The most common forms of investment in early stage business are convertible debt and preferred equity. Common stock can also be issued, but in general investors who want equity choose preferred shares because it gives them certain rights that are not shared by the common stock, both in regards to the company and in the case of a follow-on capital raise.
Preferred stock is a new class of stock issued by the company which is given certain rights apart from the company’s common stock. This can include a dividend right, liquidation preference, conversion rights, pro-rata rights, etc. It is equity and the shareholder has ownership rights in the company (and is owed corresponding fiduciary duties by the board and management).
On the other hand, convertible debt what it sounds like – debt which is convertible into equity at some later point in time. The angel then receives a discount on the conversion price to reward their risk. If all goes according to plan, the conversion generally takes place upon receipt of the next round of funding. The debt can feature many corollaries to the bells and whistles given to preferred shares noted above. While the intention is for the debt to convert, and many investors think of it as quasi-equity, until it converts it is debt, and needs to be treated as such (with attendant fiduciary duties from the board and management).
The biggest benefit to using the convertible debt model is that it allows for the investment to be made without the company and investor coming to an agreement on a valuation. As an example, I did a convertible debt deal a month ago where the investor made an investment of $200,000 into a startup with a 20% discount. The debt will convert upon the startup raising $1m within the next year. What this means is that upon that startup receiving its next material round of funding, the angel will receive $250,000 ($200k with the 20% discount) worth of shares at the pre money valuation agreed to for that next round, and on equal footing with the new investor (i.e. same class of shares).
In that previous deal, the company believed its valuation to be $5m, but the investor thought it was closer to $3m, and as with all these very early startups, there was no definitive way to break the logjam. Using the convertible debt model, the investor was able to invest, and by the time the next round happens, more information will be available to the company and the investors and that new valuation should be a better reflection of the actual value of the company.
The downside to using convertible debt is that it increases the risk that one party is going to get a sweeter deal than intended. Continuing with the example above, if the Company receives a valuation of $20m, the investor would have been better off doing a preferred share deal at any valuation below $16m (the effective valuation of the original investment reflecting the 20% discount). As discussed, a cap can be put in place to shift some of this risk from the investor to the founders, but it cannot be wholly mitigated without agreeing on a current valuation, which negates the point of doing a convertible debt transaction. The cap is also not without a downside, however, as future rounds may view it as a cap on valuation – for that reason it should never be told to a future potential investor before they make an offer. It should be noted that the above-mentioned deal did not contain a cap, and my understanding is that they are not as common as they were circa 2010.
If the parties can agree to a valuation that is a good representation of the value of the company, doing a series seed deal issuing preferred shares makes more sense. Giving equity gives the angel the full upside for the risks he is taking. If the valuation is high, however, it also gives the angel the full downside. For example, if a company is initially valued at the seed stage at $6m, but the next round is done with a $4m pre-money valuation, the equity investor sees an immediate 33% decrease in the value of his investment. If the valuation is too low, the angel will end up owning a disproportionately large percent of the company compared to the founders, which acts as a disincentive, and limits equity available for bringing on future talent.
Finally, doing a convertible note deal is simpler and cheaper from a legal costs point of view, but the cost difference is not so great that it should be outcome determinative.