What is Convertible Equity?

Convertible equity refers to startup financing whereby an investor obtains the rights to receive shares in the form of equity at a future date during another funding cycle instead of obtaining shares straight away. It makes it possible for startups to obtain funding without having to set a valuation.

Terms to Understand

• Valuation Cap: The highest value at which the company is valued to determine the price at which the investment will be converted, ensuring that early-stage investors will not be diluted should there be an increase in the value of the company before conversion
• Discount Rate: A rate that is discounted off the price per share in the triggering round, giving early-stage investors incentives for taking more risks
• Triggering Event: The event that triggers the conversion of the convertible security into stock
• Conversion Ratio: The rate at which the investment converts to shares

How does Convertible Equity Financing work?

Convertible Equity Financing Structure

• An investor invests money in the business against a convertible security.
• Conversion terms are provided in the structure under which the money is converted into shares based on an upcoming qualified financing event.
• Conversion results in the issuance of shares to the investor in accordance with the conversion terms, usually preferred stock.

Why Startups Prefer Convertible Equity

• Speed: The negotiations around and drafting of convertible equity documents are usually faster than negotiating a priced equity round
• Valuation deferral: Founders can avoid putting too low of an early valuation on their startups before they prove themselves out
• No upfront dilution: Until conversion takes place, there is no issuance of shares and no change in ownership
• No payment obligations: Unlike loans, there are no interest payments or obligations to pay back the funds that are invested

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