13 Jan

Equity vs. debt

It’s a question every startup has to answer at some point during the fundraising process: Equity or debt? In this article, we walk you through the fundamentals of each financing strategy and (while we do not believe there is a definitive answer) we explain why we prefer debt in pre-Series A rounds. And we outline a few tricks to make your debt more attractive to investors.

Before diving in, let’s review a concept crucial to this discussion: pre and post money valuation:

Valuation: Pre and post money

The ‘pre-money valuation’ is a company’s valuation prior to the injection of a financing round’s new capital, and the ‘post-money valuation’ refers to its valuation after that injection. Post money valuation = pre-money valuation + the amount of new capital raised.

 

For example, say a startup raises $1m in equity from VC’s at a $5m pre-money valuation. The post-money valuation is $6m ($5m+$1m). After the round, the VC’s will own 16.67% of the company ($1m/$6m).

 

Pre and post money valuation is more commonly referred to as ‘pre-money’ and ‘post-money’. Investors and entrepreneurs will often shorten these phrases even further: “I raised 1 at 5 pre” or “We did 1 on 5”.

 

Now that we have the basics out of the way, let’s shift our focus to convertible debt.

 

Convertible debt: A primer

 

Convertible debt is capital that begins life as debt, and converts to equity upon the next financing round. There are typically two critical points of negotiation around convertible debt: The discount rate and the valuation cap. Let’s take each in turn.

 

The discount rate is a mechanism which compensates investors who come in earlier for the increased amount of risk they are assuming (the earlier an investor gets into a deal, the riskier his investment). The discount rate ensures that when the debt turns into equity at the next financing round, the convertible investor will be offered a lower price than the other investors in that round.

 

For example, let’s say you raise $100,000 from Angel 1 in your Seed round as convertible debt with a 20% discount. This means that when Series A rolls around, and the debt turns into equity, Angel 1 will receive a 20% discount to the Series A price. So if you raise your Series A round at $1 / share, Angel 1 will get to buy in at $0.80 per share. Instead of receiving 100,000 shares for his $100,000 ($100,000/$1), he will receive 125,000 shares ($100,000 / $0.80).

 

The other key element to understand is the valuation cap (or just ‘cap’). Let’s say Angel 2 invests $100,000 at a 20% discount and a $7m cap. If the pre money valuation of the next financing round is below $7m, Angel 1 will simply receive a 20% discount to the price of the financing round, as before. However, if the pre money is above $7m Angel 1 will get to buy in at a price of $7m. So, for example, if the pre money is $14m, Angel 1 will receive a 50% discount (on a pre money basis) to the Series A equity investors.

A cap offers dilution protection to an investor. If Angel 1’s debt had a discount and no cap, and the Series A pre money end up being very high (as in the above example), Angel 1’s resultant equity stake is not (in his eyes) sufficiently proportionate to the significant risk he assumed by coming in early. Almost all convertible notes (in Silicon Valley at least) are capped.

 

Caps can get a little confusing. An easy way to remember the key mechanics is as follows: Investors want to buy in as cheaply as they can (yes, there are caveats, but forget them for now). The lower the cap the better the deal an investor gets. The higher the cap, the worse the deal.

 

These two terms are by far the most critical, and are the clauses you should spend the most time considering. That said, there are a handful of other key features of the instrument (some of which, as we discuss later, you can use to your advantage in negotiations) of which you should be aware:

 

  • Interest rate: Typically around 5-7% simple interest (not compounding). This is normally paid upon conversion into equity, or at maturity
  • Qualified financing event: The event which triggers the conversion of the debt into equity. This is typically the next round of financing, but can be other events (e.g. revenue thresholds). The convertible documentation will explicitly define what constitutes qualified financing event
  • Maturity: The date at which the debt comes due assuming no ‘qualified financing’ event. On this date, depending on how the note is structured, investors will wither receive their principal+ interest, or the note will convert to equity at a pre-determined valuation (often this valuation is the cap).
  • Principal: The amount raised under the note. You can (and frequently should) authorize more than you intend to raise, in case the round is oversubscribed or you underestimate your financing requirements. We explain further in chapter 4 of The Secret of Raising Money how to use this tactic to create scarcity

