Evaluating Deal Terms in Crowdfunding Investments: Part 2

Convertible Debt and Future Equity

All Americans, regardless of income or net worth, can invest in shares of startups and fast-growing small businesses through equity crowdfunding platforms. Offering terms vary from one crowdfunding investment to another. Deal terms for a seed-stage, pre-revenue start-up may differ from terms for a growing, established company, for example.

The SEC issued Regulation CF in 2015 to establish rules for operating these platforms. In 2021, more than 500,000 Americans invested $570 million in more than 1,500 Reg CF offerings, according to Crowdfund Capital Advisors. Reg CF contains strong consumer protection and anti-fraud provisions, and equity crowdfunding has been relatively free of fraud since the regulation launched in 2016.

If you are new to private securities, you might not be familiar with the terms of an equity crowdfunding deal – your rights, obligations, and restrictions. In a previous article, we explained the most important terms of “straight equity” deals, including stock and LLC offerings. In this one, we will look at two different kinds of Reg CF deals:

• Convertible debt, a hybrid of equity and debt
• Future equity, a fairly new warrant-like security, formally known as a simple agreement for future equity (SAFE)

I. Convertible Debt, the Hybrid Security

Whether issued by a corporation or an LLC, convertible debt starts out as a loan to the company from investors in the form of a note that can be traded later for shares of stock or LLC units. Some convertible debt notes give investors the option to convert to equity. Others require investors to convert, typically on the occurrence of some specific future event that involves a valuation and/or transfer, such as a round of equity financing. When properly structured, convertible notes give investors the best of both worlds: liquidation preferences if the company becomes insolvent and capital gain if the company grows and is acquired.

The most important items on the term sheet relate to when (under what circumstances) the debt can convert to equity, and how the conversion price per share will be determined. In other words, the amount of equity you will get for every dollar you invested if and when the conversion happens.

The ultimate objective for investors when they buy into the deal is to end up with equity instead of debt.

Drilling into the Variables

The basic mechanics of convertible debt are easy to understand, but then the variables can get complex. Let’s say you invest $1,000 in Startup City, Inc., as an equity crowdfunding deal whereby the issuer promises to pay you x% interest monthly and repay your principal in three years. If at any point before the maturity date (within three years), a group of angel investors or a VC fund invests in Startup City, you have an opportunity to convert your $1,000 note, plus accrued interest if any, into Startup City stock. If an angel or VC wants to buy stock, they believe the company has strong growth potential.

But how many shares will you receive for your $1,000? Looking at it another way, what is the price per share at the time of conversion? That is the primary question to be answered in the convertible note. This is where it gets complicated.

When you invested, the valuation of the company was not discussed. The valuation was probably difficult to calculate then because the company did not have revenue or other metrics to support the calculation. And that is the beauty of convertible debt for entrepreneurs: The company can attract investors without having to propose or negotiate a valuation.

About Pricing

The deal you made when you invested did not specify a conversion price per share because it was impossible to forecast another round of financing or how well the company would perform in the meantime, and, thus, what price per share later investors would agree to pay. And price is ultimately based on valuation.

The price per share that you (and other early, convertible-debt investors) pay to convert is derived from the price that later, straight-equity investors pay when they buy straight equity.

Let’s say this later round of investment comes two years after you invested. Startup City has become profitable, and the new investors agree to pay $1 per share of preferred stock, valuing the company at $4 million. Would you be satisfied paying $1 per share for 1,000 shares? Heck no.

Early investors took a much greater risk than later investors, investing when the company was not yet profitable. You should be rewarded for taking a big risk and providing seed capital when the company wasn’t attractive to angel investors. You should not be penalized by having to pay as much for stock as the angels who waited for the risk to subside. This fairness issue is typically resolved in one of two ways: discounts and caps.

