Financing Options: Convertible Debt

MBA Mondays are back after a one week hiatus. Today we are going to talk about convertible debt. Convertible debt can also be called convertible loans or convertible notes. For the purposes of this post, these three terms will be interchangeable.

Convertible debt is when a company borrows money from an investor or a group of investors and the intention of both the investors and the company is to convert the debt to equity at some later date. Typically the way the debt will be converted into equity is specified at the time the loan is made. Sometimes there is compensation in the form of a discount or a warrant. Other times there is not. Sometimes there is a cap on the valuation at which the debt will convert. Other times there is not.

There are a number of reasons why the investors and/or the company would prefer to issue debt instead of equity and convert the debt to equity at a later date. For the company, the reasons are clearer. If the company believes its equity will be worth more at a later date, then it will dilute less by issuing debt and converting it later. It is also true that the transaction costs, mostly legal fees, are usually less when issuing debt vs equity.

For investors, the preference for debt vs equity is less clear. Sometimes investors are so eager to get the opportunity to invest in a company that they will put their money into a convertible note and let the next round investors set the price. They believe that if they insisted on setting a price now, the company would simply not take their money. Sometimes investors believe that the compensation, in the form of a warrant or a discount, is sufficiently valuable that it offsets the value of taking debt vs equity. Finally, debt is senior to equity in a liquidation so there is some additional security in taking a debt position in a company vs an equity position. For early stage startups, however, this is not particularly valuable. If a startup fails, there is often little or no liquidation value.

Friends and family rounds, which we discussed earlier in this series, are often done via convertible debt. It makes sense that friends and family would not want to enter into a hardball negotiation with a founder and would prefer to let the price discussion happen when professional investors enter the equation.

The typical forms of compensation for making a convertible loan are warrants or a discount.

Warrants are another form of an option. They are very similar to options. In the typical convertible note, the Warrant will be an option for whatever security is sold in the next round. The Warrant is most often expressed in terms of "warrant coverage percentage." For example "20% warrant coverage" means you take the size of the convertible note, say $1mm, multiply it by 20%, which gets you to $200,000, and the Warrant will be for $200,000 of additional securities in the next round. Just to complete this example, let's say the next round is for $4mm. Then the total size of the next round will be $5.2mm ($4mm of new money plus $1mm of the convertible note plus a Warrant for another $200k). The total cost of the convertible loan is $1.2mm of dilution at the next round price for $1mm of cash.

A discount is simpler to understand but often more complicated to execute. A discount will also be expressed in terms of a percentage. The most common discounts are 20% and 25%. The discount is the amount of reduction in price the convertible loan holders will get when they convert in the next round. Let's use the same example as before and use a 20% discount. The company raised $4mm of new cash and the convertible loan holders will get $1.25mm of equity in the round for converting their $1mm loan ($1mm divided by .8 equals $1.25mm). Said another way $1mm is a 20% discount to $1.25mm.

Convertible notes also typically have some cap on the valuation they can convert at. That cap is anywhere from the current valuation (not very common) to a multiple of the current valuation. Recently we are starting to see uncapped convertible notes. These notes have no cap on the valuation they can convert at.

Startups typically think about raising capital via convertible debt early on in the life of a startup. They want to move fast, keep transaction costs low, and they are often dealing with a syndicate of angel investors and it is easier to get the round done with a convertible note than a seed or series A round. While these are all good reasons to consider convertible debt, I am not a big fan of it at this stage in a company's life. I believe it is good practice to set the value of the equity early on and start the process of increasing it round after round after round. I also do not like to purchase or own convertible debt myself. I want to know how much of a company I've purchased and I do not like taking equity risk and getting debt returns.

However, later on in a company's life convertible debt can make a lot of sense. A few years ago, we had a portfolio company that was planning on an exit in a year to two years and needed one last round of financing to get there. They went out and talked to VCs and figured out how much dilution they would take for a $7mm to $10mm raise. Then they went to Silicon Valley Bank and talked to the venture debt group. In the end, they raised something like $7.5mm of venture debt, issued SVB some Warrants as compensation for making the loan, and built the company for another year, sold it and did much better in the end because they avoided the dilution of the last round. This is an example of where convertible debt is really useful in the financing plan of a startup.

