5 ms·

The Year of the Startup Default

71 points by jedwhite 16y ago

pg 16y ago
This is written as if convertible debt financings were like regular debt, where if you can't pay a loan back by a certain time, you're in default and bad things happen to you. That's not how it works in practice. Investors who fund a startup using convertible debt are not hoping the debt will be repaid, like a regular lender is; they want it to convert to equity. So in practice if there's no equity round by the end of the term, the debt either gets converted or the term gets extended. It's not like convertible debt was invented in 2010. I've seen many startups hit the end of the term of a convertible note before raising an equity round, and it has never once been a problem.
- jswinghammer 16y ago
  Thank you for explaining this. I had a few misconceptions about these transactions.
- jedwhite 16y ago
  YC companies are the cream of the crop and have YC's backing, so are in a different position to many other startups also getting funding. YC companies are likely to be in a stronger position for debt to get converted or extended than most startups. They're more likely than the general market to be good quality companies in a stronger negotiating position, and Angels aren't likely to burn YC. Plus it's fair to say that they have the cream of Angel investors, who are likely to act in a reasonable way. I think Adeo's argument is about what happens to the bulk of the market - so applies more to all the others. YC companies have been the exception to many a rule. I hope it proves to be wrong. But if there is a panic/bubble-burst and a herd mentality develops to rush out of the market, it's reasonable to expect many individual angels will lose their nerve and want out, at least beyond the top end of the market represented by the YC startups.
  - pg 16y ago
    No one could "rush out of the market" even if they wanted to. Adeo's article is about the case where the startup doesn't have the cash on hand to pay back the angel. At best (or rather worst) a panicking angel could get the startup's IP, and good luck selling that without the people.
    - cperciva 16y ago
      You seem to be assuming that startups will run out of cash at exactly the moment that their convertible debt becomes due -- maybe this sometimes happens, but I can't help thinking that it would take exceptionally good planning (or a lot of luck). I know there have been cases where startups have decided to shut down and return their remaining cash to investors (including some YC companies, I think); what happens in the case where a convertible debt holder thinks a startup should take that option but the founders aren't ready to give up?
      - pg 16y ago
        In practice it usually amounts to that, because the term of a typical convertible note is a bit longer than the amount of time a typical funding round is expected to last.
        cperciva 16y ago
        Ok, but what if a company takes two rounds of convertible debt? Wouldn't the first one expire while the company is still burning through the second round? Or is it standard practice when a company raises a second round of convertible debt to extend the maturity of the first round?
        AdeoRessi 16y ago
        Two rounds of convertible debt does not really happen, practically, since debt is the most senior security in a company. An investor doing more debt at a later point would not have much advantage over an investor that did debt in the first place. As a result, there is no premium for coming in earlier, when it is more risky. Early debt holders block issuing more debt, generally.
- sabat 16y ago
  Since when is Angel investment a loan, anyway?
  - sabat 16y ago
    It was an honest question. Pro tip: try answering a question even if you consider it to be stupid. Don't just vote down. Not cool.
    - jedwhite 16y ago
      The original link describes the situation pretty well if you read it. A convertible debt is a form of loan, and as the post points out, this is currently the popular way that angels put funds into startups.
    - prodigal_erik 16y ago
      I would prefer not to see HN real estate wasted on redundant answers that were already available in the linked articles. Answering questions that didn't need to be asked encourages laziness and hurts signal/noise.
  - cperciva 16y ago
    Since when angels started using convertible debt instead of straight equity purchases.
- cperciva 16y ago
  I've seen many startups hit the end of the term of a convertible note before raising an equity round, and it has never once been a problem. Maybe I'm being a bit pessimistic, but this really sounds to me like "US housing prices have never fallen by X%". Investors who fund a startup using convertible debt are not hoping the debt will be repaid, like a regular lender is; they want it to convert to equity. I'm sure that this is correct at the point that they provide the funding; I'm less certain about the situation 18 months later. Do you really think that no investor will ever change their mind over the course of 18 months and decide that they'd prefer to cut their losses rather than extend the term of an investment in a company which no longer seems quite so hot?
  - pg 16y ago
