Paul Graham recently set off an in-depth discussion in the investing community into the pros & cons of convertible debt when he observed that: “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.”
Soon after, venture capitalists including heavyweights Seth Levine, Fred Wilson and Mark Suster shared their thoughts. Some of Mark’s thoughts in particular may spook entrepreneurs with such zingers as:
“How Convertible Debt with a Cap Behaves Like Full Ratchet”
“But entrepreneurs – convertible notes have no MINIMUM! So you’re taking all of the pricing risk.”
“Nobody I know accepts multiple liquidation preferences in early-stage deals… If they do a convertible note they do.“
Given Mark’s comments, convertible debt, especially capped ones, seems like a raw deal for entrepreneurs. But for investors, convertible debt remains an attractive way of bridging valuation gaps and getting a deal closed. If entrepreneurs balk at the mention of convertible debt, remind them of the following:
1) Investors typically do not expect to incorporate control provisions or seek board representation in a convertible debt financing. This leaves the entrepreneur with greater flexibility.
2) The “full ratchet” concern arises where debt is converted at a price that is lower than the cap. The entrepreneur and investor can work together to clarify that the cap is more reflective of an optimistic future value of the company rather than an estimate of its existing value. To facilitate negotiations, investors could also consider a minimum floor to the valuation. Caps protect the investor – why not allow entrepreneurs to protect themselves?
3) Another legitimate concern from an entrepreneur is the potential for a convertible debtholder to realize multiple liquidation preferences when the debt converts at a valuation much higher than the cap. Solutions include: having each note convert into a separate class of shares, each with a 1x preference (see Mark’s blog); and issuing only the value of the initial loan in preferred shares and then issuing common shares for the remainder.
Convertible debt can benefit both investors and entrepreneurs if the proper terms and protections are incorporated into the deal documents. An experienced lawyer can help with that. In the end, a deal that isn’t balanced and in the interests of both the investor and the entrepreneur will harm their relationship and the reputations of those involved.