My guess is we will see the use of convertible debt, particularly with no compensation and no cap on valuation, wane as the current financing gold rush fizzles out. It will remain an important but less common form of early stage startup financing and will be particularly valuable in things like friends and family rounds where all parties want to defer the price negotiation. But I expect that we will see it used more commonly as companies grow and develop more sophisticated financing needs. It is a good structure when the compensation for making the loan is fair and balanced and when the debt vs equity tradeoff is useful for both the borrower and lender.

#MBA Mondays

Comments (Archived):

  1. Adam Naisbitt

    Nice article, although I think you’ve used 25% rather than 20% in your discount example?

    1. Adam

      NM ūüôā

    2. fredwilson

      I don’t think so. A 20% discount of 1.25 is 1

  2. Loren Heiman

    I just wanted to say how much I enjoy reading your articles. You explain complex ¬†topics simply and easy to understand. As I’m currently working at my first startup, your site is absolutely invaluable! Keep up the great work, thanks!

  3. David Adewumi

    Great post, Fred. This is a fantastic read to go along with @dweekly ‘s Intro to Stock & Options:¬†http://www.scribd.com/doc/5….¬†

  4. Pete Forde

    Great post ‚ÄĒ this is the best explanation of the subject I’ve ever read. Instant bookmark.I’m curious if your preference against convertible notes has ever taken otherwise promising deals off the table at USV. If so, is this more likely to be the startup walking away or your team deciding against involvement?

    1. fredwilson

      Its never gotten in the way. We can offer an entrepreneur an attractivealternative to a convertible note

      1. ShanaC

        what makes for attractive alternates if you are part of the group that isn’t so into convertible debt

  5. megawhiz

    In your example, if the warrant is for 20% and the VC is anyways paying the whole $200k how is that compensation? To illustrate, the VC will end up paying¬†1.2M ($1M convertible debt & 200k warrant) and end up owning whatever share of the company he can get for $1.2M – why not simply get a convertible debt of $1.2M initially?¬†On the other hand, aren’t discounts better since you get $1.25M of equity for $1M debt?

    1. fredwilson

      A warrant is usually a 5 or 10 year option so you get to wait to invest that200k

  6. awaldstein

    I learned a few valuable things here Fred. I like that to happen every day, Thanks.

    1. fredwilson

      I drank a white wine from Jura on sat night at Les Fines Gieules in Paris.Gotham Gal has a post about that meal on her blog

      1. awaldstein

        Been following her posts and suffering Paris envy big time.The wine was most likely a Vin Jaune from the Savagnin grape, the most famous indigenous white of the region. Jura wines, red and white, just rock.

  7. Bruce Colwin

    What happens to the note holders if there’s an acquisition prior to the venture round? Also, you don’t mention interest. What’s typical?

    1. fredwilson

      You get your money back. Sometimes investors will negotiate for a multiplierin liquidation like 1.25x or 1.5x

      1. Robganjon

        Just happened to me. I had the choice of getting 150% of my money back or taking the stock of the acquiring company at a 1-1 ratio with my original investment. But because there was no cap on the valuation and my 30% discount didnt apply to a buyout, I didn’t participate in the 3x increase in value from the valuation when I invested to the take out price (4 months). Had it been an equity round at that valuation, I would have been great. I ended up taking the stock in the acquiring company because it’s a private company with good upside potential and I don’t have access to the company’s stock on my own.

      2. Chris Field

        In convertible notes with a conversion cap, investors sometimes will have the option immediately prior to the acquisition to convert the note into stock at the valuation cap. ¬†If the valuation cap approximates the value of the company at the time the note was issued, this effectively makes the note function as preferred stock with a non-participating 1x liquidation preference (Brad Feld has a great post about liquidation preference¬†http://www.feld.com/wp/arch…. ¬†The investor would not convert and simply have their note repaid (i.e. 1X) unless they are better off converting the note into stock and taking the equity upside in the acquisition. ¬†Y Combinator companies often use this form of convertible note.Edit: I also meant to respond to a couple requests in comments for typical interest rates. My experience is that it is pretty typical in the past few years to see interest rates in a seed financing convertible note range from 2%-6%, and occasionally up to 8%. However, if a seed financing convertible note is structured to mimic an equity investment economically (i.e., note has a conversion cap that reflects the current valuation of the company), then I would typically advise my clients to use the lowest interest rate permitted under IRS regulations (currently 0.37%) since the investor is essentially making an equity investment and is not looking for debt returns. Venture debt financing from banks or venture debt firms would typically have a higher interest rate reflecting the current market for commercial loans, often based on some fixed rate above an index such as LIBOR (e.g., LIBOR +6%).