    As I explain here http://news.ycombinator.com/item?id=2318164 http://news.ycombinator.com/item?id=2318164 cutting one's losses is not usually an option.
  - AdeoRessi 16y ago
    It only takes one or two investors to pull out of one company, and that company faces bankruptcy. With so many newbies entering the angel market, you just never know.
    - localhost3000 16y ago
      kind of like a bank run on startups? scary thought
- AdeoRessi 16y ago
  Right now, Paul, convertible debt is not a problem today and was not a problem in 2010. Most startups with debt negotiate an extension when the note comes due if there is not a Series A. However, the amount of debt is ballooning, and there are many new angel investors entering the market. The signals are not good. This is a preventable problem with a better angel investment structure that gets widely adopted. I am just pointing out the problem.
- deleted 16y ago
  [deleted]
- mmaunder 16y ago
  I actually thought this post was brilliant. A few items I liked: "First, startups with large debts on their balance sheet will have challenges securing loans, partnerships and vendor credit, impeding their growth. " Debt by any other name is still debt on the balance sheet, so this is a great point. Also: "The majority of convertible debt deals have no mechanism to convert to equity without the occurrence of a Series A, and standard convertible debt deals come due in 12 to 18 months." This is startling. If this is true then many startups are facing a big unknown i.e. how renegotiating their convertible debt will turn out. Will you lose control of the board? How much equity will you lose? etc. While a pat on the back and a "this has never once been a problem" may work for some, it wouldn't make me sleep better at night. I think this is excellent advice: "negotiations should start sooner rather than later about converting the debt to equity upon maturity with your debt holders" Remove the unknown ASAP and give your company a more predictable and stable environment to operate in.
bradgessler 16y ago
The good news, assuming this happens, is that it won't be as difficult for profitable startups that aren't saddled with debt to hire great technical talent since more startups will go under and more developers will be available.
ericd 16y ago
Minor point, but from where I'm sitting, the standard term length seems to be two years rather than 12-18 months. Also, I think in a large percentage of cases, the angel can convert at the cap if there's no liquidity event, so it's not necessarily going to result in mass defaults. If the startup is doing really well, this seems like a more likely outcome than the angels calling back their debt.
- cperciva 16y ago
  If the startup is doing really well, this seems like a more likely outcome than the angels calling back their debt. If a startup is doing well, the worst-case scenario involves issuing stock to new investors in order to pay off the convertible debt. The problem would come in the marginal cases -- where a startup is still running and still has cash in the bank, and the founders aren't ready to give up yet, but hasn't produced anything interesting enough to bring in new investors... or to convince the convertible debt holder to keep his money in.
jayzee 16y ago
Another option where you can have best of the both possible worlds is to do a convertible debt round with a conversion cap. That way the deal gets executed cheaply and quickly benefiting the entrepreneurs. The cap benefits the angel for taking some early risk. And such notes have a clause that convert the debt to equity at the price implied by the conversion cap at the end of the term so no fear of going into default.
iamelgringo 16y ago
Anecdotal evidence suggests that angels are now investing as much as $50 billion Naval Ravikant, who runs angel list states that there's been an additional $500M that has been invested in early stage startups last year.[1] Which is essentially a smallish VC fund. Naval has also stated that 240 companies have received angel funding via Angel list this past year. If every company received $1M, that would still only be $240M invested in early stage startups. I don't understand where the anecdotal $50B comes from. Also.. Estimates are that there are now 10,000 angel financings per year, and as much as 70% of these deals are now convertible debt. Naval Ravikant runs the angel list, and he's saying there are only 240 investments that got money via angel list last year. That's a big discrepancy. I don't have a comment on whether the structure of convertible notes is good or not. I was just very surprised at the numbers Adeo brought up in the article, because they are several orders of magnitude larger than what I'm reading in other areas. If he has other data sources, I'd love to read them. My instinct has been that Angel List has been at the epicenter of getting all these startups funded, and so I've been inclined to use Naval's numbers in my thinking. ref: [1] http://www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2011/03/04/businessinsider-naval-ravikant-2011-3.DTL&ao=2 http://www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2011/03/04/...
- nbashaw 16y ago
  It's my understanding that AngelList is just one small part of the broader Angel market, even if it is the epicenter.