• Discounted convertible note. One way to reward early investors is by discounting the price they must pay to convert when later investors buy stock. The convertible note states in its list of terms that you can convert debt to equity at a discount in a subsequent round of equity financing. Discounts are typically 10% to 30% of what new investors agree to pay per share. In the Startup City example, if your convertible note has a 20% discount, you could convert to stock at 80 cents per share.
• Convertible note with a cap. Early investors can convert to stock just before a round of equity financing. The stock price is calculated on a hypothetical valuation. Capping that hypothetical is an early-bird effective reward. In our example, if your convertible note caps the valuation at $2 million, then you would pay half the price per share compared to later investors who value Startup City at $4 million. Since the company was probably worth no more than $1 million when you invested, this seems like a fair deal.

The two terms can be combined as a discounted convertible note with a cap. But if these discounts and caps are carelessly planned, they may be too advantageous to the investor. That could backfire for the company. The discount might be too high or the cap too low. Therefore, future angel investors — and especially VC funds — would balk at investing alongside crowdfunding investors who get inordinate bargains with the same rights and a remarkable difference in valuations. Alternatively, later equity investors will want a bargain, too.

It’s a Mixed Blessing for Issuers

The company is profitable, its valuation has soared to several million, and VCs want to invest.  However, a large group of earlier equity crowdfunding investors are ready to convert at a much lower valuation (and a much lower stock price), which scares the VCs. For this reason, some convertible debt offerings allow the issuer to pay off the note with interest at any time. That eliminates the investors from the seed round, clearing the way for a Series A round.

For seed investors who bought convertible debt, assuming the interest rate is high enough (which it certainly ought to be), an early payoff is better than parking that money in a savings account, but the original objective of owning equity in the company will be defeated. Before you invest in a convertible note, make sure the interest rate is sufficient to make you happy in this payoff scenario. You can specify in the deal terms that the issuer may not pay off the loan before the maturity date without the consent of a majority of investors. After all, if your objective is to earn good interest on your savings, you — that is, nonaccredited and accredited investors — can safely invest in debt-based crowdfunding deals, also known as peer-to-peer lending.

Series A investors might establish a valuation less than the cap specified in seed investors’ convertible notes. In this case, the seed investors are happy (although the issuer is not quite as happy) because their conversion price is nice and low.

These scenarios where the company becomes profitable, grows quickly, and attracts Series A investors, are not the only possibilities, however. Two equally likely scenarios are

1. The company does not become profitable enough to attract angels or VCs, and the conversion event does not occur before the loan’s maturity date, so the convertible-debt investors merely get paid off with interest.
2. The company is not profitable at all and can’t pay off its creditors. The convertible-debt investors may have senior status over other creditors but may or may not receive payments, depending on the company’s financial condition.
3. The worst case, of course, is that equity crowdfunding investors lose most or all of their investment.

One key to a successful convertible debt investment is assessing the possibility that the issuer will, if the business is successful, attract future rounds of straight-equity financing. Without that possibility, it’s just a loan.

II. Future Equity

Y Combinator, a well-known tech accelerator, created the SAFE note (simple agreement for future equity) in 2013 and uses it to fund most of the seed-stage startups in its three-month development sessions. Since 2005, Y Combinator has funded more than 2,000 startups with a combined valuation of over $100 billion. They include Dropbox, Reddit, WePay, Airbnb, Scribd, Weebly, WePay, Coinbase, and Instacart.

The SAFE is something like a warrant entitling investors to shares in the company, typically preferred stock, if and when there is a future valuation event (i.e., if and when the company next raises “priced” equity capital, is acquired, or files an IPO.)

Outside of Y Combinator, the SAFE is being scrutinized and used by startups in the equity crowdfunding markets. In 2020, non-convertible notes (e.g., SAFE notes and KISS notes) used by pre-funding companies are just as prevalent (58%) as convertible debt notes issued. As early-stage companies become more familiar with the SAFE, this young security may find its ideal niche in Title III offerings, also known as equity crowdfunding for all investors.

Depending on the terms of the SAFE, it is possible that the conversion event is never triggered. If the triggering event doesn’t happen, you could lose your entire investment.

