Convertible debt with an equity kicker – these days usually a discount on the conversion price – has been a part of the venture capital landscape for as long as I have been in the space, which takes it back thirty some years. In the beginning, it was used mostly in the context of bridging a company cash for several days or maybe weeks while the company and its investors tackled the complexities of moving money and documents around when FedEx was in its infancy, fax machines with crinkly paper were costly and unreliable, and word processing was a cost center run more or less like the typing pools of the 1950s.
More recently, the convertible debt structure (and its cousin, convertible equity) has been adapted to seed stage financings, mostly as a way for investors and entrepreneurs to keep costs down and avoid talking about the elephant at the negotiating table – valuation. And for good reason: with the right facts, a modest convertible debt deal can be a great way to move a company from the back-of-the-envelope hypothetical stage to the ready-for-serious-capital launch phase.
Alas, over the last several years, convertible debt has started popping up in places where it really does not fit, and in so doing has led to a lot of unnecessary headaches for entrepreneurs and investors alike. It is time for folks on both sides of the convertible debt table to step back and remind themselves about the limits of the convertible debt financing structure, and what can happen when those limits are ignored.
Let’s start, then by reviewing what kind of startup financing scenario is a good fit for a convertible debt structure. We can then look at some of the bad things that happen when various parts of those scenarios are ignored.
1. Modest Capital Need. That is, relative to the projected need in the projected “real” priced capital raise after the convertible debt capital is used up. Say a 1 to 5 ratio.
2. Well-Defined Milestone for Convertible Debt Round. The use of the convertible debt funds should be focused on a well-defined milestone the accomplishment of which will clearly put the startup in a position to complete a “real” round of priced financing.
3. Milestone is Near Term. Generally, the milestone for the convertible debt round should be something that can be accomplished (or not) in six months or less.
4. Be Very Careful with Conversion Valuation Caps. A too-low conversion valuation cap can all too easily into a real round valuation cap.
5. Investor and Entrepreneur must Appreciate Realities of Failing to Accomplish the Milestones. The realities of convertible debt financings are simple – when they play out according to the script. They can get complicated fast when they don’t.
Ok, let’s look at what can go wrong when convertible debt deals wonder off the reservation.
1. The Too-Big Convertible Debt Round. If the convertible debt round is too big it will almost assuredly result in a lower valuation at the next round. In this situation, the convertible debt “tail” starts to wag the real round “dog.” All the more so as the conversion discount increases. While there is no hard and fast rule, surely by the time the convertible debt share of the real round (be sure to include the impact of the conversion discount) approaches one-half of the aggregate capital in the real round, the investor in the real round will start adjusting the valuation she is willing to pay to reflect the overhang from the convertible debt round.
2. No Well-Defined Achievable Convertible Debt Milestone. This is the classic “bridge to nowhere” scenario where the foundational premise for the convertible debt deal – that with a limited amount of capital the startup can accomplish something that makes doing a larger priced round realistic – isn’t respected. When that “what were we thinking” eventuality is realized, the entrepreneur will have to go back to the well with existing (and probably unhappy) investors or find new investors on terms that work for the old investors and the startup. All in the context of the entrepreneur failing to perform as advertised. And, of course, the new convertible debt will add to the tail of the earlier convertible debt, bringing the prior issue – the too big convertible debt problem – back into play.
3. The Too-Far-Out Milestone. This is mostly an investor issue. For whatever reason – one of my earlier blogs suggested that it was not common sense – convertible debt discounts are almost always between 10% and 30% – no matter the projected timeline for getting to the “real” round. Given how much risk the convertible debt investor is taking even a 30% “kicker” on the debt conversion price doesn’t look very attractive on a risk-adjusted basis. Remember: the typical “real” round investor is probably looking for a 100% return between the initial real round and the next round.
4. Beware the Conversion Valuation Cap Trap. Perhaps recognizing problem 3 above, convertible debt investors are increasingly looking for caps on conversion valuations in addition to the standard conversion price discount. Now if the cap is high enough, so what (or so says the entrepreneur). But what if the cap is too low? In theory, a low cap is no big deal; in practice, a low cap can morph into a real round valuation cap. A too-low cap will lead to the same problematic “tail wagging the dog” dilution dynamics as the “too-big” convertible debt round discussed in 1 above. And before you know it, the real round investors will set their valuation limit at the valuation cap in the convertible round.
5. The Inexperienced Investor/Entrepreneur. Too many convertible debt deals are “premised on success.” That is, both parties assume the capital provided will get the entrepreneur to the milestone that will result in successful (timely and well-priced/structured) “real” round. Having been part of or a witness to dozens of convertible debt deals, in my experience that outcome is the exception, not the norm. More often the entrepreneur will have to go back to the convertible debt well, where all of the issues at play get a second bite at the apple, and this time in the context of an at least surprised investor (the initial convertible debt investor) who is now in the position of a creditor. A creditor of a startup that, presumably, is neither interested or able to pay off on the debt, and is looking for a future investor who will undoubtedly only consider the investment if the prior investor/creditor agrees to surrender some of her rights. Not a pretty picture.
Now, let me say again that a convertible debt round with a conversion discount is a great tool in the right situation. But entrepreneurs and investors alike should appreciate and respect the parameters of those situations. Failure to do so has burned too many investors and entrepreneurs who should have known better – and in the process too many otherwise doable downstream deals have gone undone.
More articles by Paul A. Jones
Pausing for a Reality Check
Thinking about financing rounds
Thoughts on why good venture investors turn down good deals
Employee Turnover: A Cloud with a Silver Lining
Paul Jones works with emerging technology companies and their investors as part of the Venture Best team at Michael Best & Friedrich LLP. A serial venture-backed technology entrepreneur and institutional venture capital investor, he is also the Entrepreneur-in-Residence at the College of Business at the University of Wisconsin-Oshkosh. He can be reached at email@example.com. This post was originally published on his blog at OnRamp Labs at the Journal Sentinel.
The opinions expressed herein or statements made in the above column are solely those of the author, and do not necessarily reflect the views of WTN News. WTN accepts no legal liability or responsibility for any claims made or opinions expressed herein.