71 points by jedwhite 16y ago

pg 16y ago

This is written as if convertible debt financings were like regular debt, where if you can't pay a loan back by a certain time, you're in default and bad things happen to you. That's not how it works in practice. Investors who fund a startup using convertible debt are not hoping the debt will be repaid, like a regular lender is; they want it to convert to equity. So in practice if there's no equity round by the end of the term, the debt either gets converted or the term gets extended. It's not like convertible debt was invented in 2010. I've seen many startups hit the end of the term of a convertible note before raising an equity round, and it has never once been a problem.

jswinghammer 16y ago
Thank you for explaining this. I had a few misconceptions about these transactions.
jedwhite 16y ago
YC companies are the cream of the crop and have YC's backing, so are in a different position to many other startups also getting funding. YC companies are likely to be in a stronger position for debt to get converted or extended than most startups. They're more likely than the general market to be good quality companies in a stronger negotiating position, and Angels aren't likely to burn YC. Plus it's fair to say that they have the cream of Angel investors, who are likely to act in a reasonable way. I think Adeo's argument is about what happens to the bulk of the market - so applies more to all the others. YC companies have been the exception to many a rule. I hope it proves to be wrong. But if there is a panic/bubble-burst and a herd mentality develops to rush out of the market, it's reasonable to expect many individual angels will lose their nerve and want out, at least beyond the top end of the market represented by the YC startups.
- pg 16y ago
  No one could "rush out of the market" even if they wanted to. Adeo's article is about the case where the startup doesn't have the cash on hand to pay back the angel. At best (or rather worst) a panicking angel could get the startup's IP, and good luck selling that without the people.
  - cperciva 16y ago
    You seem to be assuming that startups will run out of cash at exactly the moment that their convertible debt becomes due -- maybe this sometimes happens, but I can't help thinking that it would take exceptionally good planning (or a lot of luck). I know there have been cases where startups have decided to shut down and return their remaining cash to investors (including some YC companies, I think); what happens in the case where a convertible debt holder thinks a startup should take that option but the founders aren't ready to give up?
    - pg 16y ago
      In practice it usually amounts to that, because the term of a typical convertible note is a bit longer than the amount of time a typical funding round is expected to last.
      - cperciva 16y ago
        Ok, but what if a company takes two rounds of convertible debt? Wouldn't the first one expire while the company is still burning through the second round? Or is it standard practice when a company raises a second round of convertible debt to extend the maturity of the first round?
        AdeoRessi 16y ago
        Two rounds of convertible debt does not really happen, practically, since debt is the most senior security in a company. An investor doing more debt at a later point would not have much advantage over an investor that did debt in the first place. As a result, there is no premium for coming in earlier, when it is more risky. Early debt holders block issuing more debt, generally.
sabat 16y ago
Since when is Angel investment a loan, anyway?
- sabat 16y ago
  It was an honest question. Pro tip: try answering a question even if you consider it to be stupid. Don't just vote down. Not cool.
  - jedwhite 16y ago
    The original link describes the situation pretty well if you read it. A convertible debt is a form of loan, and as the post points out, this is currently the popular way that angels put funds into startups.
  - prodigal_erik 16y ago
    I would prefer not to see HN real estate wasted on redundant answers that were already available in the linked articles. Answering questions that didn't need to be asked encourages laziness and hurts signal/noise.
- cperciva 16y ago
  Since when angels started using convertible debt instead of straight equity purchases.
cperciva 16y ago
I've seen many startups hit the end of the term of a convertible note before raising an equity round, and it has never once been a problem. Maybe I'm being a bit pessimistic, but this really sounds to me like "US housing prices have never fallen by X%". Investors who fund a startup using convertible debt are not hoping the debt will be repaid, like a regular lender is; they want it to convert to equity. I'm sure that this is correct at the point that they provide the funding; I'm less certain about the situation 18 months later. Do you really think that no investor will ever change their mind over the course of 18 months and decide that they'd prefer to cut their losses rather than extend the term of an investment in a company which no longer seems quite so hot?
- pg 16y ago
  As I explain here http://news.ycombinator.com/item?id=2318164 http://news.ycombinator.com/item?id=2318164 cutting one's losses is not usually an option.
- AdeoRessi 16y ago
  It only takes one or two investors to pull out of one company, and that company faces bankruptcy. With so many newbies entering the angel market, you just never know.
  - localhost3000 16y ago
    kind of like a bank run on startups? scary thought
AdeoRessi 16y ago
Right now, Paul, convertible debt is not a problem today and was not a problem in 2010. Most startups with debt negotiate an extension when the note comes due if there is not a Series A. However, the amount of debt is ballooning, and there are many new angel investors entering the market. The signals are not good. This is a preventable problem with a better angel investment structure that gets widely adopted. I am just pointing out the problem.
deleted 16y ago
[deleted]
mmaunder 16y ago
I actually thought this post was brilliant. A few items I liked: "First, startups with large debts on their balance sheet will have challenges securing loans, partnerships and vendor credit, impeding their growth. " Debt by any other name is still debt on the balance sheet, so this is a great point. Also: "The majority of convertible debt deals have no mechanism to convert to equity without the occurrence of a Series A, and standard convertible debt deals come due in 12 to 18 months." This is startling. If this is true then many startups are facing a big unknown i.e. how renegotiating their convertible debt will turn out. Will you lose control of the board? How much equity will you lose? etc. While a pat on the back and a "this has never once been a problem" may work for some, it wouldn't make me sleep better at night. I think this is excellent advice: "negotiations should start sooner rather than later about converting the debt to equity upon maturity with your debt holders" Remove the unknown ASAP and give your company a more predictable and stable environment to operate in.

