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The Truth About Convertible Debt and The Hidden Terms You Didn’t Understand

70 points by DanielRibeiro 14y ago

simonbarker87 14y ago
Wish I had read this before taking on a convertible - if only so I knew a bit more about the nuances of it
robryan 14y ago
Sounds like the convertible note would discourage a down round and end up making investors less as more companies fold knowing their equity is about to get mostly taken by investors.
- simonbarker87 14y ago
  That's a genuine possibility, I guess it is an upside for the founders. They can see they equity is going to disappear and can take the out rather and accept the huge equity loss - although convertible loan is higher up the debt chain so the VCs will still get a chunk back
jpdoctor 14y ago
There is a big point missing in the article: The dynamics of the folks entering the next round with those in the current round. For example: The purchasers of the next round would be idiots to let the first investor execute the equivalent of a full ratchet, and all such provisions are usually throw-aways in a negotiation.
- msuster 14y ago
  Not true. The full ratchet is implicit in the deal. If the deal said $8m cap and next investor invests at $4m then the deal gets done as $4m and doesn't impact the next investor. It comes out of founders' equity. It is the "equivalent" of a full ratchet but disappears after the deal is done.
  - jpdoctor 14y ago
    > It comes out of founders' equity And how is the next investor incentivized to let that occur? Edit: I should be more explicit. The next investor is anti-incentivized to let it occur, which is why it gets negotiated away by sensible investors.
unobliged 14y ago
If anyone is interested in some additional material on this topic, MIT OCW covers entrepreneurial finance. Relevant Lectures: http://ocw.mit.edu/courses/sloan-school-of-management/15-431-entrepreneurial-finance-spring-2011/lecture-notes/MIT15_431S11_lec08.pdf http://ocw.mit.edu/courses/sloan-school-of-management/15-431... http://ocw.mit.edu/courses/sloan-school-of-management/15-431-entrepreneurial-finance-spring-2011/lecture-notes/MIT15_431S11_lec10.pdf http://ocw.mit.edu/courses/sloan-school-of-management/15-431...
001sky 14y ago
So to me the real advantages of convertible debt are: 1. They often don’t have control provisions. With equity often investors want “blocking rights on a sale or future finaning” that they often don’t get in a convertible debt deal. If this is the reason you’re doing it, then perhaps talk to investors about whether they’d be willing to give up that right in a Series Seed equity deal. 2. They often don’t have board seats attached to them. Again, this should be negotiable with a Series Seed. --Summary of the argument. The rest of the article is useful, too. It provides good background and context for his conclusions.

70 points by DanielRibeiro 14y ago

Wish I had read this before taking on a convertible - if only so I knew a bit more about the nuances of it

Sounds like the convertible note would discourage a down round and end up making investors less as more companies fold knowing their equity is about to get mostly taken by investors.

simonbarker87 14y ago
That's a genuine possibility, I guess it is an upside for the founders. They can see they equity is going to disappear and can take the out rather and accept the huge equity loss - although convertible loan is higher up the debt chain so the VCs will still get a chunk back

jpdoctor 14y ago

There is a big point missing in the article: The dynamics of the folks entering the next round with those in the current round. For example: The purchasers of the next round would be idiots to let the first investor execute the equivalent of a full ratchet, and all such provisions are usually throw-aways in a negotiation.

msuster 14y ago
Not true. The full ratchet is implicit in the deal. If the deal said $8m cap and next investor invests at $4m then the deal gets done as $4m and doesn't impact the next investor. It comes out of founders' equity. It is the "equivalent" of a full ratchet but disappears after the deal is done.
- jpdoctor 14y ago
  > It comes out of founders' equity And how is the next investor incentivized to let that occur? Edit: I should be more explicit. The next investor is anti-incentivized to let it occur, which is why it gets negotiated away by sensible investors.

unobliged 14y ago

If anyone is interested in some additional material on this topic, MIT OCW covers entrepreneurial finance. Relevant Lectures: http://ocw.mit.edu/courses/sloan-school-of-management/15-431-entrepreneurial-finance-spring-2011/lecture-notes/MIT15_431S11_lec08.pdf http://ocw.mit.edu/courses/sloan-school-of-management/15-431... http://ocw.mit.edu/courses/sloan-school-of-management/15-431-entrepreneurial-finance-spring-2011/lecture-notes/MIT15_431S11_lec10.pdf http://ocw.mit.edu/courses/sloan-school-of-management/15-431...

001sky 14y ago

So to me the real advantages of convertible debt are: 1. They often don’t have control provisions. With equity often investors want “blocking rights on a sale or future finaning” that they often don’t get in a convertible debt deal. If this is the reason you’re doing it, then perhaps talk to investors about whether they’d be willing to give up that right in a Series Seed equity deal. 2. They often don’t have board seats attached to them. Again, this should be negotiable with a Series Seed. --Summary of the argument. The rest of the article is useful, too. It provides good background and context for his conclusions.