 

Equity

 

The mechanics of equity are more straightforward and intuitive to understand than those of convertible debt. The defining features of an equity round are that it confers ownership immediately and creates a valuation for the company. Let’s say a VC invests $250,000 in a company’s seed round at a $5m pre money valuation. This means that he ends up owning 4.8% ($250,000 / ($250,000 +$5m)) of the company on a post money basis.

 

There are a whole host of other economic and control terms to consider in an equity round. These include liquidation preference, option pool allocation and the allocation of board seats. Given that our purposes here are to compare debt and equity as the financing instruments for your seed round, we will not go into these in detail. We take you through all of these concepts in detail in Chapter 5 of The Secret of Raising Money.

 

So now that you have a basic understanding of the two key financing instruments available to you as an entrepreneur, which should you opt for? We’ll analyze each in turn.

 

Why debt?

 

The advantages of debt boil down to two factors: It takes less time and costs less money.

Time

Debt has fewer terms to negotiate, and requires signatures on fewer and shorter documents. The only terms an investor is ever likely to spend cycles examining in a seed round note are the cap, discount rate and perhaps the prepayment. A seed round equity term sheet, however, contains a large number of terms that investors might reasonably want to debate, most notably valuation. Other examples are option pool size, liquidation preference (both the size of preference and nature of participation), founder vesting and board seats. The list goes on and on.

If you are a first-time founder, negotiating these terms burns through time not only via endless back and forth with investors and lawyers, but also because it creates additional mental overhead. You have to not only educate yourself on how these various clauses work, but also have a sufficiently developed understanding to be fully comfortable with the negotiation dynamics. Yes: your lawyer is there to help you out here, but it’s your company, and you need to understand what’s going on.

Even when you are done with the negotiations and you sign a term sheet, there are still a host of other docs to sign and process. Not so with debt – the process is far more efficient and painless. Check out the resources section at the end of the chapter for places you can download high quality fundraising documents. And make sure you check out our Legal Document explanation pack here.

Finally, as long as the terms of the note are reasonable, convertible debt enables companies to easily do a rolling close in their angel round. That is – take in money as it comes, without having to spend the time up front getting a lead and corralling multiple investors around a single valuation simultaneously.

Cost

Since a debt round requires less negotiation, and drafting of shorter documents, it requires fewer lawyer hours, and is hence cheaper. Multiple rounds of negotiations with various investors can rack up hours on the clock pretty quickly, and your equity round can end up costing you as much as 4-5x the amount you would have paid had you raised debt.

 

Why equity?

So what about equity? Debt can produce misaligned incentives. In the case of uncapped convertible notes (even though these are very rare these days in Silicon Valley), the investor and entrepreneur’s incentives are at odds. The entrepreneur is incentivized to increase the value of the company as much as possible, since the greater the value of the next round, the lower the dilution he will incur. Conversely, the investor’s position becomes worth more as the price of the next round decreases. With equity, both parties have aligned incentives: Increasing the value of the company benefits everyone.

In addition, following the close of an equity round, the investor and entrepreneur both understand exactly how much their respective stakes are worth. Each knows where the other stands. This is especially important for an investor: With debt, an investor can’t quantify the value of his investment until the next financing round.

Fred Wilson goes into more detail on this point: “When you set the price, both sides know what deal they got. It’s locked in and they are in business together and aligned. The entrepreneur can’t get screwed later when the price drops on them. And the investors can’t get screwed later when the price jumps on them. This is a big deal. I don’t understand why folks don’t understand it”

Some, including Brad Feld, argue that a cap is equivalent to the valuation in a priced equity round, but has added downside protection for the investor. Equivalent to an equity valuation because it would be irrational for an investor to agree to a cap that is higher than the amount he would have paid in an equity round.  Added downside protection because if the next round is done at a valuation above the cap, the investor gets to pay the amount he would have agreed to pay in an equity round. If the valuation is below the cap, he gets the added downside protection via the discount. As a result, according to this line of reasoning, you might as well just raise equity.

