Angels: Convertible Debt Is Seldom the Right Security for Startup Investments

December 23 2009 No Commented

Angels:  Convertible Debt Is Seldom the Right Security for Startup Investments

Just after the Internet bubble burst in 2001, many of us angels were “crammed down” unmercifully by subsequent investors in our portfolio companies.  These new investors were funding our companies at valuation far below the pricing we had agreed to earlier, resulting in substantial dilution to our ownership.  To avoid these “cram downs”, some angels began investing in startups using debt instruments that convert to equity at the same time and under the same terms as subsequent investors, with a small discount in pricing, based on the greater risk in our earlier investment.  While there are some advantages to using convertible debt for early stage investments by angels, I dislike these instruments and seldom use them.

The advantages of convertible debt investments by angels in startup ventures are:

  • Protection from down rounds, at least by the next subsequent investor.  (It would be my contention that the only protection from subsequent down rounds is negotiating the appropriate valuation at the time of the angel round.  Only “over priced” deals are eventually crammed down.)
  • No need for contentious negotiations with entrepreneurs over pre-money valuation.  We can leave these negotiations to the subsequent investors (VCs).
  • As debt holders, investors “stand ahead” of all shareholders, in the case of an early unplanned  liquidation
  • Legal costs for investing via a debt instrument are generally much lower than for an equity investment, particularly compared to a preferred equity round.  The disadvantages of using convertible debt in angel deals are simple:  At exit we angels end up leaving too much money on the table.
  • According to Wiltbank (see my blog dated December 14, 2009), angels lose money on 50% of deals and make 75% of their ROI on only 7% of our deals.  Clearly, this means that we angels can only bet on home runs (or “smash hits” in a theatrical analogy).
  • Down side protection at the expense of ROI is unacceptable.  As an example, convertible debt holders are lucky to enjoy a 30% discount off the valuation of the subsequent round.  But, in “smash hits,” the valuation of the target company may have tripled in value with the angel’s money, before the subsequent investor is engaged. 
  • Protection from down rounds implies one of two perspectives:
        – The angels are unwilling or unable to negotiate the appropriate valuation at the time of their investment.
        – The angels are focused on downside protection at the expense of enjoying huge returns on that tiny fraction of deals that, in fact, provide all our ROI.
  • Convertible debt investments can create misalignment between entrepreneurs and angels.  It is clearly in the angel’s best interest to eventually convert at a low valuation, while entrepreneurs wish to see conversion at a higher valuation.  This can results in contentious Board meetings!

My perspective is that angels should (1) look only for “smash hits,” (b) negotiate an appropriate valuation at the time of investment, (c) don’t chase losers by continuing to invest when they don’t meet milestones and (d) enjoy the fruits of your labors on those very few “smash hits” that, in fact, provide wonderful exits.

It’s a GREAT time to be an angel.  Find a group and jump in!

Bill Payne is the 2010 BNZ University of Auckland Business School Entrepreneur In Residence.