When is Convertible Debt the Right Instrument for Angel Investments?

December 24 2009 No Commented

When is Convertible Debt the Right Instrument for Angel Investments?

In my last post, I concluded that convertible debt securities are seldom appropriate for angel investments.  My primary conclusion was that using convertible debt was likely to substantially reduce the ROI of “smash hits,” those 7% of angel investment that provide 75% of our ROI.

But, I implied there might be times when using convertible debt might be appropriate.  OK, Payne…when?

  1. If a subsequent investor has been identified and our investment is a true bridge to that round, then using convertible debt might be appropriate.  Part of our due diligence as angels should include the likelihood that this subsequent investor will, in fact, complete their planned transaction.  In this case, I would prefer a fall-back position (as is described in #3), in case the subsequent investment does not close in a timely manner.
  2. When the terms of the conversion are fixed in advance.  For example, it is agreed by both sides that the debt will be converted to equity at a specific price by no later than a specific date.  This enables a rather inexpensive transaction at the time of investment, gives the investors first rights to assets (such as patents) in the case of company liquidation, and provides the angels with reasonable terms of investment, agreed-upon in advance.
  3. When the angels really like the company and a serial entrepreneur, but cannot agree with the entrepreneur on a pre-money valuation.  One solution would be to develop an agreement which provides that the angels will received an agreed-upon discount (say, 30%) to the next round of investment of at least a minimum size by a fixed date (say, one year).  If that round cannot be closed during this term, then the conversion takes place, at the option of the angels, at “their price,” that is a valuation fixed in advance which is satisfactory to the angels (but not the entrepreneur) at the time of the closing of the angel round.

An important feature of the described uses of convertible debt for angel rounds is that a subsequent round of investment will occur quickly (within a year) to which the angels will enjoy conversion at a discounted valuation, or the angels investment can be converted to equity at the angels’ price at the time of their original investment. 

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. www.billpayne.com