Ray: Convertible debt deals – yes or no?
Convertible debt has been an integral part of the financing landscape for venture backed companies for many years. Its use has historically been in situations where the company is in a fundraising or liquidity process and needs additional capital to bridge it to that event or in situations where the company is very close to achieving certain milestones that could significantly increase the value of the enterprise. Often, the existing institutional investors will participate on a pro rata basis keeping them generally aligned and as long as there is adequate reward provided to the note holders for the risks of the debt, usually in the form of warrants or conversion at a discount to the next round, all the equity is aligned.
The phenomenon of using convertible debt as a means of raising new money from new investors is a recent one. In particular, it is an increasingly preferred method for many angel investors, a funding source that has become more and more prevalent in recent years. Generally speaking, this is a company (existing investor) friendly method. It basically allows a company to raise capital to theoretically increase the value of the enterprise into which this convertible debt converts. What has been driving more and more of these types of financings are a somewhat frothy funding market, particularly at the seed stage level, and a desire to move quickly with limited distraction given the low barriers to entry of today’s many digital start-ups. While investors appreciate these dynamics, they look to level the economic playing field with a few constraints including conversion at a discount (usually a bit bigger than the historical use case) and a cap on conversion. For companies that are capital efficient in driving value, this can be a very enticing way to go. However, without much history showing how this structure plays out in the long run, it remains to be seen if it truly is company friendly.
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