Angel investing · Startups

Should I give my investor an option to convert unpaid roylaties to equity?

Ken Huling Animator at Blue Sky Studios

July 28th, 2016

I'm negotiating with my angel investor right now. We agreed to paying his investment back in royalties per customer until he has doubled his money. He's asking about an option to convert unpaid roylaties into company equity. How would this work? It seems unnecessarily complicated to me. I'd prefer to just go with one or the other up front but I'm new to entrepreneurship so maybe it's not as bad as I'm seeing it. One thing I love about the royalty deal is that it doesn't require a lengthy valuation discussion.
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Steve Everhard All Things Startup

July 28th, 2016

Right now your deal sits as a debt on the business with defined payment terms. I imagine issues of default have been built into the agreement to avoid personal liability if the business doesn't make it? Does he get the royalty whether or not the company is making a net profit? If income from sales is subject to a royalty regardless of the state of the business finances it has no tax value. I can't see it putting off another investor either as it is a standard debt repayment but with an open term based on company performance.

The good news about the offer is that your investor now sees upside to the business that they didn't see before as the deal has to deliver more than 2x the money to make sense for them. Converting to equity moves the debt off the books, and your repayment isn't subject  to tax when paid from profits. Does that materially affect your situation? It really depends on the royalty rate and how that is triggered. If the repayment rate is low then I would try and link an equity conversion to a top-up investment whilst they are hot to go. If they don;t go for it there is little downside to leaving things as they are. If the rate is high you are more disposed to get it off the balance sheet so you might not drive such a hard bargain.

Prem Bajaj Chief Advisor at PB Corp Advisors

July 28th, 2016

this sounds like Kevin's scheme right out of shark tank.... not a straight forward answer - depending much on your comfort levels with the investor, his intentions of continued support, your comfort of incremental payout (now that its turning to equity, he gets all future upside!), and and additional funding that may be required, and so on. Bottom line summary - if investor commitment has been met fully/satisfactorily, keep it simple, and restart with a fresh formula/equation on the future. Keep the equity to oneself

Martin Omansky Independent Venture Capital & Private Equity Professional

July 29th, 2016

Two issues here: valuation and conversion. I generally advise conversion because (a) the investor and the management have the same interests in mind, and (b) unpaid royalties show up on the balance sheet as a company obligation, which devalues company's stock, and (c) start-ups need all the cash they can get. Conversion: this is a math exercise. If the royalty payment is low, you might not want to convert at any price; if you do, there are published guidelines on what is a fair conversion rate. Your angel may not agree with the rate. However, get used to valuation discussions - you will be dealing with them eventually anyway. Sent from my iPhone

Irwin Stein Very experienced (40 years) corporate,securities and real estate attorney.

July 28th, 2016

There is no easy answer for this and no answer is right for everyone. Hire a lawyer to advise you.  Watch out for potential tax issues.

Laura Oliphant Business Development and Venture Capital Professional

July 29th, 2016

I would agree with Martin, and add that the unpaid royalties/loan show up on the balance sheet and are a negative if you should happen to want (you say that you don't need) future funding.  You really should consult a corporate attorney, and I would also advise that you take a look at the book "Venture Deals: Be smarter than your lawyer and venture capitalist" by Brad Feld and Jason Mendleson.

Leslie Roth Owner, Great Fabrications

July 29th, 2016

This sounds like the investor believes in this project and has thrown out a preliminary offer to demonstrate that. It seems simple enough to go to the next step. If you concur, I am sure you will take it to a attorney. Your investor appreciates an uncomplicated process as demonstrated. Your next step with him would be more complicated. Good luck! Leslie Deane Roth

Ted Weverka License Manager

July 28th, 2016

If you anticipate further investment, you could offer that this early investment converts to equity in a later round at a modest discount.

Richard Reed

July 28th, 2016

Hi Ken, without knowing the details of the proposed investment, it would be rare for an experienced investor to not ask for the right to equity for his investment. Whatever the vehicle you are using for the investment, such as a convertible note, it will typically have a provision that the company will issue stock on the principal value of the investment (including any accrued interest) at the time that a round of financing is closed, or as a secondary provision that the company can pay back the investment instead of issuing equity. While convertible notes may be issued without a final valuation set, as that is typically set when an institutional investor participates, the investor will want to have a very informed understanding of what the likely valuation will be, otherwise it wouldn't make sense to participate. So even in the case where you are able to pay out your investor, you and he still need to have an understanding on what the likely valuation will be. Assuming you do that, and you are able to agree on a cap on the valuation, then I don't see the issue with the investor converting his investment into stock.

Ken Huling Animator at Blue Sky Studios

July 28th, 2016

Since profit margins are strong in this business I don't anticipate another round of investment. I would prefer to retain 100% equity so I'm leaning toward offering a higher percentage royalty instead. Maybe the debt to equity conversion could be used as a fail safe if we struggle to repay the investment within a specified time.


Joe Valof Independent General Counsel [IGC]

August 2nd, 2016

Ken, my 2 cents: in a closely held non-public corporation, which I assume you are, officers and directors have a duty of care and loyalty to the company and its shareholders. In Massachusetts [my jurisdiction] we are also governed by a very old Ma Supreme court lawsuit called the 'Donahue doctrine' which states that all shareholders must be treated equally, meaning that what you do as a shareholder all your shareholders also have the same rights. It was a very expensive lawsuit for the founder. Any shareholder can sue an officer or a director for a breach of its obligation of loyalty, so the less stockholders one has the less risk and opportunities for a lawsuit. If you can handle the royalties my suggestion would be to continue them and not go with any equity. I prepared a compliance/ethics guide for officers and directors outlining their obligations and risks that you may find interesting. If you would like a copy send me an email off line. joe