Founders Love It

SAFEs are attractive to founders, especially at the pre-revenue stage.

• They’re very simple. The founders don’t have to hire a lawyer to draft the agreement (although I wouldn’t discourage them from getting legal advice). Y Combinator released four versions of the agreement in December 2013, each is five pages plus signatures. Issuers can adapt. Inexperienced angel investors enjoy simplicity, too.
• As in convertible debt, issuers and investors need not agree on a current valuation or share price. Those numbers are fixed later in a liquidity event, presumably when the company has more revenue. At that point, the company may be in an acquisition or IPO or in a priced-funding round with more sophisticated venture investors.

But be aware that as a start-up business issues more SAFE shares, founders are left with fewer shares, which could be unappealing to venture capital investors in later funding rounds. Use them with restraint.

How is a SAFE Note Similar to a Convertible Note?

In addition to lacking a valuation requirement, SAFE deal terms can include valuation caps and share-price discounts, similar to convertible debt. Caps and discounts give early crowdfund (CF) investors a lower price per share than later venture capital (VC) investors or acquirers in that liquidity event. Earlier investors take more risk than later investors in pursuit of the same equity.

Unlike convertible debt, there is no debt with a SAFE. There is no maturity date either, which means investors have to wait an unspecified amount of time before they can get their hands on the equity they bought. In fact, they may never see that day.

Investor Protection

On the surface, a SAFE note offers investors less protection than convertible debt. Investors should be generously rewarded for such a sacrifice, right? The magnitude of the reward depends entirely on low caps and/or high discounts since those are the only variable terms — a feature of the SAFE note’s exquisite simplicity.

Experienced angel investors are skeptical about whether issuers will offer sufficiently generous discounts. Seed-stage investors take a greater level of risk compared with later-stage investors, so sophisticated angel investors see a 10 or 15% discount as not much reward. I personally wouldn’t settle for less than 50%. That would represent a 2x valuation jump from the CF round to the liquidity event, quite reasonable when the time between events is indefinite.

Drilling into SAFE Terms

The SAFE note was originally drafted by Carolynn Levy, a lawyer, and Y Combinator partner. Here are the most important terms:

• Along with valuation and share price, many terms of the equity agreement — including distribution preferences, anti-dilution mechanisms, conversion from preferred to common stock, protective provisions, and other details — are deferred to the future liquidation event.
• If the issuer is unsuccessful and dissolves the business before there is a liquidity event, SAFE holders may receive their investment back (without interest) before distributions to company stockholders, if cash is available for that purpose.
• Often the SAFE holder’s liquidation preference is equal to the original SAFE investment even if later investors get a higher liquidation preference for the same preferred stock equity. For this reason, SAFEs are said to convert into “shadow preferred” stock.
• Some SAFES provide that in the event of a merger, acquisition, or IPO, a SAFE holder may convert the SAFE into shares of common stock rather than preferred stock, calculated based on the valuation cap. Or, a SAFE note holder may opt to get the original investment refunded.
• SAFEs, unlike current equity stock in a company, do not give investors voting rights in the company, though there are some instances in which investors may have a voice in regard to the SAFE.

Compromise?

You naturally wish for deal terms most advantageous to investors. But remember that more advantages for you often mean more disadvantages for the issuer. You don’t want to put the company in a very disadvantageous position. In fact, you want it to have advantages. The company is then flexible enough to make smart strategic decisions without undue constraints and demands by investors. The best deal is always a compromise between your interests and the issuer’s interests, meaning both parties’ interests should be aligned.

We think you’ll also like:

1. Evaluating Deal Terms in Crowdfunding Investments Part 1: Straight Equity
2. How to Target Equity Crowdfunding Deals

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):

1. Crowdfunding from the Investor’s Perspective
2. Crowdfunding from the Start-up’s Perspective
3. Crypto, Crowdfunding, and Other Crazy Concepts

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