The most common way to raise startup finance is to sell preferred stock. However, startups often use convertible debt in certain situations.
What Is Convertible Debt?
In the context of startup finance, convertible debt is a loan in which the borrower’s obligation to pay the lender back in cash can be converted into an obligation to pay the lender back in preferred stock. As in any loan, the company gets cash and must pay it back within some period of time with interest. Unless the debt is converted, the loan must be paid back in cash.
How Does Conversion Work?
In the typical startup convertible debt financing, debt conversion will be tied to the next round of equity financing, as well as some “exit” events, such as a sale of the company.
Now to the question: There are two main advantages of raising seed funding through convertible debt. Neither one is an unequivocal benefit, so I’ll give you the pluses and minuses.
The first advantage is that the documentation is much simpler than the most common alternative – a full set of documents, establishing a class of preferred stock and various other contractual stockholder rights. The reason that it’s simpler is that the investor is not trying to secure the complex set of rights to control the company and secure a return on investment. In their place, a convertible note substitutes one main right: The right to be repaid, with interest, after a fixed amount of time. Sometimes, the note will also allow the noteholder certain control rights if the note isn’t repaid as agreed.
Think of it this way: If you’re planning to build a new house with a bank loan, the bank could try to secure the value of its investment by requiring you to check in at various stages (approval of the architect, the plans, the builder and certain stages of the building etc.). Alternatively, the bank could just tell you that you owe a lot of money in a relatively short period of time and rely on that as an incentive to get you to build something that will justify the loan (i.e. by resale or refinance). That analogy isn’t perfect. I’ll get to that later.
In the meantime, however, it should get you thinking about one of the downsides: If the time runs on the debt and you haven’t found new equity financing, the angel can call in the debt and put you into bankruptcy (or foreclose on the assets if you’ve used them to “secure” the debt).
It might not be quite that bad. The main reason is that if you can’t pay back the debt and you can’t raise financing, it’s likely that there will be almost nothing there. Bankruptcy and foreclosure are costly and inefficient processes. So the more likely scenarios are that everyone agrees the company is failing, in which case you’ll just agree on how to shut it down and give whatever’s left to the angel, or everyone agrees the company is worth carrying forward, in which case the angel will be working with you to raise more capital, not playing the evil landlord. That’s not to say there’s no risk. I’ve seen good companies on the verge of success trashed by short-sighted early investors. But that’s not really a reason not to use convertible debt. It’s another reason to be very cautious about whose money you take.
Getting back to the bank loan analogy, it isn’t perfect because angel investors aren’t banks: They aren’t looking for a fixed return on their capital. They’re looking for home run appreciation on a high-risk investment.
That leads to the second benefit of convertible debt: It puts off discussion of a final valuation. How? To back up, the “convertible” in “convertible debt” means that the investor can turn your money obligation into a certain share of the equity. That’s where an angel investor differs from a bank. The trick is, what price do you use to convert dollars to stock? If you agree on a specific “conversion” price, you’ve effectively agreed how much the stock is worth and you might as well issue preferred stock (preferred stock also has a conversion price and usually involves a right to get the invested money back, often with significant “interest” in the form of cumulative dividends and liquidation preferences).
When companies issue convertible debt to angels, they shortcut the difficult valuation discussion by providing, in one of various ways, that the conversion price will be set by the next round of equity investment. In other words, they put off the final valuation discussion until the company is a bit more developed and the VC money comes in.
You may have noticed that I haven’t been saying that you avoid a discussion of valuation, but rather that you avoid a discussion of “final” valuation. That’s because a savvy angel investor will never simply provide for conversion at the price of the next round. The reason is that the angel is not putting her money up at the next round, when the company has presumably proved its concept more and is a much safer bet. She’s putting her money up early, when the risk is greatest. But if she converts at the price of the next round, she’s effectively borne that early investment risk for free. In fact, given the time value of money, she’s effectively paid you some money for the privilege of coming in with the VCs.
So experienced angels will always “cap” the conversion price. You can’t determine the right “cap” without some determination of the company’s value. The trick is that you don’t have to reach agreement on an exact value. You have to agree that the “cap” valuation is high enough that you’ll be happy if you can get to it with only the angel’s capital. The angel has to believe that it’s low enough to provide a reasonable percentage of total equity at the first VC round. In many ways, this is more of a psychological benefit than an actual benefit. But psychology is important, especially if you’re trying to reach agreement quickly and get on with building the company. You should notice, however, that setting a “cap,” rather than a final valuation tends to move the angel toward a higher valuation because everyone can pretend that it’s just the highest valuation the angel will accept, not the actual valuation the angel will receive. That favors the company, a fact that it not lost on experienced angels.
There are more potential complications to convertible debt, but that’s the difference in a nutshell. You should also be aware that not all angels will take convertible debt, although it has become more popular recently. As noted, negotiating a “cap” rather than a valuation tends to favor the company. Some angels also feel that a full set of preferred stock documents isn’t so complicated that it’s not worth doing.