  8. George Tziralis

    Fred, is there a way to secure other investor rights (apart from equity / monetary returns) with a convertible note? My understanding is that there is not, or at least it is not typical at all, and that’s another characteristic of convertible loans¬†with is pros and cons¬†as an option.

    1. fredwilson

      not typically. that’s what entrepreneurs are trying to avoid by doing a ¬†quick and easy debt deal

  9. Adrian Sanders

    Thanks for the article – it’s a great overview on convertible debt.You mention often that when you talk to companies, you want to discuss partnerships in terms of equity only which makes a lot of sense to me at the VC level.But at the early angel stage, maybe just after friends and family, is that really an option for the entrepreneur?¬†Evaluating growth can be pegged to market size, user¬†acquisition, revenue etc., but deciding on valuation that early spooks me.¬†Maybe that’s a case by case basis for each startup to decide, I guess.¬†

  10. Guest

    Thanks Fred. ¬†When I was deciding on whether to raise money from friends via convertible note vs. equity I had already incorporated as an LLC. ¬†I was advised that in order to raise money on a convertible note that I would need to convert to a C-Corp. ¬†If someone in the comments could clarify I think that might be very helpful to others so they know how to incorporate for the first round of fundraising they will be doing.¬†I ended up doing an equity round. I didn’t need to do hardball negotiations with friends because I set a fair price. ¬†I made it clear that I had several friends coming in on the same terms and that everyone had to stay on the same terms for this round. ¬†I’m not sure if this is the “right” way to go, but it worked for me. ¬† ¬†

    1. ZekeV

      You don’t need to be a c-corp to use convertible debt. ¬†You can make the note convertible into LLC equity interests or any other security you desire. ¬†In fact most convertible notes of the type discussed here are convertible into a generic security “of the type subscribed for” in the next significant outside fundraise, leaving it open.

    2. TonyS

      the advice that you received (re: LLC or C-Corp) was quite possibly given in the context of the type of investor and their requirements.¬† i.e., if securing capital from a institutionally backed venture fund there is a likelihood that said fund has some ERISA and/or tax-exempt limited partners, an LLC structure “may” present some tax¬†consquences for the underlying limited partner irrespective of the type of financing instrument (e.g., convertible debt or preferred equity).¬† tax consequences that could arise include UBTI, passive income, etc.¬† that said, there are ways to address it…but, it will be much cleaner to a traditional fund to have a C-Corp status.

    3. Steve Marzocco

      Kelly, we just went through an extensive and current, exercise on the best structurings for our own and certain key/ target portfolio companies we are working with, including best State. ¬†Given that for one of these, we see solid odds for what would otherwise represent an exceedingly rare opportunity for a quick and very lucrative flip, we settled on an LLC structure rather than a C-Corp. ¬†This was for one specific portfolio company of those we’ve actually formed/ are forming, around spinning out one or more, of several key substantial fields/ licensing opportunities, from another of our portfolio companies. ¬†In short, the only reason it made sense for us to do the LLC formation in that case, was expressly due our minimizing double taxation exposure for the proceeds in event the quick flip completes. ¬†Simply stated, my bet from what you have shared, is that TonyS has likely communicated the reason you were informed as you were, regarding your own LLC. ¬†Now this all said and now I’m writing generally since one never knows who else is reading, this certainly isn’t to be taken that it does not make sense for certain or perhaps even many NEWCOs to be formed as LLCs; there are far too many reasons someone should ensure they have the right corporate counsel and finance plus tax professional inputs, with the right areas of expertise, before locking down on initial structure.

  11. Alex Murphy

    If the main point of¬†convertible¬†debt is to not get too diluted … ie take a $100k investment with a pre money value of $200k, one option is to sell stock for a much smaller amount, say $10k or $20k, with a post money value of $200k, and then have the investor make an unsecured shareholder loan (low rate) to the company for the difference that can be converted much later as straight contribution, or that can ride along until the company wants to pay it off. ¬†This way the entrepreneur doesn’t get too diluted, the investor gets to hold stock, and the company gets the working capital. ¬†I have wondered for a while why this isn’t more popular.

