Is Convertible Debt Preferable to Equity?

Posted on Aug 30, 2010 | 22 comments


Seth Levine of Foundry Group addresses this important topic this morning on his blog with a post, “Has Convertible Debt Won?”Seth was basing this on a Tweet by Paul Graham that said”

“Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”

I have to say that I didn’t take the question to mean that convertible debt had won for the entire market, but either way it’s clear that convertible debt has become an increasing trend.  I’ve written about the topic of convertible debt at length before specifically about how angels & entrepreneurs should think about pricing.

Convertible debt is an investment that “converts” into equity in the future usually at a discount to your next funding round price and sometimes has a “cap” (maximum price).

Clearly this is is a trend and a topic that is interesting entrepreneurs.  Funnily enough I just answered this question yesterday on Quora when somebody asked,

“Why would an early-stage investor specifically NOT prefer a convertible note structure to straight equity (e.g. a priced/valued preferred stock financing)?”

Here is my answer with some minor editing:

_____________

Why many early-stage investors DO price rounds (e.g. prefer equity to convertible debt):

  • If you’re an early stage investor (e.g. angel, seed) you’re taking the most risk.  If you’re the “first money in” usually there is still product risk, market risk, financing risk and execution risk
  • So from basic econ 101, the higher the risks, the greater the failure rates, the higher the returns need to be to accomodate for those increased failures and the higher risks taken
  • Your goal as an early stage investor is specifically to lock in the most fair early-stage valuation you can
  • You clearly don’t want to price it so low that the founders don’t feel incentivized so it’s not about the lowest possible price but more about guaranteeing a certain cap
  • As an investor when you do convertible debt you’re usually pricing the round when the next money comes in.  But as an angel you’re usually not only taking risks but also helping the company succeed (through introductions, social proof, coaching, recruiting). So think about it – why should you be penalized for helping a company to get a higher valuation in the next round and thus your money gets converted at a higher price?

How early-stage investors have learned to accomodate convertible debt

  • The mechanism that people use to resolve this conflict is a “convertible debt with a cap”  meaning that while the funding instrument is still debt when it converts it has a maximum price – a “cap.” Make no mistake – this IS a priced round.  In fact, in some ways can be worse for the entrepreneur.  It basically sets your maximum price rather than your actual price.  Example: If you do a convertible note raising $400k at a $3.6m pre money you’re ceiling is that you’ve given away 10% of the company ($400k/$4m post money).  But your actual next round might come in at $2m pre money.  You might have been better just negotiating an agreed price in the first place.  Not always, but sometimes.
  • So why do people do convertible debt with a cap? 1) it can be cheaper to complete the round from legal expenses 2) emotional.  Entrepreneurs are increasingly trained to think convertible debt is better (when it’s not always the case)
  • I’m OK to fund companies with a convertible debt with cap model for small investments – no problem.  In my mind the deal is priced.

Should entrepreneurs ever prefer a priced equity round to convertible debt?

  • If you have a choice between pricing a round and not pricing a round for the exact same investors then it is in the entrepreneur’s best interest not to price it and I could understand why one would do this.
  • That said, I have seen times where convert with no cap was done and the entrepreneur slightly regretted it EVEN when the got a big up round in the next financing.  I know that sounds crazy, but the situation is – you got people that you like, trust, respect as angels that really, really help a lot.  You then get a big VC to invest at a high price and you realize that means your angels are going to be unhappy with how much they own of your company after the financing relative to what they THOUGHT they would own.  The reality is that as an entrepreneur you really do want to try and keep all of your investors happy and it really is fair that early investors who were willing to take a risk on you before you were a BIG DEAL should really be compensated.
  • Also, f you have 2 competing offers from different investors and one has “convertible debt no cap” and the other has a “priced round.” If the second firm or people were much stronger investors I’d take their money all day long even thought it’s priced as long as the valuation / price range was “fair” (e.g. 20-25% dilution).  I’d optimize for success vs. exact ownership.  Most companies fail and most entrepreneurs who raise money don’t make a return.  Therefore anything you can do to turn this into a 1 vs. a 0 is a smart move IMO.

Why would an angel agree to a convertible note with no cap?

