Venture Capital Investors and the Convertible Debt Option
Investors, venture capital or otherwise, dislike convertible debt (usually, but not always) because it offers no upside other than the interest and discount price, at least until the note converts to equity.
The investor has more risk with a convertible note and loses upside potential. The investor has more risk because the note might never convert, or many years may pass before a conversion occurs. If, during this time, the company’s value doubles, the investor doesn’t see a penny of that increase in value because he has to pay the high stock price at the time of conversion.
This is the reason why convertible debt is almost never an option for institutional venture capital (VC) investors, although it seems to work for friends and family who are willing to lend you money just to help you to succeed.
Set caps: Provisions to protect investors
One such provision involves setting a cap on the stock share price. Say that you set a cap at $1 per share. If VC investors come in after 18 months and give it a $2 valuation, then the investor doesn’t pay any more than the $1 price. In this way, the early investor can benefit from the increase in value by buying stock cheaper than the new Series A investors.
Some people feel that, by the time you have negotiated a cap, you have effectively set the value, and no good reason exists to not just do an equity round anyway.
Caps can sour the deal for VCs. VCs understand that early-stage investors have taken a risk and should be rewarded for that, but VCs don’t like to see others coming in at the Series A round for half of what they’re paying.
If a VC thinks that others are getting too good of a deal, they may back out or demand that the cap on previous investors stock price be raised closer to the Series A price before they will invest.
Set a time-based conversion trigger
Conversion triggers are not always limited to happening at the next priced investment round. Investors can set a time based trigger so that the stock converts on the earlier of a Series A investment or 12 months. Of course, this conversion requires a valuation without having a VC on board to set the price, so this solution can be tricky.
Imagine that you issue a convertible note for $100,000 and pay 8 percent interest with a 20 percent discount. If the note converts in a year, the investor has made a 28 percent return on his investment. That’s about normal for an early-stage investor.
But if the note goes for two years, then the return on investment is only 18 percent (half of the 20 percent discount — you’re spreading it out over two years instead of one — plus 8 percent per year).