Equity, debt and the grey zone in-between

Marc Penkala
8 min readAug 27, 2017

“Being an entrepreneur is like jumping out of an airplane while building your parachute on the way.“

In order to survive this extraordinary journey you will probably at some point have to raise venture capital. It’s surely not easy to pick and choose the right course of action when it comes to capitalizing your own start-up, especially as a first time entrepreneur. Even serial entrepreneurs tend to tap into financing pitfalls, the playground kind of seems like a vast minefield designed by a mean VC commander to lead entrepreneurs astray, which results in:

A competitive advantage for the VCs on their home turf.

Entering the VC shark tank will immediately expose you to a unique vocabulary, people will be talking about liquidation preferences, dilution, participating preferred, distribution waterfalls, valuation caps, pari-passu et cetera.

And all you seek for as an entrepreneur is money to kick-start your start-up — you didn’t aim to learn a complete new language! Still it’s part of the game, wether you like it or not. Aside of this new and complex language, you will have to find the right investment instrument to finance your start-up.

Lets take a closer look at the common ones:

In general we should distinguish between two different types of investment instruments for start-ups to finance their growth. Debt and equity and of course the grey zone in-between.

Debt instruments usually represent fixed obligations to repay a pre-defined amount of money at a specific date in the future, including the accrued interest — Of course there are certain exceptions.

Equity instruments generally represents ownership interest, which is usually entitled to dividend payments, if declared. Though, without a right to a return on capital.

The grey zone in-between including SAFE (Simple Agreement for Equity) and KISS (Keep It Simple Security) instruments. They are surely no debt instruments, as they do have clear equity characteristics, still I would put them in the grey zone — Especially due to the accounting perspective.

Each instrument has a wide variety of rights and privileges, as well as certain limitations, which might be established by the actual issuer.


It might be important to explain the main difference between common stock and preferred stock, which is highly relevant when it comes to equity investments.

Common (or ordinary) stock is the most fundamental form of equity. It stands for an ownership interest in a company, including interest into declared dividends, as well as an interest in assets distributed upon dissolution. Though, common stock holders bear the risk of loss, as they are generally subordinate to all other creditors and preferred stock holders.

Advantages i. Voting rights ii. Rights to residual profits iii. Higher degree of control (BoD and voting rights)

Disadvantages i. Last in liquidation ii. No guaranteed returns iii. No conversion option to preferred

Preferred stock is an alternative form of equity, which has preference rights over common stock holders e.g. when dividend payments and liquidating distributions are made. Preferred stock is like a hybrid between a bond and common stock. Preferred stock is entitled to some of the best of both types of investments, but they also get the drawbacks.

Advantages i. Preference over common stock in liquidation ii. Preference over common stock dividends iii. Conversion option to common stock

Disadvantages i. Subordinate to debt in liquidation ii. Stated dividends might be skipped iii. (Usually) no voting rights

There are specific types of preferred stock i. Cumulative: Granting the right to accumulate dividend payments ii. Non-cumulative: Not entitled to receive payments for skipped dividends iii. Participating: Entitled to receive higher than normal dividend payments iv. Convertible: May be converted into a specified number of common stock.

So what’s the better deal after all?

Well, it depends on the risk profile of the investor and on what the entrepreneur is willing to offer. VCs will usually seek for (participating) preferred stock with a conversion option, anti-dilution provisions and of course preemptive rights — They will at all times try to maximize their returns, while having the highest degree of security.

Lets highlight the core elements of the myth-enshrouded liquidation preference.

A liquidation preference more or less governs how a company distributes the proceeds from an exit, merger, dissolution, or any other liquidation event. The liquidation preference entitles preferred stock holders to receive distributions before common stock holders and of course other series of preferred stock with a lower preference priority. Entrepreneurs, as well as VCs should pay careful attention, while negotiating these terms.

The key components of liquidation preferences are i. which type of transaction triggers the liquidation preference ii. the actual amount of the initial preference and iii. whether preferred stock participates with common stock or not.

Lets take a closer look at the three most common types of participating preferred stock.

Non-participating preferred stock doesn’t receive distributions along with common stock and is only entitled to the initial liquidation preference. The only way for holders of non-participating preferred stock to receive a return beyond the initial liquidation preference is to convert into common stock.

