Why I Hate Convertible Debt...Let Me Count the Ways

My partner in Menlo Incubator, Gary Kremen, and I had a recent debate on which one of us hates convertible debt more. We weren't able to declare a winner, but I did agree to write a blog post on the topic. This will also serve as a good pointer for all the entrepreneurs who ask why I am not interested in their company led convertible note financing round.

I thought about doing this in a top 10 format, but will limit to my top 3 reasons:

1. Misalignment of incentives - As an angel investor I want to do everything I can to help the entrepreneur succeed. In a convertible note structure, I'm penalized for increasing your valuation. Instead of getting a 2-3x multiple from seed to Series A, I get a discount off of the Series A, so I'm better off financially with a lower valuation. Investors are taking all of the downside risk and not getting the upside.
   
2. Is This a Bridge or a Pier? What is the debt converting into? At some point, the debt has to convert or be paid back. Convertible debt can be like a drug - "just a little bit more and we'll hit that milestone". I've seen a number of entrepreneurs, angels and VC's fall into the trap of providing debt in small pieces. It all adds up and the more you have the bigger the round needs to be justify the valuation based on new cash in.
3. Why Invest in an insolvent company? Technically, the start-up is insolvent from the day they take the first dollar of investment. This can make it much more difficult to get any bank financing, new investment, and trade credit. Most entrepreneurs don't realize this, but they have actually given a lot of control to investors with convertible debt. Depending on how the transaction is structured, investors could block a financing and potentially take over the intellectual property. Most don't have any interest in this, but why take that risk that one of your investors may decide to call the note.

The arguments for convertible debt are that it is quick, easy and cheaper to get a financing done. There isn't a need to negotiate a number of terms in standard preferred financing documents and legal fees will be less. From my experience, negotiating debt deals with an experienced investor will result in a number of the same terms and won't save much (if anything) on legal fees. Particularly, now that standard Series Seed docs are commonly used.

So when does convertible debt make sense? In cases where it is truly a bridge financing (i.e. venture term sheet negotiations in progress with strong likelihood of closing), I'm willing to take that risk and don't deserve a ton of reward for taking the additional risk at that point. Also, for first money in from friends & family, it makes sense. In some cases, where the round is very small ($100-$200K), it doesn't make sense to price. However, I would generally look to increase the size a bit and price if I were involved.

There was a good post recently by The Funded, "The Year of the Start-up Default" that discussed the potential ramifications of all of the convertible debt outstanding now. There are probably thousands of companies that have taken convertible debt in the past 18 months. Most of these are not going to raise venture financing, get acquired or become profitable. Even the ones that do get to cash flow breakeven, will not likely be in a position where they could pay back the debt. So what happens to these companies? Some will just shut down. Others will attempt fire sales. Many others may end up filing for bankruptcy or doing an assignment for the benefit of creditors (ABC).

You may say, if you are investing in the next facebook or google, why care about valuation? The returns are going to be so big that you want to have a piece of the best deals rather than more ownership in companies that aren't going to do well. That seems to be Paul Graham's (YCombinator) argument. However, using portfolio theory, your losers are going to far outnumber your winners, so taking half or more of the gains out of the winners will have a big impact on the overall returns.

So, the next entrepreneur that tries to convince me that a convertible debt is good for everyone, I'll say, "Let's figure out how much money you need to get to a significant milestone, raise the funding, price the round, and work together to build value. If we're successful, everyone wins. If we're not, let's go down on the ship together and hopefully stay out of those lawyer (I mean shark) infested waters..."