Why Convertible Debt Is A Sucker's Play

There are some good posts going around today on the topic of using convertible debt in seed stage venture financings including one by my former colleague Seth Levin over at Foundry that is worth a look.

Rather than beat around the bush, let me just say that as someone who has made numerous angel investments in addition to lots of VC investments, Convertible Notes are generally a sucker’s play in today’s market for angels/investors and can even be bad news for entreprenuers.

Sure back in the day when convertible notes were truely just a very short term “bridge to close” for an institutional financing they made a lot of sense in that they allowed the entreprenuer to close “money on the table” while they hammered out terms with the lead investor.  When used in this fashion I still think they are totally appropriate.

However, times have changed and convertible notes no longer make sense from an angel investor’s perspective primarily because startup capital/operating costs are now so low.  These days companies can raise a very modest amount of money, say a few hundred thousand dollars, and have 12+ months of cash in the bank.  When a company raises 12+ months of capital that’s not a bridge, that’s a financing.

Investors who agree to convertible debt in such a situation are paying for their own participation.  They are getting all of the downside and none of the upside between the Seed and Series A and since these days that’s where all of the risk/reward is thanks to insitutional investors abandoning the early stage market, it makes zero sense to give up all that upside … that is if you are investing to actually make money.  And people who bring up the point “but the investors are getting debt which is safer than equity so they should be happy” haven’t wound down many seed stage start-ups.  All that’s left when a seed stage company fails are some empty Jolt Cola cans and nerf guns.

Now I don’t begrudge entreprenuers for asking for a free ride.  Why not?  A lot of people are offering them.  But what I don’t like is the sermons from entreprenuers who seem to think that angels asking for equity is somehow a violation of the rules of fair play. Let’s all just be honest with ourselves:  entreprenuers like convertible debt because it’s a free ride: it allows them to build equity value with no dilution. Who wouldn’t like that deal? There’s nothing wrong with that position but it doesn’t mean investors have to agree.

Granted, at the end of day it’s a market and entrepreneurs should obviously try to raise money at the best possible terms, but entreprenuers should realize that when they ask for convertible debt with a term of greater than 3 to 6 months they are basically asking investors “Just how stupid are you?” 

Finally, convertible debt is not without its downsides for an entreprenuer.  As another of my former colleagues, Jason Mendleson points out, a convertible debt financing technically makes a start-up insolvent from Day 1.  This is bad from a liability perspective but also very bad from a control perspective.  If an entreprenuer can’t roll or convert the debt it gets called and the debt holders will own 100% of the company, whereas if you do an equity financing the investors will just have a relatively powerless minority equity position.  Also, convertible debt in small amounts won’t screw up an institutional round, but as you get over $500K+ in convertible debt it starts to become very noticeable to VCs and often they will want to “haircut” it in a financing.  If you have some particularly hard headed or irationally principled debt holders this can blow up a financing.

So, net, net, convertible debt as a means of angel financing really makes no sense in today’s start-up market from an investor’s perspective and it is not without its downsides from an entreprenuer’s perspective.  That doesn’t mean I wouldn’t ask for it I was starting a company but it does mean I wouldn’t be offened when investors said no.