Understanding the Perils of Convertible Debt
Convertible debt is a popular way for new businesses to get investment. But it's important to understand the risks and challenges before signing a convertible debt agreement. This blog post discusses the possible problems with convertible debt and what entrepreneurs should think about before signing.
Why Convertible Debt is Popular
Convertible debt lets businesses get investment without having to decide how much the company is worth right away, making this type of investment vehicle very popular with startups, specially pre-revenue. This is helpful because it's hard to say how much a company maybe worth, and it offers protections to the investors that equity may not offer, like in the case the company does not do well, they still have to repay the loan to the investors.
A Real-Life Example
We recently saw a situation that showed some of the possible problems with convertible debt. A company received an investment via a convertible note , thinking it would turn into ownership in the company later. But when it was time for the note to turn into ownership, the company and the investor could not agree on the terms, this turned into a difficult situation that could have affected the company's ability to get additional investments in the future.
Possible Problems with Convertible Debt
The situation highlighted some of the possible problems with convertible debt. These can include:
Not agreeing on conversion terms: The terms of conversion can be hard to agree on. This can lead to disagreements between the company and the investors. - Do you understand the conversion terms ? and its triggers ?
Discount percentage: Within the terms, there may be a discount at conversion that may have a large impact on the capital table. Have you calculated such impact on the cap table ? and how do you manage it with new investors ?
Risk of not being able to pay back the debt: If the company doesn't do well, the investors are in the "front of the line" to get their money back first. Do you understand the risk ? and its impact of possible Intellectual Property (IP) or other assets ?
Special rights or terms: Some convertible notes may have special rights or terms that business owners may not fully understand. These could include certain voting rights or other terms that could affect the company's future. Do they have prefered rights ? board representation ? are you aware of those provisions and its impact on your business or future capital raises ?
What to Think About Before Signing
Before signing a convertible debt agreement, it's very important for everyone to fully understand the terms and what they could mean for the future. It's a good idea to get legal advice to make sure everyone understands the agreement. It's also important to think about other ways to get investment. While convertible debt can be a good way to get investment early on, it might not always be the best choice depending on the specific situation of the business or your capital raising strategy.
If you're considering using convertible debt to raise investment, here are some next steps you can take:
Learn more about the different types of convertible debt.
Understand the pros and cons of each type of convertible debt.
Get legal advice to make sure you understand the terms of any convertible debt agreement.
Convertible debt can be a good and bad thing for businesses. While it's a convenient way to get investment, it can also lead to potential problems and disagreements. Business owners should be fully aware of these possible problems and think about all their options for getting investment before making a decision.