  • Simple: he/she feels the deal is “hot” and therefore competitive.  He/she is hoping to “get in on the deal” whatever the terms may be.  I personally don’t believe this makes for a good long-term investment thesis but that’s not for me to decide.
  • In frothy markets (like we’re seeing in August 2010) this happens more frequently. In down markets more deals are priced.
  • YCombinator might determine that it is best for them but they’re not the typical angel investor.  YCombinator runs a program where they get a really wide group of companies involved for which they invest in each one.  That’s not the typical angel investor

What about “super angel” funds?

  • I think super angel funds may be more willing than angels or VCs to do convertible debt.  Super angel funds usually want to invest at really early stages and are putting small amounts of money to work.  Therefore if they put $250k into your company and it’s not priced it’s not the end of the world to them (on a $40 million fund) if the eventual round gets done at $8m pre-money vs. $3 million pre-money.
  • The reason they might feel this way is that they’re really just placing an option that if you succeed that they’ll have the inside track to invest a larger amount in your next round.  I’ve heard at least one super angel tell me this.
  • I can understand this investment philosophy since as an investor like this you’re really trying to optimize for finding the few really big deals and price (within reason) will be less relevant.  If they got in at $3m pre vs. $8m pre doesn’t matter if the company sells for $500m.
  • True that this logic COULD be applied to angels.  But angels typically don’t have as deep of pockets and therefore don’t do as many deals and don’t follow as much as do angel funds.

Maybe we should move towards “convertible debt with a price?”

  • Thinking about it some more – the biggest reason I keep hearing cited is that the process is so much quicker & cheaper legally than an equity round.
  • As I’ve cited the problem I see for investors is the risk of not pricing and for entrepreneurs “convertible debt with a cap” gives them a maximum price but not a minimum.
  • In larger rounds I think equity makes sense so that everybody agrees to the terms up front
  • On smaller rounds, why don’t we just do “convertible debt with price” and everybody can be happy?

In summary – I don’t believe the “convertible debt” has “won” in the market – especially not “convertible debt with no cap.”  The market is frothy right now so terms are bending toward entrepreneur-friendly terms.  But as you’ll see in my next post – I dont’ believe this will last for long.

** Image courtesy of 22Dollars.com

  • http://columbusholdinggroup.com Mark Birch

    My perspective is that convertible debt with cap is the fairest and most expedient way for early stage start-ups to get seed funding. For entrepreneurs, the legal expenses for an equity round are simply outrageous, the complexity of terms too time consuming to negotiate, and the pricing is specious at best. For angels, the process is straightforward and the relationship with the entrepreneur is less contentious as the interests are more aligned. I do agree however that such a structure is “priced” if we are talking small rounds of < $500K.

  • http://ffassetmanagement.com/ John Frankel

    I disagree that “super angel” funds are/should be just buying an option and do not care if the get in at $3mm pre vs. $8mm pre. If I were in a fund that had this attitude I would be extremely upset. Any GP has a fiduciary responsibility to their LP's to invest wisely. I cannot understand the perspective that, Oh well, I made some money so it is fine. Each investment has to be made on its merits and with a view to the impact on IRR, and I can assure you there is a big impact on IRR if you overpay. Every “super angel” I know is price sensitive and generally has a severe aversion to convertible rounds, unless they are a follow on to an existing equity investment. They look out for their LP's.

    Regarding options, I have heard a number of large funds look to do this, and generally I think it is bad for the companies, as they are writing options, which is generally a mugs game. I can go into why in more detail, but the comment section of a blog is not the place to do this.

    The problem with this current debate on convertible rounds is that we are talking in generalities about something that is specific in each individual case. Thus not that meaningful.

  • http://markloranger.com Mark Loranger

    Mark, thanks for a thoughtful post. For entrepreneurs, I firmly agree that the convertible note structure is the most advantageous approach to a seed round. However, one disadvantage that hasn't been directly addressed is if the note holder has a say in pricing the A round. Entrepreneurs taking convertible note seed rounds from VCs who plan on participating in the A round should be very wary of the incentive structure for the note holder to keep the A round price as low as possible.

