What is Convertible Equity

“What is convertible equity” is a common question among start-up businesses that need additional financing and companies that are at risk of becoming insolvent. Particularly, convertible equity, also referred to as convertible security, is debt that doesn’t require repayment when it is matured. This type of debt is a cheap and quick method for newly established companies to raise capital from investors and venture capitalists.

Convertible Debt & Equity: An Overview

Many start-up companies, approximately two-thirds, use convertible equity and/or convertible debt in their financing. Generally, the debt is a short-term note that converts to equity at a later date, once the business has raised enough money for Series A financing. Such notes might be capped at a certain amount, i.e., $5 million. This capped amount ensures that investors can benefit from any increase in the valuation of the company and obtain additional percentage in equity.

For example, assume that a corporation is formed, and during the formation stage, the company wants to obtain initial financing as it continues conducting research into what the potential valuation of the company is. This initial financing can be in the form of convertible debt whereby the corporation and those investors and venture capitalists offering funds will enter into a written agreement stating the terms and provisions of the convertible debt. Such terms and conditions could include capping the valuation of the company at a certain ceiling amount. The reason for this is because if absent from the contract, any added valuation that results need not be given to the investors in terms of equity. Therefore, the investors want to ensure that they are receiving the proper amount of equity after the company eventually secures Series A financing.

Additionally, convertible equity can be issued at a discounted price or be subject to a required conversion to equity if the owners can’t obtain additional financing within a specified period of time. Therefore, assuming that the company isn’t able to secure Series A financing after entering into the agreement with the investors and venture capitalists, these investors can either require the company repay the debt or still provide the percentage of equity based on the amount of capital contributed to the company.

Concerns with Convertible Equity

One of the concerns regarding convertible equity is that it will need to be repaid if another financing process doesn’t take place. When convertible equity was initially introduced, its purpose was to assist those companies that needed to obtain financing in between rounds of equity financing, i.e., between Series A and B. In essence, the convertible equity bridges the loans, which is why this term is also referred to as a bridge loan.

However, if an owner creates a corporation and engages in the initial financing to setup the business (obtaining convertible equity), but the company doesn’t raise enough capital, the convertible equity will convert into the last round of financing when it has to be repaid in full. With that said, most convertible equity financing has an expiration term of at least one year subsequent to the initial convertible equity, giving the company sufficient time to engage in another round of financing.

Why Would an Established Company Have Convertible Equity?

In addition to several start-up companies having convertible equity, some companies that have been in existence for several years might also find themselves with convertible equity. Some reasons for this could be:

  1. The company might be insolvent
  2. The company might owe a significant amount of money to various creditors
  3. The company might be facing a lawsuit wherein it is nearing insolvency and needs financing to recoup the funds spent on litigation

Benefits of Convertible Equity

There are two key benefits to convertible equity, as follows:

  1. Owners can postpone the valuation of the business to a later date
  2. Such contracts can be drafted and finalized quickly and at cheaper costs than an equity agreement

So long as the newly established company is properly valued, the owners should have no issues with hitting their mark, and therefore, not having to repay the debt. However, there are many companies that might fail to obtain additional financing or place correct valuations on the business, which could result in default and an immediate repayment request on the convertible equity.

If you need help learning more about convertible equity, or if you need legal help entering into a convertible debt or convertible equity contract, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law, and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.