Convertible Security
/kənˈvɜːtɪbəl sɪˈkjʊərɪti/
Discover how convertible securities work, including their transition from debt or preferred stock into company shares to provide downside protection and future growth.
Discover how convertible securities work, including their transition from debt or preferred stock into company shares to provide downside protection and future growth.
A convertible security is a hybrid financial instrument that combines features of both debt and equity. It begins its life as either a loan (convertible debt) or preferred stock (convertible preferred shares) but contains provisions allowing it to convert into ordinary shares of the issuing company at some point in the future. This conversion typically occurs during a specified event, such as your company's next funding round, acquisition, or at a predetermined maturity date.
For startups and growing companies, convertible securities offer a flexible financing option that bridges the gap between early-stage bootstrapping and formal equity financing. Investors receive the security of a debt instrument with interest payments whilst gaining the potential upside of equity conversion if your company performs well. This structure is particularly attractive during periods of rapid growth when your company's valuation might be difficult to determine precisely.
The conversion mechanism is governed by specific terms outlined in the security agreement, including a conversion price, conversion ratio, and conversion triggers. These terms determine how many ordinary shares the security holder receives upon conversion and under what circumstances the conversion occurs. Convertible securities allow both founders and investors to defer valuation discussions until your company has more traction or a clearer growth trajectory.
Convertible notes are a form of convertible debt that initially function as a loan to your company. They accrue interest over time and have a maturity date when the principal must be repaid unless conversion occurs first. Convertible notes are particularly common in early-stage funding rounds, often referred to as seed rounds or bridge financing between major funding events.
Convertible preferred stock, on the other hand, represents an ownership interest from the outset, albeit with preferential rights over ordinary shareholders. It may include features like liquidation preferences, dividend rights, and anti-dilution protection. Whilst convertible notes are simpler and faster to execute, convertible preferred stock offers investors more comprehensive protections and rights from day one.
Both instruments ultimately convert into ordinary shares, but they follow different legal and financial pathways to reach that endpoint. Convertible notes tend to be favoured when speed is essential and your company's valuation is still uncertain, whilst convertible preferred stock is often used in more formal funding rounds where detailed terms have been negotiated.
Several key terms define how a convertible security operates. The conversion price determines how many ordinary shares each security converts into, typically set as a discount to the price per share in your next qualified funding round. A valuation cap establishes a maximum valuation at which conversion occurs, protecting investors from dilution if your company's valuation increases dramatically.
The conversion trigger specifies when conversion happens automatically, such as during your next equity financing round that exceeds a certain threshold. Interest rates apply to convertible notes, accruing until conversion or repayment. Maturity dates create a timeline for either conversion or repayment, adding urgency to reaching the next funding milestone or achieving specific growth targets.
Understanding these terms is crucial when negotiating convertible securities, as they significantly impact your company's capital structure post-conversion and determine how much dilution founders experience. Each term represents a negotiation point between your desire to retain ownership and investors' need for protection and upside potential.
Convertible securities offer several advantages for startups seeking funding. They allow you to raise capital quickly without immediately setting a formal valuation, which can be challenging for early-stage companies with limited financial history. This flexibility enables you to focus on growth whilst deferring detailed valuation negotiations until you have more substantial traction and data points.
For investors, convertible securities provide downside protection through their debt-like features whilst offering significant upside through equity conversion. This balanced risk-reward profile often makes them more accessible than pure equity investments during uncertain early stages. The conversion discount and valuation cap give early believers extra reward for taking early risk.
From an administrative perspective, convertible securities are generally simpler and less expensive to implement than traditional equity rounds. They require less legal documentation and can be completed more quickly, allowing you to secure funding when you need it most without diverting excessive time from building your business.
Whilst convertible securities offer flexibility, they also come with potential complications. The accrued interest on convertible notes increases the total amount that converts into equity, which can result in greater dilution than initially anticipated. If your company experiences delays reaching its next funding round, this interest accumulation can become significant.
Valuation caps, whilst protecting investors, can create future complications if set too low. When your company achieves substantial growth, a low valuation cap means early investors receive disproportionately large ownership stakes at the expense of founders and employees. This can create misalignment between different shareholder groups and complicate future fundraising efforts.
