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There should be an interest rate, because the value of money changes over time. There is a difference between the value of $50,000 in hand today, and the expect

There should be an interest rate, because the value of money changes over time. There is a difference between the value of $50,000 in hand today, and the expectation of being paid today's $50,000 a year from today. That difference is reflected in the interest rate. Risk is also accounted for in the interest rate, although fundamentally, not all risk can be accounted for. There is always going to be the risk that the startup goes bust before it can pay back its IOUs, and it would be silly to expect an interest rate exorbitant enough to account for all of that risk. A rate of 15-25% is probably fair to the individual in a nominal sense (more than fair, actually), but it is unfair to the company. This is a case where the individual will need to bear some of the risk in the financial interests of having a successful company. He is not a loan shark, after all.

rahimnathwani 12y ago
"A rate of 15-25% is probably fair to the individual in a nominal sense (more than fair, actually), but it is unfair to the company." I think we are in agreement on the first part, i.e. that a rate of 15-25% should adequately compensate the individual for both the time value of money and for the large risk of default. I don't agree that it's unfair to the company. Consider: - The company has no alternative, cheaper sources of debt financing - The capital and interest will be deferred until such time as the company has money to pay (e.g. from a Series A) so will not cause any hardship by constraining cash flow - These IOU are non-participating, i.e. they don't get any of the upside should the company do well. If you think about it, it's similar to an investment by an angel: you want to compensate for the risk, you don't know when you will be able to return the cash, you don't have a reliable way to come to consensus on valuation. Perhaps the right way to structure these IOUs is as a capped note with a low coupon (2-5%) but a reasonable conversion discount. That way the equity-like element of the note compensates for the risk, instead of requiring a large coupon on the debt-like part.

rahimnathwani 12y ago

"A rate of 15-25% is probably fair to the individual in a nominal sense (more than fair, actually), but it is unfair to the company." I think we are in agreement on the first part, i.e. that a rate of 15-25% should adequately compensate the individual for both the time value of money and for the large risk of default. I don't agree that it's unfair to the company. Consider: - The company has no alternative, cheaper sources of debt financing - The capital and interest will be deferred until such time as the company has money to pay (e.g. from a Series A) so will not cause any hardship by constraining cash flow - These IOU are non-participating, i.e. they don't get any of the upside should the company do well. If you think about it, it's similar to an investment by an angel: you want to compensate for the risk, you don't know when you will be able to return the cash, you don't have a reliable way to come to consensus on valuation. Perhaps the right way to structure these IOUs is as a capped note with a low coupon (2-5%) but a reasonable conversion discount. That way the equity-like element of the note compensates for the risk, instead of requiring a large coupon on the debt-like part.