  12. Reid Curley

    Nice post Fred. It is kind of implied in your discussion, but it’s probably worth mentioning that convertible debt is often used in later stage companies as the first chunk of a round as a bridge to the rest of the round. One example might be when existing investors want the company to get some cash immediately but want a new investor to provide a valuation. This can also reduce the chance that a new investor tries to play chicken when the company is running low on cash. You just need to make sure, as the saying goes, that the money is in fact a bridge rather than a pier.

  13. andyswan

    When it comes to freinds and family…a¬†convertible¬†can backfire. Remember, you’re kicking the “valuation” can down the road to a much different environment.Imagine scenario: ¬†F&F put in $150k on a 20% discount conv. to get your product built and have you step away from job for a while. ¬†Things go exceedingly well, the product is an enormous hit instantly! ¬† They are excited, you are excited. ¬†You set out to raise money and in frothy environment you manage a $12.5m valuation! ¬† Awesome, right? ¬† Except now your F&F are pissed because they own 1.5% of the company that they believe would not have existed without them…. “I never thought we could have less than 20%!”Thanksgiving’s gonna be rough….Summary: ¬†Walk through all possible scenarios with F&F no matter what tool you use. ¬†From abject immediate failure all the way through skyrocketing success.

    1. ChuckEats

      thus the need for a cap of some sort for any serious investor. 

    2. Nate Boyd

      The problem is not that they end up with 1.5% of the company, it’s that the entrepreneur set the wrong expectation.¬† Your friends and family should be happy that they own 1.5% of a high-valued and presumably fast-growing company and they paid 20% less than the superstar VCs who just invested.

  14. Guest

    What types of assets are pledged (collateral sought) in the consumer internet convertible debt deals? Are/Is there any? For example, in a non-tech deal a debt financing investor might seek some additional underlying collateral. I have been wondering if this happens in tech deals.Bottom line, I am curious as to what happens to (who gets claim to) any underlying IP that might get developed in a convertible debt deal if the company goes under (liquidation, etc.). Do/Can the creditors lay claim to it? What do the standard docs (if there are any) typically allow?Thanks in advance to the community for any wisdom you can share here.GeoffreyP.S. Welcome back Fred{UPDATED}

    1. ZekeV

      The note can be unsecured (no collateral) or secured (usually by all assets and business).  Either way, the creditors of a bankrupt startup could very well walk away with the IP.  Even the unsecured creditors, if there are no secured or senior unsecured creditors, could end up holding the remains of the business.  If you want to use a debt instrument but still hold onto your IP in bankruptcy, you might try licensing all the IP to the startup rather than having it actually owned outright.  However, more sophisticated investors might balk at that move.

      1. Guest

        Thanks so much for the reply Zeke. I appreciate it. I have been waiting for Fred to touch on this topic. Debt financing in consumer internet tech has really fascinated me for a number of months now. As I said earlier, I do not have any firsthand experience in this particular area. I have been hoping to gain some wisdom from the AVC community in this particular niche area of consumer internet company financing.I have been wondering if there are any additional execution risks for entrepreneurs. It seems the risk of not executing successfully could actually be greater using this type of financing mechanism if the underlying idea/concept/prototype is something really off-the-chart provocative with the potential for major disruption and the creator has the potential to lose access to their IP if the first attempt fails.

    2. fredwilson

      no specific assets are pledged. it could be secured by all assets but usually there aren’t any of consequence

  15. VC Experts

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  16. PhilipSugar

    ” If a startup fails, there is often little or no liquidation value”¬† I agree its money spent on coding and marketing and if things don’t work out, who wants to buy a failed idea?This is the key to why this is a challenge.Convertible debt was originally structured so that if I loaned you money to buy a machine and that machine made you successful I could share in the upside.¬† I was protected on the downside because I could repossess the machine.¬†Debt in general is always lent against the value of an asset.¬† Here that is not the case.

