A major advisor to entrepreneurs, working with a major law firm, has developed a new type of security that they believe is particularly advantageous in "angel" stage financings, which they call convertible equity. Many angel deals are structured as convertible debt, providing that the debt converts into the next financing at some agreed upon discount, with an alternate pre-determined valuation if no next financing occurs in a certain time.
It protects the investor's downside by providing that the money is repaid if not converted, but it generally burdens company's balance sheets with debt and results in regular confrontation between company and investor each time the note becomes due without being converted. And the back and forth on what interest rate to charge gets complicated and puts the investor at risk of being in the lending business without a license.
Convertible equity removes the debt aspect but pretty much retains the rest. It provides that you convert at a discount to the next financing automatically. If there is no next financing in a certain time, you convert automatically at a pre-determined valuation. If the company is sold, again there is a conversion, or alternatively you can provide the right for the investor to get their money back with some kind of return upon a sale.
This may not be ideal where a company is very early stage but has very valuable assets, such as intellectual property, that the investor wants to be able to grab if things go bad. This is much easier to do with a secured debt instrument. But removing debt from the books of small companies seems to make sense. Will investors go for it? We will see!
For additional insights on reverse mergers, SPACs, other alternatives to traditional initial public offerings, the small and microcap markets and the economy, visit the Reverse Merger and SPAC Blog by David N. Feldman, Esq., Partner of Richardson & Patel LLP.
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