    Also, you wrote the following:
    That said, I have seen times where convert with no cap was done and the entrepreneur slightly regretted it EVEN when the got a big up round in the next financing. I know that sounds crazy, but the situation is – you got people that you like, trust, respect as angels that really, really help a lot. You then get a big VC to invest at a high price and you realize that means your angels are going to be unhappy with how much they own of your company after the financing relative to what they THOUGHT they would own. The reality is that as an entrepreneur you really do want to try and keep all of your investors happy and it really is fair that early investors who were willing to take a risk on you before you were a BIG DEAL should really be compensated.

    The opposite situation is also problematic. For example, a startup raises a seed round from high-net-worth individuals (not professional Angels) where the pre-money valuation is too high. When the company needs to go to institutional investors for the follow-on round, his seed investors will likely end up getting burned due to a lower-than-expected valuation by the professional investors.

  • http://caterpillarcowboy.com dlifson

    You said: “The reason they might feel this way is that they’re really just placing an option that if you succeed that they’ll have the inside track to invest a larger amount in your next round. I’ve heard at least one super angel tell me this.”

    Seems to me the same signaling issues that scare entrepreneurs away from VCs in seed rounds might also apply to super angel funds?

  • http://jmillerinc.com Jeff Miller

    Mark, great post and great summary of this issue. Can you elaborate on why it doesn't matter what the investor got in at if the company sells for $500m? If you get in at $3m pre vs $8m pre, won't you make almost 3x more money in the $3m case versus the $8m?

  • http://bothsidesofthetable.com msuster

    John,

    We're in violent agreement:

    - I personally agree that all deals should be priced, I've lost deals over it. I do accept convert with a cap
    - I agree with you that 'super angels' not worrying about price isn't always the best strategy. That said, I've seen many well known super angel groups do it. Even people I respect tremendously like Andreessen Horowitz have done this. I'm not arguing for it – just pointing out that it “is”
    - I have already written posts saying that I don't believe investments should be “options” – http://www.bothsidesofthetable.com/2009/10/18/v

    Mark

  • http://bothsidesofthetable.com msuster

    Maybe. But:
    - I've been able to negotiated legal fees for EQUITY to $5-10k for seed deals. Reason? Lawyers are betting there will be future business. I've agreed that if I offer terms that are non-standard or drag my feet on terms they can charge more but I don't do this.
    - It might be expedient to avoid negotiating terms up front – but I would argue entrepreneurs would be better having alignment on expectations of terms with investors before taking their money. Punting down the line is bound to lead to problems.

  • http://bothsidesofthetable.com msuster

    Thanks for your comments.

    On your first point – I agree it's a risk. But with the right investor it's not really. More important to reference check the VCs than worry about the wrong incentives. IMHO. Even great terms with the wrong VCs can screw you long terms.

    On your second point – I always tell entrepreneurs to be careful not to price rounds too high. It makes future financings more difficult and down-rounds are very destructive for everybody.

  • http://bothsidesofthetable.com msuster

    Of course. That's why I keep telling everybody this whole VC signaling thing is bullshit.

  • http://bothsidesofthetable.com msuster

    All else equal, yes. My point is that if you're giving a choice between 8.8% of a $500 million exit or $0 (you didn't invest) in the end you're fine with just having gotten into the right deal. Conversely, owning 33% of a company that never goes anywhere is a waste. So investors are mostly obsessed with “getting in the right deals”

  • http://jmillerinc.com Jeff Miller

    If an angel follows a value strategy, and only invests in say $3m pre deals but avoids $8m pre deals as being overpriced, do you think the value angel will systematically miss out on the “right deals” as compared with an angel who ignores price and accepts the $8m pre deals? I haven't seen any evidence that high seed valuation is correlated with eventual success/exits (although I'm eager to see the evidence if it's out there, even anecdotally).

  • http://columbusholdinggroup.com Mark Birch

    Then maybe I need to get the names of those laywers from you :)

    If you can do a straight forward equity deal at low-cost, then I am all for that. Just speaking from my own experience, that has not been the case. I think it only works if you have a lead investor and that is rare at the seed stage if there are no VC's or super-angels involved.

    In regards to terms, the only ones that should matter on the note should be term, cap price and conversation discount. I do agree that it is in the everyone's best interest to understand what the expectations are for the next round before putting money down. However, we can all agree that this is the riskiest of investments and you simply do not know what the next round could look like, so why bother impeding entrepreneurs at the onset.