Finally, some proponents of equity argue that the ‘cost’ argument no longer holds due to the growing wealth of boiler plate documents available online (e.g. Y Combinator, Series Seed, Techstars). These docs are designed to significantly cut down on lawyer hours.

Our take

This is not a debate with a definitive answer, which is why it continues to resurface. That said, we are pro debt. In most situations, debt continues to be the quickest, easiest and cheapest way to get dollars into the bank account. Given that you are raising this round right at the beginning of your company’s life, time and money are in particularly short supply. You should be getting this fundraise done as quickly as possible and return to focusing on what really matters: building product. This is especially true if you have no pre-existing of fundraising or finance, and running a priced equity round will entail a very steep learning curve and require significant investment of time to get up to speed.

While we agree that the boilerplate docs in theory cut down legal fees, this only holds if you are dealing with investors who are familiar and comfortable with all of their terms. Many will not be, and as soon as there are a few negotiation cycles, the cost of the round can increase (in terms of time and money) and the value of using the boilerplates as the starting point is negated. Standardized term sheets would be an awesome development. But they are only advantageous to the entrepreneur if VC’s won’t negotiate them.

If you are already well versed on the process, can land a lead + corral investors quickly, and can do so while avoiding significant negotiations, you can likely close a priced equity round as rapidly and at the same valuation as your cap had you raised a note. And you could then proceed with all the alignment and certainty that equity offers. But it’s also possible (and perhaps more likely) that you will get lost in valuation and negotiation discussions for weeks with mediocre investors, and end up with thousands of dollars of legal fees and a potentially unsatisfactory outcome.

Making your debt sexy

So let’s say you raise a convertible debt round. What are some tricks you can use to make your debt more attractive to investors? We go through a few below. But one caveat: remember that you will succeed as a seed stage startup not because you were highly innovative with financial engineering, but rather because you executed extremely well. Your priority should be to raise quickly and get back to building product. All that said:

1.    The Cap

This goes without saying. Debt with a cap is vastly more appealing to an investor than debt with no cap. In fact, in Silicon Valley the exclusion of a cap on your seed round note will considerably hamper your ability to raise money

2.    Compensation for sale before financing event

Investors want to ensure that they get a piece of the upside if your business is sold before the next financing. One way you can make sure this happens is via a clause which stipulates that in the case of a sale, their stake converts into equity at some pre-agreed price. A less attractive option would be to offer a prepayment of the investor’s principal + a sweetener (typically 50-100% of the original principal)

3.    Variable discount rates

One concern investors might have is that the qualified financing round takes longer than expected. Let’s say an angel investor is given a 20% discount to the next round. Compare two scenarios– one in which the next round takes 2 months from the time of investment, and a second in which it takes 12 months. You could argue that in the second scenario, because Angel 1 had to assume more risk (10 months more), he should receive commensurate reward. You can give him this via a variable discount rate – i.e. one that increases with every incremental X months until the next round is raised.

4.    Valuation floor

A valuation floor provides that if a company does not hit the qualified financing event, an investor’s stake converts into either preferred or common stock at some agreed upon valuation (often the price of the previous round, or a steep discount to the price of the next round envisioned when the first round’s terms were set). This floor offers downside protection to investors, as well as avoids the unpleasant eventuality of a default

While these options certainly make the debt more attractive to investor, it’s important not to waste too many lawyer cycles negotiating these points, as we did in one of our past companies. One of the advantages of debt is the speed of closing, so make sure you don’t nullify this advantage by over engineering these features.

 

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