Wow! Now there’s a sexy topic of a blog post I probably never thought I’d find myself ever writing. Over the past week however, starting with a tweet from Paul Graham of Y-Combinator, a debate has been raging about the form the capital should take in early startups. Paul says in the tweet that all of the Y-Combinator investments in this round have been convertible notes and announces that this form of funding has won.
Plenty of other experts have chimed in with their views, so I thought I’d take a few minutes and try to give a pretty simple breakdown of what the options in play here are.
First of all, there is traditional equity funding. In the most basic sense an investor invests money into the company, the shareholding of existing shareholders dilutes and the company gets an increase in capital. Where it takes on a bit of a life of its own in the Angel funding space is with regards to “risk vs reward”. The investment in early startups is always “Preferred Equity”. Again, in the most basic view, Preferred Equity, in sale event gets paid back first (sometimes with a multiple against it) before common shareholders get paid. Often times there are other “company control rights” that come with Preferred Equity – for example, setting the CEO’s salary, issuance of more shares, etc. Preferred Equity always has the ability to convert into common shares in an advantageous way.
Next there is Convertible Debt. In its most basic form, a Convertible Debt is a loan made to the company which allows the debt holder to convert that debt into equity in a future round of funding. There are parameters around this type of conversion, so usually there is a discount rate for the debt holder on a per share basis, but there is almost always a cap on the value of the discount. Alternatively, the debt holder could request that the debt be repaid rather than receive equity.
So why is Convertible Debt winning? I’m not an expert, but it would seem that it is easier and cheaper without all of the legal costs which in a small round of funding can really eat into the equity raised. For a more thorough analysis, I refer you to a post by Seth Levine, a very highly regarded VC from the Foundry Group in Boulder, Colorado.
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