bradgessler 16y ago

The good news, assuming this happens, is that it won't be as difficult for profitable startups that aren't saddled with debt to hire great technical talent since more startups will go under and more developers will be available.

ericd 16y ago

Minor point, but from where I'm sitting, the standard term length seems to be two years rather than 12-18 months. Also, I think in a large percentage of cases, the angel can convert at the cap if there's no liquidity event, so it's not necessarily going to result in mass defaults. If the startup is doing really well, this seems like a more likely outcome than the angels calling back their debt.

cperciva 16y ago
If the startup is doing really well, this seems like a more likely outcome than the angels calling back their debt. If a startup is doing well, the worst-case scenario involves issuing stock to new investors in order to pay off the convertible debt. The problem would come in the marginal cases -- where a startup is still running and still has cash in the bank, and the founders aren't ready to give up yet, but hasn't produced anything interesting enough to bring in new investors... or to convince the convertible debt holder to keep his money in.

jayzee 16y ago

Another option where you can have best of the both possible worlds is to do a convertible debt round with a conversion cap. That way the deal gets executed cheaply and quickly benefiting the entrepreneurs. The cap benefits the angel for taking some early risk. And such notes have a clause that convert the debt to equity at the price implied by the conversion cap at the end of the term so no fear of going into default.

iamelgringo 16y ago

Anecdotal evidence suggests that angels are now investing as much as $50 billion Naval Ravikant, who runs angel list states that there's been an additional $500M that has been invested in early stage startups last year.[1] Which is essentially a smallish VC fund. Naval has also stated that 240 companies have received angel funding via Angel list this past year. If every company received $1M, that would still only be $240M invested in early stage startups. I don't understand where the anecdotal $50B comes from. Also.. Estimates are that there are now 10,000 angel financings per year, and as much as 70% of these deals are now convertible debt. Naval Ravikant runs the angel list, and he's saying there are only 240 investments that got money via angel list last year. That's a big discrepancy. I don't have a comment on whether the structure of convertible notes is good or not. I was just very surprised at the numbers Adeo brought up in the article, because they are several orders of magnitude larger than what I'm reading in other areas. If he has other data sources, I'd love to read them. My instinct has been that Angel List has been at the epicenter of getting all these startups funded, and so I've been inclined to use Naval's numbers in my thinking. ref: [1] http://www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2011/03/04/businessinsider-naval-ravikant-2011-3.DTL&ao=2 http://www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2011/03/04/...

nbashaw 16y ago
It's my understanding that AngelList is just one small part of the broader Angel market, even if it is the epicenter.