What is Convertible Equity?

Convertible equity (also called a "Simple Agreement for Future Equity" or SAFE) is a financing instrument that gives investors the right to receive equity in a company upon the occurrence of specific future events, typically a priced equity round.

Unlike convertible debt, convertible equity:

• Does not accrue interest

• Has no maturity date

• Does not need to be repaid if no qualified financing occurs

• Is not legally considered debt on your balance sheet

How Convertible Equity Works

Here's a simplified breakdown of the convertible equity process:

1. Initial Investment: An investor provides capital to your startup in exchange for the right to receive equity in the future.

2. Conversion Event: When a triggering event occurs (typically a Series A funding round), the convertible equity automatically converts to preferred shares.

3. Conversion Terms: The number of shares the investor receives is determined by:

   • The valuation cap (maximum company valuation for conversion purposes)

   • Potential discount (typically 15-25% off the price paid by new investors)

Example of Convertible Equity Conversion

Let's walk through a practical example:

• Initial Investment: $500,000 convertible equity note

• Valuation Cap: $5 million

• Discount Rate: 20%

• Later Series A Round: $10 million pre-money valuation with shares priced at $2 per share

Conversion Calculation:

1. Price per share based on valuation cap: $5M ÷ (total outstanding shares) = $1 per share

2. Discounted Series A price: $2 × (1 - 0.2) = $1.60 per share

3. Investor receives shares based on the more favorable term (lower price): $500,000 ÷ $1 = 500,000 shares

In this scenario, the investor would receive 500,000 shares, representing 10% of the company's equity post-conversion.

Convertible Equity vs. Convertible Debt

When to Use Convertible Equity

Convertible equity may be ideal for your startup when:

1. You're pre-revenue or early stage: When traditional valuation methods are difficult to apply.

2. You want to defer valuation negotiations: When you and investors prefer to wait for more data points before setting a valuation.

3. You need quick access to capital: When you want to avoid lengthy negotiations over complex term sheets.

4. You want to avoid debt obligations: When you prefer not to have debt on your balance sheet or worry about repayment obligations.

Accounting for Convertible Equity

From an accounting perspective, convertible equity is typically classified as:

• Temporary Equity: Not quite liability, not quite permanent equity

• Mezzanine Financing: Recorded between liabilities and equity on the balance sheet

• Contingent Equity: Potential future ownership that depends on specified events

Proper accounting for convertible equity is crucial for financial reporting, tax planning, and future fundraising efforts. Using accounting software that properly handles these instruments, like Timber, can save significant headaches down the road.

Tips for Negotiating Convertible Equity

1. Focus on the valuation cap: This is typically the most important term as it sets the maximum price for conversion.

2. Consider discount rates carefully: Higher discounts benefit investors but can dilute founders more significantly.

3. Watch for "pro-rata" rights: These give investors the right to maintain their ownership percentage in future rounds.

4. Clarify conversion triggers: Be specific about what events will trigger conversion.

5. Understand dissolution scenarios: Clarify what happens if the company is acquired or shuts down before conversion.