If you are reading this then you’ve likely read our Convertible Debt Part I article where we discuss the dynamics, mechanics and important terms of convertible debt financing. So now, you might be considering it for your next financing round and are curious what other items you need to address in making your decision. While popular in today’s early-stage financing, that doesn’t mean it’s the right choice for you. To be sure you’ve looked at all the angles, let’s review some of the catch points, pitfalls and alternatives before you make your decision.
Convertible debt is typically easier than equity financing, however there is one situation when it’s not, that’s during an exit. During an acquisition, convertible debt can play out in several different scenarios. First, the investor would get their money back plus interest. Second, the investor would get their money back, plus interest, plus a multiple. Third, some type of conversion would occur, for example, the investment could convert to stock of the acquiring company if it were a stock deal. Since the term ‘the exit’ is such a popular one in today’s early-stage dynamics it’s likely that if the company is successful and acquired, the founders will find themselves in one of these situations. For this reason, it’s best to structure how the debt will be handled in the event of an acquisition rather than negotiating it with the investor during the exit.
Of course, while we all plan for our company to achieve liquidity, there is always the possibility it won’t. Under these circumstances it’s important for entrepreneurs to consider the hypothetical situation that the company does fail, in which case the officers and directors have a fiduciary duty to the creditors on behalf of the company. Remember, convertible debt is frequently used because entrepreneurs and investors can postpone the hassle of valuing the company. If the company fails, there are many circumstances where things can get nasty during company dissolution and lawyers may try to show bad faith management by the company directors. In some rare cases, states could permit creditors to ‘pierce the vail’ and sue directors personally. Convertible debt is just that, debt, keep this in mind while you are pursuing your financing.
Last but not least, what are the alternatives to convertible debt? Ideally, it would be great if entrepreneurs could structure financing that combines the best of debt and equity. Enter, the Simple Agreement for Future Equity (aka SAFE) which was designed a few years ago at Y Combinator. The general concept of ‘the safe’ is that the investor essentially buys an unpriced warrant in the company. The safe can still have a cap and/or discount but it also has a few disadvantages for investors compared to convertible debt. You can find more information about the safe by consulting an advisor who is not only good at math but also has experience with VC financing. Whether you structure with convertible debt or an alternative, both the investor and the entrepreneur are deferring a discussion regarding valuation until a later date. This is something that can cause confusion and resentment if the scenarios are not considered at the time of financing.
