Ask the Wizard

I've gotten a few questions about convertible debt as an alternative to an equity seed round. I've never done a convertible debt deal, but since I keep getting questions about this, I did some digging around, and this wouldn't be the first time I've decided not to confuse experience or knowledge with expertise, so here goes.

There are a couple things to like about convertible debt and a couple of things not to like. Let's assume we're talking purely about convertible debt as a way to get ramped up in advance of doing a first bigger venture round.

Thing to like about convertible debt #1: You can get a deal done quickly. Your service really took off and you need to spend 100k on infastructure right now, you found a great vp engineering you have to hire right now, you need to buy 10 tickets to the Web 2.0 conference right now. Whatever, convertible debt will be generally be a faster way of seeding the company than raising an equity round.

Thing to like about convertible debt #2: If you do the convertible debt with a venture investor, you've now got somebody involved who's motivated to help you do your venture round, and you aren't flying so blind if this is your first time into the breach.

Both of these things to like are more than offset by a couple things to hate, in my mind.

Things to hate about convertible debt #1: Unaligned interests between the investors and entrepreneurs. This would be a good topic for a full post because there are lots of situations you can get into in which the investors interests and the entrepreneur interests are unaligned and they're probably all bad. In this case, successful serial entrepreneur turned successful serial investor Josh Kopelman has done a great job of elaborating on how interests can be unaligned with convertible notes as a seed funding approach. Also see the post Josh refers to by Brad Feld, who has written about pre-A round financings a couple of times himself.

Because the note will generally convert at a 20%-40% discount to the price of the qualified financing, the bottom line here is that you don't want an investor who's thinking "hey, if we can keep this A round down to a couple million valuation, then my notes convert at this nice low price and meanwhile the company's made all this progress....". You want somebody alongside you that's financially delighted to see you get a great price on the follow-on venture round. I can imagine that angels and other investors that prefer convertible notes will take umbrage to the suggestion that their motives are at loggerheads to the entrepreneur's here, but I don't like any situation in which you even see the suggestion of unaligned interests because it can potentially motivate wacky behavior. This is a reason to actually be wary of capped participating preferred and preference multiples as well, but that's another story.

Things to hate about Convertible Debt #2: The note holder doesn't want to convert on the venture round. Ruh Roh, George. You can set up the terms so that the note holder can be bought out or converted, but how much luck do you think you're going to have attracting a top firm to your venture round with convertible that won't come along? Why aren't they playing? What do they know that nobody else knows?

Things to note about any funding process #1: While a convertible note deal may get done a lot faster than a seed equity round, these processes all take time. We once did a B round financing with multiple investors in which structure, board makeup, etc. would change significantly from the A round financing, and this whole thing took about two months. We then later on did a B1 financing with one new participant in which literally nothing changed at all and the investor was as helpful as possible and it couldn't have been simpler and this process took two months. Why? Because no lawyer has ever used the "accept all changes" button in MS Word, that's why. And because documents need to be updated and t's crossed and i's dotted and all this is a giant pain in the ass and it always takes two months.

Despite this, you could argue there are a couple cases in which you the entrepreneur might want to play Convertible Debt Jeopardy. There are a variety of reasons anybody might take issue with this, but let's spell it out, since it's certainly a possibility for some kinds of companies. Let's say your startup is doing very well, and you need to grow. You've also been approached by some companies about a potential acquisition, and you'd like to entertain those, but you need cash to grow now. Convertible here could make sense because if you go ahead with the acquisition, you pay off the note and the capital turns out to have been very cheap indeed, and if you don't go ahead with the acquisition, voila, you've got somebody who can now help you go put a real venture round together and you were able to ramp into growth through the acquisition discussions. Note, however, that lots of seed round convertible debt investors might demand equity-like protections from this and negotiate for language that says if the venture round is pre-empted before they convert, they get a return of X. As always, everything's negotiable, even if the people across the table from you say "that's standard".

This post should not be taken to mean I don't like debt. There are lots of disagreements among entrepreneurs and investors about debt at various stages of the company and for various reasons. As always, we'll get to that in another post.

UPDATE: post updated to correct horrible spelling errors, a misplaced percent sign and a missing zero - generally shoddy craftsmanship.