This for my venture capital readers: Convertible debt is being used for too many financings.
For non-VC readers, an aside. Convertible debt is like a loan to a start-up company while they prepare for a traditional “investment round” which is when the investor purchases equity shares in the company. The convertible debt “converts” into equity when that traditional round comes along.
Got it? Wait, there’s more! The convertible debt has a “cap” on what price it will convert to in a financing, and there is sometimes a discount of 15% to 25% as a small financial benefit to the debt holder. In an “investment round” the equity purchased by investors is “preferred” rather than “common” stock which includes a whole slew of financial advantages (paid first in a sale, can participate in the next financing round), control advantages (board seats and voting rights), and exit freedom (influence on the type and price of exit or financing).
There should be an entire series of posts on those things, so stay tuned for when I get around to that.
OK, I understand the allure of convertible debt for entrepreneurs, they get to do a rolling close (raise money as they go rather than wait for the entire target amount), set their own price (via the cap and discount), and have low legal fees. But as convertible debt rounds increase to be the size of Series A rounds from three years ago, it’s gone too far.
Here is what you, dear investor, are investing in with your millions:
1) No board seat
2) No control provisions
3) No pro-rata in the next round of financing.
4) The 15% discount is not representative of the risk or progress made, particularly when the cash will last the company a year. To wit: who believes the company is only worth 15% more after a year? If you believed that, you should not have made the investment.
5) no start to the timer for tax rollovers for small business investments after 5 years (effectively, a 30% impact on your exit value)
And you, entrepreneur, are missing out on a few things as well:
1) a down round after taking debt is like “full ratchet” anti-dilution, meaning 100% of the down pricing is suffered by entrepreneurs, not investors. While you believe your success is always up and to the right, that belief might be because you haven’t lived through the last two venture industry downturns. We have one about every 8 years, which means it’s time for the next one.
2) possibility of friends and family in convertible debt getting screwed by the preferred investors, since the debt has no control over financing. Then they don’t trust you, and you don’t get to start another company if this one goes bad (which odds are, it will)
These thoughts have been building for a time, but came to a head after reading Brad Feld’s complaints about an investment made by VCs after Brad’s seed investment. You can glance at that here.
While it might not be the best practice for VCs to step on their fellow VCs toes, Brad’s complaint is, really, that he’s using a tool that doesn’t protect him, and that’s the reason that Series financings have been developed over the last 50 years. The standard terms in preferred stock investments have been honed over those 50 years, and incorporate all the protections created after bad actors did bad things over 5 decades.
What surprises me, though, is that abuses don’t happen more. Give enough people $2 million at a time with no constraints, and some portion of them will buy new cars or throw a party featuring the Dixie Chicks.