• Misaligned incentives vs.
founders on Series A valuation
• Founders want it high
• You want it low

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PRICE CAPS
• Solution proposed for the risk/reward and alignment issues:
conversion price
• Sets a maximum conversion price, e.g.“20% discount to Series A, not
exceeding a price per share based on a valuation of$5M”
• Most sophisticated angels post 2010 will not do uncapped converts
• Still not perfect
• Valuation negotiation with founders has come back into the
deal
• Founders have sometimes received the (bad) advice to refuse
capped converts
• This has become a contentious enough issue that early-
stage convert deals have actually begun to decline in
number again after peaking in ~ 2011
• Some VCs look at the cap and see it as a price ceiling for the A
round!

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SUMMARY
• Cheaper and easier, but:
• Without a price cap, not fair to angels
• With a price cap, not quite as easy
• Capped converts are often a good choice
• But there are also good alternatives: simplified standardized equity
terms
• Series Seed (Fenwick & West)
• Series AA (Y Combinator)
• Plain Preferred (Founders Institute)
• TechStars model documents
• Etc.

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