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Is There More Than One Type Of Convertible Debt?

Troy Henikoff and I had lunch a month or so ago in Chicago and the conversation turned to convertible debt. I’d recently made an offer to invest in a company Troy was an investor in and the entrepreneur and I got tangled up in the definition of pre and post money in the context of existing convertible debt. In this case there were multiple traunches of convertible debt at different valuation caps. My offer was above the highest cap, but I interpreted the way the convertible debt, and pro-rata rights associated with it, worked differently than the entrepreneur did. Given the magnitude of the convertible debt, the way the debt was handled had a significant impact on the post money valuation dynamics. Ultimately, the entrepreneur and I couldn’t narrow the gap and we didn’t end up working together.

There were no hard feelings on my side (I like the entrepreneurs a lot) but it made for an interesting and awkward discussion. Troy did a great job of processing it and wrote an important, and thoughtful blog post, titled Convertible Debt: really Bridge Loans and Equity Replacement DebtIf you are an entrepreneur who is raising, or has raised, convertible debt, I encourage you to read it carefully.

In our conversation, we talked about a nuance which Troy left out – namely that the magnitude of “equity replacement debt” matters a lot. If it’s a small amount (say – $300k or less) this issue isn’t that severe. But once it gets up to $1m or more, the problem often appears in a big way. My partner Seth covered this nicely in his post That convert you raised last year is a part of your cap table.

All of those convertible debt rounds that happened in 2010, 2011, and 2012 – including a bunch of uncapped ones – are now turning into either equity rounds or unhappy situations. The more everyone on both sides understands the dynamics, the more effective the future financings, including the future convertible debt rounds, will be.

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November 28th, 2012 by     Categories: Convertible Debt     Tags:
  • http://twitter.com/TroyHenikoff TroyHenikoff

    I totally agree with Brad that the magnitude of the issue is related to the size of the “equity replacement debt” that is raised. At Excelerate Labs, our rule of thumb is that you should try to not have more than 30% of your expected next raise in convertible debt. So if you are expecting to raise $2MM in your next round, do not have more than about $600k in debt or it will start to become an issue…

  • http://www.pointsandfigures.com pointsnfigures

    I won’t do an uncapped convert debt round. Hate em. Passed on an interesting company with a great entrepreneur simply because it was uncapped convert debt.

    I agree with Troy and Brad that entrepreneurs should be very careful about how they use debt, and understand what it means to have debt on their sheets instead of equity. I might be more conservative about the amount of debt than Troy. Most companies can get going with a seed round of 300-500k-if they are it/digital.

    If you can do a big round, then price it, and make it a series A. It’s better for everyone in the long run.

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  • JeffCorn

    My team has bootstrapped our way for two years and are now considering a convertible debt ‘seed’ round to scale. We have relatively strong and growing revenue, and expect that distributions will be made prior to a conversion event. How have you seen convertible notes handle distributions (if any) prior to a conversion event? ie, if there is no established valuation, would any distributions be deferred until conversion?

    • http://www.feld.com bfeld

      Why would you raise a convertible note and then do a distribution? I’m not sure I understand this.

      • JeffCorn

        In this case the conversion event would be an exit rather than an A round. ie, if we determine that after the seed round we don’t need add’l funding in order to pursue a successful exit, there could be a case where we make a distribution prior to the conversion. Thoughts?

        • http://www.feld.com bfeld

          Why wouldn’t you just pay down the debt?

          • JeffCorn

            I was under the impression that paying down the debt is not typically an option with a convertible note. Am I mistaken? ie – If I’m an investor, I’m entering the deal for an equity position – I’m not going to be excited about being made whole with a debt paydown.

          • http://www.feld.com bfeld

            It can easily be written into the note as an option.

          • JeffCorn

            Thanks Brad. Do you often see such clauses in convertible notes?

          • http://www.feld.com bfeld

            Sometimes.

          • joewallin

            Jeff, notes can be written either way. They can be written so that the investor can’t be repaid in cash without the investor’s consent. They can also be written to give the company the right to repay the investor in cash at the company’s option.

            By the way, it does happen that investors change their mind and don’t want to be converted into equity.

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