Maturity dates create time pressure that might force premature funding rounds or conversion events. If your company hasn't reached appropriate milestones when the security matures, you may face difficult decisions about repayment or conversion terms that don't reflect your current situation. This pressure can distract from core business operations.
Convertible securities directly impact your next equity financing round through their conversion mechanics. When you raise your next round of funding, convertible securities typically convert into ordinary shares based on the terms negotiated in the original agreement. This conversion dilutes existing shareholders, including founders, but rewards early investors who took risk before the formal valuation.
The presence of convertible securities with attractive terms can sometimes complicate later fundraising. New investors will examine these instruments carefully, as they affect the price per share they receive and their percentage ownership post-investment. Sophisticated investors will factor convertible securities into their valuation calculations and may negotiate adjustments based on outstanding convertible obligations.
In some cases, convertible securities can actually smooth the path to your next funding round. They demonstrate that previous investors believed in your company enough to provide bridge financing, which can serve as a validation signal to new investors. The terms of conversion also create a minimum valuation floor that can anchor negotiations in your favour.
If a convertible security reaches its maturity date before a conversion trigger occurs, the holder typically has several options depending on the specific terms. Most commonly, they can demand repayment of the principal plus accrued interest, though startups often negotiate extensions or alternative arrangements if they cannot repay immediately.
In some agreements, the security automatically converts into equity at maturity based on a predetermined formula, even without a qualifying funding round. This avoids the cash repayment burden but may result in unfavourable conversion terms for founders if the company hasn't achieved expected growth milestones by the maturity date.
Negotiating the maturity terms requires careful consideration of your company's likely financial position at that future date. Including provisions for extension options or alternative conversion triggers can provide flexibility if your growth trajectory doesn't align precisely with initial projections.
Yes, convertible securities can coexist with various share option schemes and other management equity arrangements, though careful planning is required. When convertible securities convert, they create new ordinary shares that dilute all existing shareholders proportionally, including employees holding options or restricted stock.
To mitigate this dilution impact on employee incentives, many companies create option pools before or alongside convertible security issuance. These pools ensure that future employee grants don't face excessive dilution from conversion events. Sophisticated investors understand the importance of employee retention and often expect option pools to be accounted for in conversion calculations.
When designing compensation packages alongside convertible security fundraising, consider how conversion will affect the percentage ownership represented by employee grants. Transparent communication about dilution effects helps maintain team morale and ensures that your compensation structure remains competitive and effective at retaining top talent.
Before issuing convertible securities, founders should carefully evaluate their company's likely growth trajectory and funding needs. Consider whether you truly need the flexibility convertible securities provide or whether a priced equity round would be more appropriate given your current stage and progress.
Pay particular attention to the valuation cap and conversion discount terms, as these will significantly impact founder dilution when conversion occurs. Model various growth scenarios to understand how different outcomes affect ownership percentages. Seek legal advice to ensure you understand all terms and implications, including what happens if milestones aren't met or if fundraising takes longer than expected.
Remember that convertible securities create obligations that extend beyond immediate funding. They influence future fundraising dynamics, employee compensation structures, and overall company governance. Whilst they offer valuable flexibility, they should be approached with the same diligence as any other significant financing decision.
Convertible securities and SAFE (Simple Agreement for Future Equity) notes share similarities but have important differences. Both defer valuation to a future funding round, but SAFE notes are not debt instruments—they don't accrue interest or have maturity dates. SAFE notes represent a simpler, more founder-friendly structure developed specifically for early-stage startups.
Convertible securities, particularly convertible notes, include debt features like interest accrual and maturity dates that create repayment obligations if conversion doesn't occur. This additional complexity can create pressure on founders but provides more traditional investor protections. The choice between these instruments depends on your specific situation, investor preferences, and risk tolerance.
In Ireland and Europe, convertible notes remain more common than SAFE notes, which originated in Silicon Valley. Understanding local market preferences and investor expectations will help you choose the most appropriate instrument for your fundraising needs whilst maintaining alignment with your growth objectives and governance preferences.
