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!