    1. Guest

      I am not so sure about this, hence my earlier reply/question/comment. What if the idea is just way too early for the market? I understand loads of the money spent in a consumer tech company might not have liquidation value (marketing and coding) but that is not necessarily always the case. Some of that coding could retain a bit of value … even going out a few years. And if there was some patents (I am NOT trying to open up this can of worms) these could potentially have some value too. So, I am curious if a creditor can lay claim to IP assets like creditors can lay claim to hard assets in traditional debt financing deals. I do not have any firsthand experience in this area of consumer tech at all and am very curious.

      1. PhilipSugar

        “Some of that coding could retain a bit of value … even going out a few years”With all respect, I enjoy your comments, that is just plain wrong. I once was negotiating with a BigCo exec that was a former navy guy about buying a tiny piece of their business.¬† He kept going on about how much they spent to code it, and that they might “mothball” it.¬† Code loses value faster than bananas.I know its hard to¬†wrap your mind around it¬†but in technology the only thing that is worth money is if users think its worth money.¬† Effort means nothing.¬† Which if it fails means its worth nothing.Here is an interesting question I have for you a CPA: Is the company now techincally insolvent because they owe more than they have in assets??

        1. awaldstein

          This is true outside of tech as well Phil.Market proof is all there is.

          1. PhilipSugar

            You are completely right.¬† It is so stark in technology though.¬† If you build a building in a bad location it doesn’t matter what you paid its worth what the market says it is.¬† But usually it has some residue value.¬† In technology it can all go up in smoke.

          2. awaldstein

            True.¬†Hadn’t thought of it that way.¬†Without inventory or physical assets, zero value is possible.¬†

          3. PhilipSugar

            Thought about this some more.  Code and marketing efforts lose value faster than bananas.  Its why its a huge red flag if I see a company capitalize either.How long would a tech comany last if they fired their entire development staff and stopped all marketing? 

          4. awaldstein

            Ultimately tech (=online) companies have little value outside of the relationship of the customers to the product (revenue/biz model). What else is there really?In biz model/product fail situations, certainly code with specific capabilities (especially with an engineering team) and IP can have intrinsic value even if the mission they were built for is a fail. Case by case determination. Fire sales sometimes are flames, often though lots of smoke.¬†Brand as encapsulated in a name and belief are the residue of successful product/marketing can sometimes pivot with the company (Apple for example), sometimes (but infrequently) live after they change hands (in M & A rollups) but a shell is usually just that…a shell and not worth that much.Exception like big URLs aside, I think above stands true for most of my personal experiences winning and not.

        2. Guest

          Philip,”I know its hard to wrap your mind around it but in technology the only thing that is worth money is if users think its worth money. Effort means nothing. Which if it fails means its worth nonthing.”there is no disagreement with me on that point. I am a firm believer that effort does not equal value … even outside of tech. Example, a building that was built recently but in a poor location should not necessarily be valued at a “replacement” cost (e.g. effort) if history has shown it is in a poor location and does not support rents and a decent vacancy rate.However, the productivity of an asset in the hands of one person is not necessarily the same as it is in the hands of another. Another person, or team, might use the assets in a better manner and therefore the assets might have some value to them. That is what I am trying to get a better understanding. Are convertible debt financing deals typically secured in the consumer internet industry? If so, who then controls some of these assets in a liquidation type of event? Is the underlying tech and IP meaningful enough for entrepreneurs to consider this when they are considering equity vs debt financing? Etc.{Updated}

          1. PhilipSugar

            Funny we gave the same example at the same exact time.There is always a¬†maturity to the debt.¬† If you call it and the company doesn’t have the money, you can force it into bankruptcy.So yes its secured by the assets.¬† But the point is the assets aren’t worth much.Frankly, other than this instrument, unless you are large, any debt is going to be personally guaranteed.

          2. Guest

            Hah! Yeah, I see that. I replied via Disqus dashboard so I didn’t even see the new thread that you and @awaldstein ¬†had started. Using real estate, where possible, is nice to use in examples because it is SOOO tangible and, well, real.¬†I am so intrigued with the popularity of convertible debt in this industry. Honestly, I don’t get its acceptance and adoption personally, especially among the investor side of the equation in the consumer tech space ¬†… but what the heck do I know. I have been waiting for this post since Fred mentioned he was doing these.I have seen both liquidations and some ‘calls’ outside of tech and that is why I have been so curious as to what happens in consumer internet. My guess is 9 times out of 10 there is zero value but for the 1 out of 10 liquidation events that occur in this space I can see where there is some underlying IP/tech that was launched too soon and needs the market to catch up or whatever. In those cases (even under a liquidation scenario) I just wonder who retains the upside potential.

