The Ramifications of Convertible Debt

For many early stage companies two oft-used financing mechanisms are convertible debt and preferred equity. The former typically provides investors a discount to subsequent equity raising on the conversion – sometimes at a set price, other times at an adjustable price – and the latter is, well…preferred, and a topic for another day.

I discussed a few aspects of convertible debt in an earlier post on solving the pre-money valuation conundrum.

In that article I spoke of why and where convertible debt can be advantageous to both the founders as well as the investor. I also highlighted some of the benefits of using a convertible note, especially for a pre-revenue, difficult to value business.

What I didn’t mention and should have, is the fact that using a convertible note is relatively easy and typically doesn’t incur massive legal fees. Compared to a typical Series “A” equity round, the cost difference can be pretty substantial.

Where founders are raising a few hundred thousand dollars for example, that $30,000 legal bill is a bitter pill to swallow and accounts for a relatively large % of investor capital. It can be disheartening to both investors as well as founders to successfully complete an equity raise and then watch a decent chunk of it head straight back out the door into the lawyers pockets. That is capital which will never go towards building the company. See my post on the “friction” costs for a broader look at some of the ways your investment capital can vanish before hitting the balance sheet.

Gladly there are an increasing number of free legal templates available on the Web. None of us will shed a tear for the boiler-plate-toting attorneys who in some (not all – I’m not demonizing all attorneys) cases just click “replace all” with the next client’s name and send an insultingly large bill. The positive side of this is that it forces the attorneys  to add REAL value in the transaction, something which far too few actually do.

With that in mind, today I want to expand on the convertible debt topic and look at where it may be a bad deal for the founders.

For sake of my example I will recall a deal I participated in many, many years ago, when I was completely green to convertible notes and in fact private equity in all its various forms.

I’d co-invested with a group of other investors into a deal. We’d financed a small start-up via convertible notes, and now a subsequent financing was taking place. Fortunately for me I’d only invested a small amount together with a friend. I say fortunately since things were going pear shaped relatively quickly.

We had a 15% discount in the convert and had invested at a $2.5M valuation. The note was structured such that we’d get 15% on our money over 12 months, or convert at “$2.5M less 15%”. In addition, there was another clause that effectively provided a full ratchet on any lower round that may take place (a subsequent round done at a lower valuation to the valuation we participated in, thereby offering some additional protection). This was the devil in the details. 18 months later the company was doing an equity round at a $1.25M valuation, or HALF of what we came in at!

Yeah, things were not heading in the right direction. Their burn rate had far exceeded estimates and they were more than 24 months out from any revenues. On top of that, the macro timing found us in a period where the capital markets were very skittish. A terrible time to finance, but the company had little choice other than to be facing potential bankruptcy.

Our provisions in the convertible note stipulated that we could convert 100% of our stock at the new valuation, effectively giving us twice the equity we started with. The founders were diluted accordingly, and to make matters worse, the guys who were leading the new round (I was mostly a bystander, watching and learning) insisted on the 15% discount ON TOP OF the $1.25M valuation.

There are always two sides to a coin. When valuations go up everyone is happy, and when they go down it hurts.

I vividly recall the founders being incredulous. The conversation went something like this:

You’re going to convert at a 100% discount?

Uh huh.

Jeez, that’s not going to look good for our cap table!

And they want that 15% discount too. It’s part of the deal dude

F*&^k you serious?

Yeah, sorry about that.

It’s like a full ratchet on the entire initial deal.

Yep, guess it is.

Now, in some instances founders have failed to execute on their business plan, have blown money on hookers and booze, or are just plain morons and should never have been entrusted with anyone’s capital in the first place. However, there are often times when the market for private capital and venture capital gets very tight, and valuations have to be adjusted substantially to get funded. This may have very little to do with how well the company is executing their plan or how diligently they are managing investor funds.

In the situation I described above, it would have been better for the founders to have issued preference shares instead of convertible notes, or to have structured the convertible note with specific price caps. Hindsight is 20/20, and you can bet they learned an important lesson.

The take away is that when you’re raising capital you need to look at all available options. Founders need to consider the ramifications of the various funding mechanisms they are considering, and EXPECT that the worst-case scenario is likely. This goes not only for the current round, but all future rounds as well.

In my next post I’ll discuss the options I think an entrepreneur should consider before looking at attracting angel or VC money.

– Chris

“The most valuable thing you can make is a mistake – you can’t learn anything from being perfect” – Adam Osborne