Participating preferred stock (subject to a cap or return multiple) receive the initial liquidation preference distribution, holders of a series of preferred stock with a capped participation feature will share in the liquidation proceeds on a pro rata basis with common stock until the agreed upon return cap is reached.

Fully participating preferred stock receives the initial liquidation preference, holders of fully participating preferred will share in the remaining liquidation proceeds on a pro rata basis with common stock holders. As there is no cap, there is no dead zone of indifference either.


Debt instruments (notes, bonds and debentures) are entitled to receive payments, which have seniority over preferred and/or common stock. Debt instruments may be secured or unsecured by certain assets of the company. They usually have no right to participate in the value appreciation of the company, though they carry variable or fixed interest rates.

I would like to take a closer look at convertible notes (C-Note), which is rather common in an earlier stage, when the value of the company is fairly uncertain and hard to predict. Agreeing upon a valuation is rather art than science at that stage. Furthermore, C-Notes are commonly used in bridge rounds, in order to bridge a shorter gap between equity rounds.

A C-Note is a form of debt, though it does not necessarily imply regular payments to pay off the debt, it is overall aimed to convert the amount of the note into equity, at some point in the future.

Common terms of a C-Note are:

Discounts might be granted as it’s not fair for early investors to convert their investment at the exact same valuation as future investors — This is due to the higher risk they are exposed to. Therefore, convertible note investors receive a discount against the future valuation upon conversion in the ballpark of 15% to 30%.

Valuation cap, as the companies valuation may skyrocket, it would be highly unfair to the convertible note investor to only profit from a discount. Therefore, it is common to set a valuation cap to offset his risk. Though, discounts and valuation caps can’t be combined, if both are applicable one would choose the better alternative.

Interest rate, a convertible note carries an interest rate as well. The interest accrues until either the conversion takes place or the note is paid off. In order to convert the note, the interest is added to the investment before to calculate the amount of equity.

Conversion trigger, there are several triggers from maturity to the amount of money raised in a future equity round also called qualified transaction, whichever comes first.

Maximum authorized amount/capital describes the limit on how much can be raised, its also called the aggregated principal amount.

Early exit multiple within a change of control event the C-Note investor usually receives a 2–3x early exit multiple, instead of his initial investment plus the accrued interest. An alternative option is to convert at the valuation cap.


The SAFE (Simple Agreement for Equity) had been developed early 2014 and was rolled out to Y Combinator companies, right after that 500 Startups introduced the KISS (Keep it Simple Security), both are no debt instrument. They come in a variety of forms, most common is a valuation cap with no discount, just a small fraction has some form of discount as well.

There are small but very important differences between a SAFE/KISS and a C-Note. The SAFE/KISS has no maturity date, no interest rate and no issue with lending laws (some states, including California, require lenders to have a lending license).

Lets compare a SAFE/KISS to a C-Note.

As both instruments are convertible securities all parties intend to convert to a preferred equity class at some point. Both instruments offer the investor the better of the discount or pre-negotiated valuation cap. A SAFE/KISS usually only returns a 1x or a conversion at the valuation cap compared to a 2x or higher in a C-Note in case of an early exit payback in a change of control event. Usually a C-Note stipulates a minimum amount to be raised in a future equity round to trigger the conversion of the qualifying transaction. SAFE/KISS instruments convert with any amount raised in preferred equity. SAFE/KISS neither have a maturity date (one main reason why they are not considered as debt), nor an interest rate, C-Notes do.

But remember:

“Raising venture capital is the easiest thing a startup founder is ever going to do.” — Marc Andreessen

Any thoughts or questions? Reach out! Want read more?

The Angel Performance Playbook

Modern Entrepreneurial Fraud

Schrödinger’s Valuation Problem

Maximizing Fund Distributions

Cap Table Madness

Venture Capital Fund(amentals)

KPI <kē pərˈfôrməns ˈindiˌkātər> Hunter

About myself

I am a passionate and hands-on venture capitalist (+5y), entrepreneur (+7y), mentor and angel investor. After 5 years of flying over 1.000.000 miles, spending 1.200 hours on airplanes, looking at 1.000 start-up pitches on all continents, I decided to gather some of my thoughts based on this extremely rewarding professional journey at Mountain Partners. Reach out!

Sources, which were fairly helpful:


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Marc Penkala

Venture Capitalist @ āltitude | creating better access, earlier.