          3. PhilipSugar

            “Honestly, I don’t get its acceptance and adoption personally, especially among the investor side of the equation in the consumer tech space”Fred nails it as usual when he says: “will be particularly valuable in things like friends and family rounds” but not for investors.You as a CPA understand Balance Sheets.¬† The problem is you have no asset to balance the liability:Don’t get me started on capitalising development expenses.

    2. fredwilson

      that is why i don’t like debt in startups. it doesn’t make sense to me. i feel the same way about venture debt.¬†

      1. Nate Boyd

        Fred, if you were a startup CEO and thought that the “frothy market conditions” made an attractive convertible debt round possible, would you go for one?¬† You wouldn’t want to use that to bridge to a higher valuation in 6-12 months and perhaps a much stronger VC round?¬† (Of course, betting on continuing strong market conditions is another risk/discussion).I get *your* perspective on this as VC investor, but I don’t see the compelling argument against it for a startup that can attract “smart money” angel investors, such as brand-name fellow entrepreneurs, as a way to accelerate and maximize the first valuation investment event.

        1. fredwilson

          i wouldn’t because i don’t like to gamble like that

  17. ZekeV

    The delayed pricing feature built into this convertible debt instrument can also be had with simple warrants or options. ¬†Friends and family types often don’t care whether they receive collateral or even unsecured creditor status in a bankrupt startup. ¬†So why not give them warrants with the same exercise and delayed pricing terms as the note? ¬†Then you have all your credit and collateral left to pledge to a lender who really does care about such things (e.g., a VC providing a bridge loan pending final negotiation of a larger preferred stock round).

  18. GregJ

    FREDCan you write a blog post on investor taxes (e.g. filing 83b vs deferring, etc)

    1. fredwilson

      i’m no expert on taxes

  19. JLM

    Great read, as usual.Convertible debt is like a three legged stool, you can trim one leg but you better pay attention to the other two also.Folks sometimes forget that debt and equity have different characteristics and upside.Convertible debt bridges some of the differences but it is still debt and not equity and will earn a debt style rate of return.

  20. JoeyRoccioSV

    Thanks Fred. ¬†Trying to understand your preference for convertible notes… you like this form of financing when you already have a stake in the start-up (“later on in a company’s life convertible debt can make a lot of sense”), but you don’t like it when you’re on the outside of a deal looking to buy in?From an entrepreneur’s perspective, this makes convertible notes sound attractive at both times. ¬†Maybe I’m missing something. ¬†Thanks.

    1. fredwilson

      debt makes sense when there are assets to borrow against

  21. ShanaC

    with no upside cap on convertible notes, have you ever seen an entrepreneure get into trouble because the note was called?

    1. PhilipSugar

      That is an interesting question.  Most have 1-2 year periods.  One could paint an interesting scenario, like the company got an offer that was just the amount of the note and the investors just wanted their money back, but I would think most convert.  I.e. most times you can convert to a preferred round at a fixed price.

      1. ShanaC

        Yeah, I know – it is a situation that could happen, but that I don’t hear about happening….

    2. fredwilson

      not on a seed investment

      1. ShanaC

        Other rounds then?

    3. BillReichert

      This is indeed a somewhat rare but important issue for entrepreneurs — not that investors will ask for their money back, but they might ask for better terms as the note approaches a due date.¬† Generally, convertible notes term out and become due in a year.¬† Some investors will limit the term to six months.¬† Usually, everyone expects that the next financing will happen sooner, so no one pays that much attention.¬† But we have definitely seen seed rounds get extended beyond the term of the first convertible note, at which point the entrepreneur might have a problem.¬† As the note becomes due, the investors have significant negotiating leverage.¬† Whether the business is doing well or doing poorly, the investors can now adjust the terms to improve their position.

