Convertible Debt is Bad For Angels
A couple of years ago, Paul Graham (Y Combinator) tweeted “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”
The truth is convertible debt has not won. Many sophisticated angel investors and angel groups refuse to invest in convertible debt in seed/startup deals. Why? Because convertible debt investment undervalues this very high risk capital. As Adam Fusfeld has pointed out, there are multiple issues involved in choosing between convertible debt and a shares deal, but I’d like to focus on one – the issue that seems to be most important to most angels – the impact of valuation on returns.
Why is convertible debt so popular? It is inexpensive to do a convertible debt round. Plus, convertible debt does stand ahead of all shareholders in case of liquidation. Personally, I believe it is popular because the press made such a big deal out of Y Combinator and other accelerators doing pre-seed deals using convertible debt.
Note I said accelerators do pre-seed deals…. Yes, most entrepreneurs entering accelerators are pre-seed – and many do a significant pivot while in-house, before graduating. Most angels invest later, in companies at the seed/startup stage, companies that are pre-revenue (with customer validation) or are beginning to generate revenues. (Of course angels invest in much later stage deals, as well.) It is very difficult to negotiate a valuation on a pre-seed deal that is likely to pivot soon while the valuation of startups that are beginning to ramp revenues is more obvious. Comparing accelerator deals to typical angel deals is really comparing apples (pre-seed) to oranges (seed/startup).
So what is my beef with convertible debt? The primary concern of most angels is that, if and when our debt eventually converts into equity, it will do so at a valuation that is too high, higher than can be justified for the risk involved in a seed stage deal. Proponents of convertible debt will counter that the notes stipulate either a cap on the conversion valuation or a discount on the valuation negotiated by the subsequent investor. Unfortunately the conversion cap is seldom as low as the typical valuation of the equivalent seed/startup deal. The discount, while perhaps as high as 30% off the valuation of the subsequent round, may or may not result in a valuation that fairly rewards the earlier angel investment. There is no quicker way for angels to reduce their return on investment than to invest in a convertible debt round that eventually converts to equity at a high valuation.
According to Wiltbank, angel returns are very skewed with less than 10% of funded deals providing virtually all the upside return on investment. It is very important that we angel investors really capitalize on our winners because very few angel investors fund more than 20 deals in their lifetime. Investing in convertible debt which eventually converts to equity at a high valuation reduces the return on that deal, compared to investing at a fair seed/startup stage valuation. If that deal is one of the few home runs in our portfolio, returns for the portfolio will be radically reduced.
Fortunately, cooler heads seem to be prevailing (regardless of the Paul Graham quote above): According to the Fenwick and West Seed Finance Survey 2012 just released, we are seeing a significant decline in convertible debt financings and an increase in preferred shares offerings for seed stage of deals. Hallelujah!
Written by Bill Payne
You might also be interested in
Canada has not tapped its female angel investor potential – yet.
The female angel investor conversation has been discussed inside and out. From TechCrunch, BetaKit to the Financial Post, there have been more than a few arguments made about the lack of female representation in Canada’s early-stage investment community and the benefits of tapping into this financial resource.
One of the most common questions we get is: What are the biggest challenges and rewards of angel investing? High net worth individuals become angel investors for a number of reasons, but the opportunity to work with entrepreneurs and provide guidance to founders is typically high on the list. In this video, angel investor Chenoa Farnsworth explains why, interestingly, both the biggest
Entrepreneurs seem genuinely surprised to find that investors in Peoria or Little Rock are not willing to invest in startup companies at Silicon Valley prices. After all, they just read in TechCrunch that investors funded a company similar to theirs at an $8 million pre-money valuation!
The valuation of startup companies shouldn’t be impacted by location, should they? Guess again!
The first question you need to ask is “What country are you in?” and the second is “Are you an Accredited Investor by that country’s standards?”
If we’re talking about the US and you are NOT at the Accredited level ($1 million in investable assets, or $200,000 annual income), then for the moment you are actually not allowed to invest in privately held startups
First, it’s important to understand that the four platforms you list fall into two very distinct groups.
Kickstarter and IndieGoGo are project-based crowdfunding platforms through which anyone can contribute money, either as a donation or with the promise that they will receive a tangible ‘reward’ of some kind if the project is successful.
Gust and AngelList are equity-based platforms, used by Accredited Investors to facilitate the investment of money for an ownership interest in