Why I Won’t Invest in Convertible Debt

Convertible debt seems to be an increasingly popular vehicle for angel investing. While it has it’s benefits, it also has it’s drawbacks, but there are certain instances when I WILL NOT INVEST in convertible debt. Here’s one of them:

A company that earned over two million in revenue last year sent me this:

We are working to complete a $1.0M Convertible Note with the following terms:
o 6% interest
o December 31, 2013 Maturity Date (that’s 18 months from now)
o 15% conversion discount
o $8.0M pre-money conversion cap

They sent this to me because their investment has the potential to make a significant social and environmental impact as well as a financial return, but unfortunately their terms illustrate the typical reasons why I won’t invest in convertible debt:

  1. An equity trigger is unlikely. This company is already doing a million in sales and their planned future efforts aren’t particularly capital intensive. I kind of doubt they’ll be raising an A round before the note matures. They could be acquired, but that’s a crap shoot, especially within an 18 month period.
  2. The interest rate is too low to tie up my capital for 18 months. I could invest in a much less risky socially responsible mutual fund which would also make an impact and likely produce a 6% return. There is a lot debate about appropriate convertible interest rates (Brad Feld says 7-10%), but in my opinion, it should at least be higher then lower risk mutual funds.
  3. The valuation cap is too high. I have no scientific evidence to back this up, but it’s been my experience that most notes convert at the conversion cap price. If this company converted at 8 million, it would have to sell for 80 million to produce a 10x return.
  4. There is no reason why the company can’t be valued now. They have historical financial data and did over two million in sales last year. The company could easily be valued today.
  5. The 15% discount rate is too low to compensate the early risk takers. If I invest 25k now, I will earn 3, 750 dollars more in shares. I’d be better off investing my money in a less risky venture today and coming in with 3, 750 extra dollars later.
  6. The investor and entrepreneur incentives are misaligned. It is in the investor’s best interest to keep the valuation as low as possible and for the company to be acquired or financed as quickly as possible. This company for example, could very well bootstrap their efforts by increasing sales. That may likely be in their best interest, but it’s not going to be good for investors.
  7. They are raising too much for convertible debt. It is likely that within 18 months this company will increase sales enough to bootstrap their efforts, but it is unlikely that they will have an extra million sitting around in cash. If they choose to bootstrap, the investors will call the note and that could kill the company.
  8. They are not likely to attract sophisticated investors. The non-monetary value of the right angels will far exceed their dollar contributions. If you attract savvy investors and incentivize them properly, they will be much more likely to provide valuable advice, connections and follow-on capital.

In summary, if a company raising convertible debt:

  1. Is so early stage, it’s impossible to value it,
  2. Has already secured interest from likely financers or acquirers,
  3. Sets a short term for the note (less than a year, preferably six months),
  4. Will likely be able to pay off the note if it’s called,
  5. Is offering an interest rate higher than lower risk mutual funds, and
  6. Will likely produce a 10x return on the valuation cap,

I, and other savvy investors I know, will consider it. If not, it’s going to be a hard sell.

What do you think? Leave a comment.

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4 Responses to Why I Won’t Invest in Convertible Debt

  1. rockiesventure says:

    I think one of the overlooked issues in convertible debt is the amount of time between when the note is issued and the conversion event is expected. This makes a huge difference in the ROI for the investor.

    For example, if you have an 8% note with a 20% discount and the note converts after a year, your return is effectively 28%, although this is still not a liquidity event, so it’s hard to say your return is actually this rate and your capital is still at risk.
    But, if you don’t convert for three years, then the 20% discount is now only 6.66% per year which is 14.6% interest (8% annual rate plus 20% discount rate divided by three years)- far too low for risky angel investments.

  2. John Ives says:

    IMO – the worse trait of convertible notes is the term and forced conversion. The long duration of most notes used for major fundraising events, as opposed to short term (< six months) bridges makes convertible notes unattractive. Keeping the term short allows the company and the potential investors to focus on near term execution. This execution may include raising a larger round via priced equity.

    A longer term note creates numerous challenges. Is the interest rate reasonable? Is the amount of discount or warrant coverage a function of time (i.e. the longer the larger the discount or coverage).

    At the end of the day, I personally do not find long term convertible notes attractive and are something to avoid. I will avoid any security that I cannot price.

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