  22. Mark Essel

    Appreciated the utility of convertible debt in both a first round, and a pre-exit round. Warrants and Discounts sound like two sides of the same coin (mathematical equivalence)

  23. Carl J. Mistlebauer

    My experience, as a non tech company, is that the value of convertible debt is nada.VC and angel investors are interested in “investments” rather than “financing.”If you propose funding (and let me add that I am a novice in the field of financing and would have been better served keeping my mouth shut) where two thirds of the funds requested would be secured with inventory, equipment, and AR, that within 8 months of receipt you would begin making payments with 10% interest and even establishing an exit plan, naming who most likely would buy the company and establishing shares of ownership at that time…even though you have dealt with the issue of risk, and you have offered an attractive upside…its too much like financing to be attractive to investors.When the focus is on frothy valuations the concept of risk aversion pretty much bites the dust.I totally agree with Fred that it is an option that start ups can use in particular situations and obviously with friends and family funding but the reality is its limited in its usefulness.

  24. Jim Shook

    What is a typical range of interest rates on this convertible debt before it converts?

    1. fredwilson

      low, like 4-8%

  25. bramcohen

    The big problem with convertible debt for an investor is that on the investments which really hit it out of the park, the ones which are the whole reason you’re doing investment in the first place, they’ll just give you debt returns.

  26. Thom Maslow

    very well covered and points well taken — we did convertible notes for our F&F and it has worked well.¬†

  27. Anand Kamannavar

    Also one of the other issue with convertible debt with warrants/discount, is that the new investor can always price them in. So in above example instead of giving $4M valuation, the investor may give a lower valuation so that he still ends up having the same % of the company as would have been the case if there was no convertible debt.¬†Other reasons for convertible debt include – Corporate VC’s not wanting to set valuation.

  28. Ethan Stone

    Great post, as usual.¬† It’s worth mentioning that capped convertible debt necessarily involves some pricing, since the investor and the founders have to agree on a cap that makes sense.¬† Admittedly, both sides only need to agree on a range of acceptable prices, which is easier.¬† But you can’t avoid the pricing problem entirely unless you don’t cap.¬† And there are serious problems (from the investor’s perspective) with not capping.Also, there’s another, darker, situation in which startups use convertible debt.¬† When a company is in trouble, the investors sometimes put up one or more rounds of convertible debt to try and salvage the situation.¬† When it’s rational (not very often), the idea is to bridge over to a realistic sale of the company or to finance the company to a defined point (e.g. a product launch or a big partnering deal) that might change the financial situation.¬† Often, it’s just good money after bad.¬† That said, the terms of these “circling the drain” rounds are often draconian, with the conversion and attached warrants effectively wiping out the existing equity.¬† That can result in very bitter fights later, whether the business succeeds or fails, since the board is almost always conflicted in approving the debt and often acts with unseemly haste (usually there’s a topsy turvy rush when the company realizes it won’t be able to make the next payroll).¬† So it’s probably worth thinking more carefully about these things before doing them.¬† It’s a very different animal, but worth mentioning in this context.

    1. fredwilson

      totally agree. when things go bad, the financing discussions get really ugly. i’ve seen it so many times

  29. jb

    Great post and fantastic comments.  Thanks all.

  30. Mark Kornak

    The only thing not mentioned here is that debt needs to be secured. If a company does a debt offering it must pledge some asset such as IP as collateral. The company better make sure the funds from the debt issue gets them to profitability. If not, it is difficult to raise additional funds. I have seen many investors and founders loose their companies when they take under fund or take the only money available to them at the time.

  31. Dave W Baldwin

    Good post.¬†I would be pushing the offer of equity so the convertible (1 becomes 1.25) makes more sense.¬† At least that guards against the first investor(s) not putting the money forward and the later investors getting better deals.Otherwise, in today’s tech world, if the design makes sense, the investor expecting return in interest will more than likely be pissed realizing they would have been better with the equity.Re the later investors getting sweeter deals, that is a problem.¬† I have a couple a guys in the wings who’ve really been burned and that definately leaves a bitter taste in one’s mouth.

  32. Tim O'Loughlin

    One minor clarification: The SVB debt was venture debt – not convertible debt…because it doesn’t have a convert feature.¬†

  33. Harry DeMott

    Maybe I’m crazy on converts – but the way I view them is – it is what it is.they are here and as long as the market is frothy – they are here to stayCompletely agree that uncapped converts are insane. All the downside – none of the upside.As to capped converts – I just assume that you are pricing the deal at the cap. If you don’t reach the cap in the next round – something has generally gone wrong – or you have just put the cap way to high.