Seth Levine from Foundry Group touched off a debate on which is the best way to raise startup financing: convertible debt or equity. Paul Graham (intentionally or not) actually started things with a tweet, “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.”
Fred Wilson joined the conversation, as did Mark Suster. All prominent and successful investors. And generally, they’re not fans of convertible debt. But oftentimes, entrepreneurs are attracted to convertible debt, and clearly with Y Combinator, the trend is moving strongly in that direction.
The two main reasons why entrepreneurs are attracted to convertible debt are:
- It’s supposed to be easier; and,
- It delays pricing the round.
Pricing a round and the value of a startup is hard. It can be an uncomfortable conversation to have with investors, and it can turn into a bit of a stand-off, where no one wants to be the first one to name a price. So I understand why delaying it sounds appealing. But the truth is that a convertible debenture doesn’t really delay pricing, especially when you set a cap on the conversion in the next round.
Let’s say I’m going to raise $500,000. And I’d like the pre-money value to be $1.5M. The post money-value would be $2M and the $500k is worth 25% of the company. That’s the way you would price it for equity. When you raise the next round, they would of course get diluted.
With a convertible debenture you’ll get $500,000 (and there’s interest payments to be made too.) When you raise the next round, the initial investors convert their debt into equity, but typically at a discount. Let’s say 20%. So in the Series A, when you now want to raise $2M and the pre-money valuation is $6M, the $500k is measured against a pre-money valuation of $4.8M. They would own 10.4% instead of 6.25%. (Not including interest in the calculation.)
But there’s also the issue of a cap. The cap is put in place by investors with a convertible debenture to peg the value of their debt (with the discount), regardless of what you raise the Series A at. So, let’s say the cap is $5M. Now when you apply the 20% discount, the first investors’ money converts in at $4M. They now own 12.5% instead of 10.4%.
Investors will peg the cap amount at what they think you’ll raise the Series A value at. If you raise a lower Series A they still have the discount and own a bigger piece of the company. If you raise a killer Series A at an astronomical value, the cap protects them.
When raising financing with a cap, you’re basically negotiating the price of the deal, it’s just the mechanisms you’re using (% discount and cap) are different than company valuation.
I’ve raised money as convertible debt. And I’ve spoken to others that have done so (and others that have raised money through equity.)
In my experience, it wasn’t any easier to raise financing through convertible debt. It didn’t take any less time, and it wasn’t that much less expensive. It might seem easier because it avoids the big question about “the price of your startup”, but it’s really not doing that. Remember: Investors know how much of your company they want to own, and whether they price the deal upfront or delay it through convertible debt, they’re likely (and you’re likely) going to end up pretty much in the same place.
Generally, I expect (and have seen) fairly common standards for early stage companies. So I would bet that most convertible debt deals are being done around the same % discount and cap numbers. The same is true when pricing deals (angels and investors have told me, “When we see an early stage deal, it’s always in this range…”) That might be less true these days with the market being as frothy as it would appear to be (in Silicon Valley) but I don’t think there’s a whole lot of mystery around the value of early stage companies. Assume that’s true, and the stress of “pricing a deal” is lowered.
For entrepreneurs, here are the important things to ask yourself:
- How can I get a deal done as quickly as possible?
- But without sacrificing value-add for speed (Yes, I do believe in “smart money”)?
- How can I make sure interests are truly aligned (as best as possible!) between me and investors?
- Being more blunt, can I stomach working with these investors for the next 3-10 years of my life?
- What deal is the least likely to bite me in the ass later and make my life miserable?
- Do I really understand all the math at play and the various scenarios (not just the good ones!)?
- How does taking this money really impact the strategy and focus of my startup?
Where a convertible debenture can be very valuable to entrepreneurs is for early exits that don’t require follow-on financing. If that’s the case, when a company is acquired (let’s say for $10M), it’s likely the debt will convert at the same price as was agreed upon if the company was to raise a Series A. So the initial investors get a smaller piece of the pie and the founders get more (compare 12.5% to 25%, because there’s no further dilution.) For a lot of web startups and founders, this is appealing. Raise a bit of money and see if you can exit before raising too much. And I think that’s a perfectly legitimate strategy.
Overall, the debate is an interesting one, especially because it helps shed light on how investors are thinking and educates entrepreneurs on the different investment mechanisms and strategies that exist. But I certainly don’t believe that a convertible debt structure is a slam dunk win for entrepreneurs when raising early stage financing.