  • http://bothsidesofthetable.com msuster

    Everybody is different based on their economic means. I personally don't invest in angel deals priced at $8m+ (except in rare situations. I did one deal at an outrageously highly priced deal – but I still think will be my largest return). If I'm in early:
    - I help
    - If asked I'm active
    - I will help just as much if I invest $10k as $100k (and this is referenceable)
    - But I don't have the personal capacity or desire to do $250k follow on rounds. So I get diluted. So I care about my price going in.

    Others write $1m angel deals so they may feel differently.

  • ldmangin

    I have an issue with convertible notes that doesnt seem to be mentioned very often. As i understand them, they are, in the end, loans. If no equity round occurs within the X months (typically 12) of signing them, the startup is on the hook for that money, plus what ever interest (if any) was agreed to… and thats not a fun position to be in.

    Do you feel investors see that as an actual bonus (i.e. an ability to recoup perhaps some percentage of their investment if things dont materialize), or is it more likely to be a write off? For the entrepreneur, i wonder if it would be possible to have a convertible note with a guaranteed conversion, regardless of any investment event, and whether that would be even mildly acceptable.

  • http://giffconstable.com giffc

    There have been a few seed deals this year where the entrepreneurs raised much more than they expected to due to demand gaining steam. I was curious as to how those deals played out. Did they flip to an equity round for everyone once the round hit a certain size? Did they change the valuation for everyone, or just for investors jumping in later in the process, so that they could raise the bigger round without giving away a significant chunk of the company?

    Are there any norms with this?

  • http://bothsidesofthetable.com msuster

    No, they're not repayable unless they are never converted and there are funds inside the company. Your stated risk is not a real one in any credible deal. That said, entrepreneurs should always double check this with their lawyers.

  • http://bothsidesofthetable.com msuster

    Probably were convertible debt and they probably convert with a 25% discount to next round. So entrepreneur is just banking on doing a large enough round. If priced, my guess is that entrepreneurs just took more dilution. But obviously deal specific.

  • http://avc.com fredwilson

    i am glad to see you posted this here mark and not just at quora. this is an important discussion.

    i think the converts are cheaper argument is not valid anymore. we have a “non negotiated light series A' template that we use frequently. neither side negotiates it. there aren't any lawyers. and we can get a series A done for less than $5k

  • http://www.justinherrick.com Justin Herrick

    Great analysis, I really can't add much to the discussion in this case, but I found it very informative.

  • http://www.capitalistcounsel.com Lee Weinberg

    Thanks, Mark. I posted the question on Quora (“Why would an early-stage investor specifically NOT prefer a convertible note structure to straight equity (e.g. a priced/valued preferred stock financing)?”), and I posted in response to seeing a question without the “NOT” in it that had answers that all were touting convertible debt financing. Of course, all were “entrepreneur friendly” touts — and that is why instead of replying to that question and its flurry of happy answerers, I posted my own “NOT” question. I am concerned that a lot of the Quora answerers are telling budding entrepreneurs what they want to hear instead of giving a balanced reply. Some investors actually like to make money as they help grow the next X company, so, again, thank you for answering!! !

  • Blk911

    “optimize for success vs. exact ownership” this IS the challenge of the start up entrepreneur and it's a struggle. I think the benefits are much clearer than maybe even presented here – convt debt favors the founder and equity favors the investor.

    The “cap” on value/conversion is probably the best way to get both parties on the same side…with all the failures, the tax (pricing) issue is ONLY relevant in 1 in 100 cases; relevant meaning the tax consequences are sever.

    All the work to create value happens AFTER funding, which is missed by folks who have just taken a dive into the startup business…a point here, a percent there, etc, is wasted time. Get the deal done and get to work is the key to success.

    $0.02

  • http://www.theequitykicker.com brisbourne

    Nice post Mark. An additional reason for going for a convertible that we have seen here in Europe is to avoid over paying and looking at a down round when the Series A or B comes in. I guess that might be a feature of the immaturity of the market here where angels have been caught out setting prices too high and then getting upset with the VCs that come in at a lower price, or (worse) pushing the company to hold out for a bigger valuation when it really should be getting funded now.