The convertible vs. equity trade-off

Posted on 18. Apr, 2007 by jon in Building eduFire, eduFire News

We’ve spent a fair amount of time in the last couple of months analyzing whether it makes more sense as a start-up to raise money as straight equity or convertible debt. Some might say that was wasted time but I think it’s an important decision and has been a great learning process for Kareem and me. Based on what I’ve learned here’s my summary:

Straight equity is better than convertible debt because interests are better aligned.

Convertible debt is better than straight equity because early-stage businesses are very tough to value.

So there’s a trade-off here. If you go with equity everyone is on the same page. The better the business does in the early stages the more rewards the investors receive. At first glance that seems pretty appealing. But here’s the problem. When a business is pre-launch and has no traction, revenue, etc. it’s very tough to value. Is it worth thousands? Hundreds of thousands? Millions? Trying to assess a proper value is pretty difficult. And here’s the problem with that.

Scenario #1 – Let’s say the entrepreneurs convince the investors that the biz is worth a ton (e.g., say $5 million post-money). They raise some money (let’s say $500K for 10% of the company). Over the next six months the biz hits some hardships and when they go out to raise their Series A they can’t find anyone who will attach a value of more than $5 million to the biz. The company then has to do a “down round” which is no fun for anyone. The investors have lost money (unless ratchet provisions are in place). The entrepreneurs have seen their paper net worth descrease. Not good… OK, here’s another possibility…

Scenario #2 – Let’s say that the investors do the convincing and the biz goes out at a very low valuation (e.g., say $500K post-money on a raise of $250K). This looks like a good deal for the investors right? Not necessarily. Let’s say that the company progresses nicely and ends up doing a Series A at a post-money of $4 MM. Two VCs invest and want a total of a 40% stake so they pony up $1.6 MM for this. The original entrepreneurs now have a stake worth $1.2 MM which isn’t bad but they only have 30% of the company post Series A with the prospect of further dilution in future rounds. Plus, since they have common and not preferred it’s likely that their payout if the company is acquired could be pretty low. Not to mention the fact that they no longer control the company… The problem here? The entrepreneurs could start to lose motivation and that’s typically not a good scenario for anyone.

Convertible debt isn’t perfect (if it were everyone would use it). However, after reading up a ton on it and talking to a lot of people it seems like a good alternative to traditional equity financing because it delays the crap shoot nature of picking a proper valuation until the company has some better metrics on which to base that valuation.

Interested to hear feedback…I love people telling me I’m wrong. Seriously. :)

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sundeep

Totally agree with everything you wrote...the only issue is what if the investors you want will only do equity? Is it worth passing to find someone willing to do convertible?

jon

Depends on your situation. If an entrepreneur can get a high valuation in a seed round then that's a great option. You can always protect the investors with provisions so if there is a down round they don't suffer.

Yokum

As one of your advisors, I can see that you have really done your homework and thought through the issues. Generally speaking, I agree that an entrepreneur is better off with convertible debt (that converts into Series A at a discount) over a Series A at a low valuation. The issue then becomes whether the amount of the discount on the Series A is adequate to compensate the investor for the early risk he/she is taking. As between warrant coverage and a discount on the Series A to compensate the early investor, I prefer the discount because warrants tend to unnecessarily complicate your cap table.

Garett

I posed this post to a few Angel investors and their responses are below:

First Response:
A number of good points here, but remember that convertible debt means that the "investors" (who are still just lenders at this point) won't know what their interest in the company is until the first round establishes a pre-money valuation. They have taken investment risk and valuation risk.

One typical way to alleviate that is to provide for a discount off the valuation in that first equity round, when it takes place. Problem with this is that if the company has not performed as expected and is in need of the funding from third parties (not the convertible debt holders), the new money can require that the discount be wiped out, thereby taking any advantage away from the original risk-takers.

Sometimes, a better way to go is to have a proper first round with equity at a lower valuation (to make a next down round less probable), but add warrants to help juice the investors' return prospects.

Second Response:
This is a tough issue. Another approach is to use warrants conveyed up front to convertible debt holders (perhaps with a strike price tied to the future valuation or some performance metric) rather than a discount clause. It could be tougher to require warrant holders to give up or modify their warrants than to have the discount waived, so the convertible note holders might be in a marginally better position.

Unfortunately, anything done can be undone, so the last money in can rewrite the rules to a large extent, particularly if the company is pretty desparate.

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The convertible vs. equity trade-off

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