Start-up savior? Killing convertible debt

August 31, 2012, 9:00 PM UTC

FORTUNE — One of the secrets of Silicon Valley is that a large number of start-ups raise their first round of funding in the form of debt, rather than as equity. It’s the old convertible notes that used to be used as bridge loans for more mature companies, but which got adopted after the financial crisis by a new crop of angel investors.

“By last year almost 50% of angel deals were convertible debt,” says Adeo Ressi, CEO of The Founder Institute. “It turns start-ups insolvent by day one from a balance sheet perspective.”

So Ressi teamed with Wilson Sonsini attorney Yokum Taku to find a solution. What they came up with was something called “convertible equity.”

The idea is inspired by Sequoia Capital, which has quietly been participating in “capital contribution rounds” through its scouting program. It’s basically an equity investment at a future value, like an option with a present-day purchase price. Unlike convertible debt, there is no repayment requirement for the issuer. Here’s a sample term sheet.

That last part may make angel investments a bit more risky, although most start-ups that can’t raise Series A funding (i.e., the conversion round) are unlikely to have enough cash on hand to repay the loans anyway. And, by calling it equity instead of debt, this new structure empowers angel investors in certain states that require lender licenses.

“It’s ridiculous that the primary way to ‘invest’ in start-ups is to straddle them with debt through short-term loans,” says Ressi. “It’s time that we change this.

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