Promise and Pitfalls of Convertible Debt

December 21st, 2009

Attorney Scott Edward Walker has a post up today on VentureBeat about angel financings.  His tips on due diligence and personal liability are superb and well recommended.  He also advises entrepreneurs to push for convertible debt as a way to take on small investments in a simple way.  I left a comment on his post with a caveat about debt financings and this blog is an extension of that.

(Convertible debt means that instead of purchasing stock in the company at $ per share, an investor buys a promissory note with the intent that when a larger financing happens in the future, the promissory note and accrued interest will convert into the same kind of stock sold in the large financing).

I agree 100% with everything Scott says about convertible debt.  It is simpler to document and it avoids having to put a valuation on the company.   I also know a lot of angels who know how to evaluate great technology, but have no idea how to figure out how much it is worth.  Convertible debt helps get money to entrepreneurs more quickly and with a bit less discussion of valuation.

There are a few gotchas, though.  The biggest one is that if the later financing never happens, or doesn’t raise the minimum amount needed to convert the notes, the company is stuck with a bunch of debt it generally can’t repay.  This becomes awkward.  The investors came on board expecting to end up with equity and instead hold a bunch of near-worthless promissory notes.  The notes themselves come ahead of the founders’ stock in line for repayment, so until the company can find a new source of cash to pay them down, management’s stock is completely worthless and the founders are working 100% for the investors.

Investors would end up with $0 if they foreclosed on their notes in this situation so they tend to be very accommodating, but entrepreneurs still spend a lot of time managing the relationships.

I have seen convertible debt work best as a bridge, where everyone knows the large financing is coming and one of the investors in that deal puts up a little short-term cash to see a company through a tight spot.  In a pure startup situation, taking on convertible debt is a gamble that the big money will present itself.

I talk to clients about their early-stage financing options all the time.  Here’s how I break it down to them in a nutshell:

Pro: Convertible debt is useful to document small investments quickly and without having to place a valuation on the company in its earliest days. 
Con: If the later financing doesn’t come through, or if it takes longer than expected, entrepreneurs can spend a lot more time managing the company structure than if they had sold stock at the outset.  In the worst case, note holders could force a company to sell and shut down before the founders are ready.

Con:  Preferred stock requires more paperwork to document.  It also requires that the founders commit to sell __% of the company to the investors, and the valuation can cause trickle-down issues for stock options and other equity incentive compensation, including the dreaded 409A rules
Pro: Once done, it’s done.  If founders and investors can agree on the valuation (and the investors can agree to do a stripped-down set of financing terms), I generally recommend going the equity route since then the investors’ situation is locked down and less likely to require time spent managing the equity relationship.

Good post, Scott.

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