Convertible debt: an entrepreneur’s ticket to the fast lane or a wild ride?

The pros and cons of convertible note financing have become a hot topic in the startup world. A convertible note is a loan given by an investor who in return receives future shares in the company at a valuation that is to-be-determined. Convertible notes tend to be issued at a  startup’s early stages and act as a bridge to their Series A financing round, at which point the convertible note turns into shares of equity. Convertible note financing has become increasingly popular. Paul Graham, founder of Y Combinator, recently publicized on Twitter that all of his recent investments have been in the form of notes.

Convertible notes are much simpler than many types of financing, such as preferred stock. The documentation and legal fees are minimal, and the note can be executed quickly, which benefits entrepreneurs and investors alike. Early-stage investors tend to be more casual than the later-stage institutional investors and they often have prior relationships with the company’s founding team. As a result, they might not demand immediate board seats or a specific valuation for the company, instead letting the later stage and more formal investors determine these details. In return for putting early-stage money into the company, these investors are rewarded with options or warrants that effectively give them a discount over the price that newer investors get.

Sometimes deals will utilize what is known as “convertible debt with a cap.” This cap places a maximum price the investor can receive when the next financing round comes, essentially rewarding the investor for his early money. Many angel investors insist on having a cap when taking on convertible notes. All things being equal, entrepreneurs generally prefer to avoid a cap, which limits the valuation they can get for the converting shares. Mark Suster from GRP Partners tackled the subject in a recent blog post, noting that when you take the time to negotiate a cap, “you might have been better just negotiating an agreed price in the first place.”

When considering the option of convertible debt, entrepreneurs should also bear in mind the risk and ramifications of a potential default. Unlike equity holders, a debt holder can take over control of the company and its existing assets in the case of default. If an early-stage company is experiencing difficulty getting its business model to work, a default can happen when lenders are unwilling to wait for the company to produce, instead preferring to liquidate the company and be compensated as quickly as possible.

In conclusion, each company must consider the many details that come into place when issuing convertible debt. It works best in situations where the early-stage investors have patience and trust in the company’s founding team. Making sure that the initial agreement  (with or without a “cap”) is constructed in a way that makes both sides happy is essential.

Further Reading:

Types of Angel Financing by Scott Edward Walker

Seed Funding: Debt vs. Equity by Mark MacLeod

Has Convertible Debt Won? And if It Has, Is That a Good Thing? by Seth Levine

Converts Versus Equity Deals by Chris Dixon

Super Angel/VC Smackdown: What’s So Great About Convertible Debt? (TechCrunch)

Why would an early-stage investor prefer a convertible note structure to straight equity? (Quora question)