I think the question at this point in time should be, “Why would an early-stage investor prefer a convertible [debt] note structure to a convertible equity?”
Simply because convertible notes are used by the majority of early-stage investors doesn’t mean that they actually “prefer” them to equity.
The reason why convertible instruments have been overwhelmingly used in lieu of obtaining a straight equity position is principally for two reasons: (1) they expedite the early-stage funding round by reducing legal expense and simplifying the overall process, and (2) they kick the valuation can down the road to later funding rounds when the company’s valuation can more accurately be determined.
For example, I can write a convertible debt note in just a few pages; however, if I need to draft a straight equity agreement, then more time is required in order to perform all of the needed due diligence, assess valuation, ensure SEC compliance and negotiate. Consequently, I’ll need to draft longer and more numerous documents in order to represent as thoroughly as possible all of the investors’ rights, obligations, terms and conditions.
Put simply, it’s a more painstaking and expensive process at a time when early investors don’t want unnecessary delays and companies don’t want the disruptions; they’re anxious to pull the trigger to get operations moving with minimal distractions.
However, there’s a hybrid option that’s been available for the past three years. Convertible equity was unheard of until just a few short years ago. After Adeo Ressi pioneered the new instrument in 2012, Y Combinator caught on a year later in 2013, with 500 Startups following suit in 2014.
You can learn more about convertible equity in a piece I recently wrote. The thumbnail sketch is basically that these new financing mechanisms offer early investors the opportunity to convert their loans to equity quickly and inexpensively in the same way that convertible debt does, but without the maturity date and interest accumulations – or the threat of near extinction.
The largest challenge with traditional convertible notes is that if the maturity date is reached without securing the next round of funding, the note can be called for repayment. Without financing to repay the loans, investors holding convertible debt notes can force a company into bankruptcy.
Convertible equity solves this problem by eliminating interest and maturity dates, while still providing for automatic equity conversion upon successfully completing the Series A round of funding.
Moreover, some tax advantages could be available to convertible equity holders since it appears that they’ll be characterized as qualified small business stock, resulting in a lower capital gains tax.
If you have additional questions about which financing structure makes the most business sense to your startup, please check out. Also, don’t hesitate to message me directly with any follow up questions.
Hope that helps!