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Re: The convertible vs. equity trade-off

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Re: The convertible vs. equity trade-off

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Re: The convertible vs. equity trade-off

Garett — Tue, 24 Apr 2007 02:04:20 -0000

I posed this post to a few Angel investors and their responses are below:

First Response:
A number of good points here, but remember that convertible debt means that the "investors" (who are still just lenders at this point) won't know what their interest in the company is until the first round establishes a pre-money valuation. They have taken investment risk and valuation risk.

One typical way to alleviate that is to provide for a discount off the valuation in that first equity round, when it takes place. Problem with this is that if the company has not performed as expected and is in need of the funding from third parties (not the convertible debt holders), the new money can require that the discount be wiped out, thereby taking any advantage away from the original risk-takers.

Sometimes, a better way to go is to have a proper first round with equity at a lower valuation (to make a next down round less probable), but add warrants to help juice the investors' return prospects.

Second Response:
This is a tough issue. Another approach is to use warrants conveyed up front to convertible debt holders (perhaps with a strike price tied to the future valuation or some performance metric) rather than a discount clause. It could be tougher to require warrant holders to give up or modify their warrants than to have the discount waived, so the convertible note holders might be in a marginally better position.

Unfortunately, anything done can be undone, so the last money in can rewrite the rules to a large extent, particularly if the company is pretty desparate.

Re: The convertible vs. equity trade-off

Yokum — Thu, 19 Apr 2007 22:04:54 -0000

As one of your advisors, I can see that you have really done your homework and thought through the issues. Generally speaking, I agree that an entrepreneur is better off with convertible debt (that converts into Series A at a discount) over a Series A at a low valuation. The issue then becomes whether the amount of the discount on the Series A is adequate to compensate the investor for the early risk he/she is taking. As between warrant coverage and a discount on the Series A to compensate the early investor, I prefer the discount because warrants tend to unnecessarily complicate your cap table.

Re: The convertible vs. equity trade-off

jon — Thu, 19 Apr 2007 01:25:54 -0000

Depends on your situation. If an entrepreneur can get a high valuation in a seed round then that's a great option. You can always protect the investors with provisions so if there is a down round they don't suffer.

Re: The convertible vs. equity trade-off

sundeep — Thu, 19 Apr 2007 01:13:22 -0000

Totally agree with everything you wrote...the only issue is what if the investors you want will only do equity? Is it worth passing to find someone willing to do convertible?