This week I’m going to do pieces on convertible debt. Today, I’ll be discussing aspects of convertible debt that tend to be bad for startups or even both parties. On Friday, I’ll discuss those concerns in the context of a new private equity vehicle created by the Founder Institute and the law firm Wilson Sonsini called “convertible equity”, and give my thoughts on that.
One term often contained in convertible debt deals that can cause problems for both startups and early investors is a conversion cap, which sets the maximum pre-money valuation at the next financing round (typically Series A). While no cap is bad for investors as it can lead to too much dilution for their investment, a cap can be bad for the startup. As Mark Suster points out in a guest post on TechCrunch (http://techcrunch.com/2012/09/05/why-convertible-notes-are-sometimes-terrible-for-startups/), how bad things get for startups depends on whether the anti-dilution provision in the convertible debt agreement (and there almost certainly will be one) is a full ratchet or a weighted average ratchet. Full ratchets are particularly bad for startups, except where valuation is expected to increase rapidly, since it can cause an early investor’s share to balloon without having put in any additional money. In addition to full ratchets, discounts can give early investors and even larger stake in the company. Weighted average ratchets are better for startups, as they only convert a portion of the seed investor’s stock at the Series A price, based on the size and price of the Series A deal.
Suster also points out that some convertible debt deals can have hidden multiple liquidation preferences, since seed investors are effectively given a multiple on their investment upon conversion. Instead, he recommends giving seed investors a different series in the Series A class of stock — seed investors and VCs end up voting together, but have different prices for their stock that eliminates the hidden multiple liquidation preference.
In addition, you should also ensure that you have negotiated conversion terms in the event the company never hits a Series A round. It is important to negotiate a conversion price at maturity, rather than leave the issue for maturity. Alternatively, you can negotiate a payment of a multiple of the investment (2x is fairly common) in the event of maturity, or another Series A-interrupting event such as a sale or acqui-hire of the company.