Stop the Madness! Reconsidering Convertible Debt

September 17, 2019 | BlogBlog

A decade or so back, convertible debt (and later, its SAFE convertible equity sibling) took to the stage big-time as a vehicle for seed stage financings. And both those vehicles – let’s call them together “Convertible Securities” – had (and have) a lot to recommend them. But too much of a good thing can be unhealthy, and when I come across a Convertible Security transaction today, it is more often of the unhealthy (and sometimes terminal) variety. It is time to stop the Convertible Security madness.

Let’s start by considering the “good” Convertible Security transaction: the scenario where a Convertible Security “works” for the investor and the startup alike. Herewith the Convertible Security paradigm case. “GoodCo” needs a small amount of money, for a short period of time, to accomplish a significant and well-defined milestone that will support a significantly larger round of priced financing.

What is a “small amount of money?” Let’s say 5-10% of the size of the anticipated larger priced round. What is “short period of time?” Let’s say 3-6 months (which fits well, risk/return-wise, with the standard 20% conversion discount). What is a “significant and well-defined milestone?” An objective milestone that GoodCo and the prospective Convertible Security investor both reasonably agree the accomplishment of the same will make the larger priced round as much a certainty as any financing is in the venture world.

I used to see a lot of GoodCos doing a lot of good Convertible Securities financings. Most of them “worked” in terms of being followed up with the projected larger priced round in more or less the projected 3-6 month time frame. And most of those that didn’t work didn’t nail the milestone and “did the right thing” (which is to say, straightened their affairs and went away quietly). A few might have pushed the ball/milestone down the road a month or two with a small Convertible Security refresh, but that was the exception, not the rule and was more an indulgence of the form than an abuse.

Alas, most of the Convertible Securities deals I’ve seen over the last couple of years have been of a form nothing like the Convertible Security paradigm case. Instead, they’ve been served up by “BadCos” seeking larger, often indeterminate amounts of capital to extend their runway in the usually ungrounded – dare I say fanciful – notion that at some point they will magically take flight. The result is a growing, ugly universe of living dead startups sucking scarce capital from investors who are themselves somewhere on the road from clueless to disillusioned.

If you think I am exaggerating the problem, let’s take a quick look at a few Convertible Securities offerings I’ve seen this year. Each BadCo had raised something between $1 million and $4 million in a dozen or more Convertible Securities sales over multiple years in multiple denominations from $5,000 to in excess of $100,000. Each of these companies had issued Convertible Securities with terms (e.g. discount, maturity, conversion trigger) that were not always consistent. All but one of these BadCos posited a milestone that was basically “to get us to some traction.” (One was more honest, stating bluntly that the goal was to extend the runway a few months.)

Madness, plain and simple. For the entrepreneurs, for the investors, and for the market. How so?  Well, potentially good entrepreneurs were wasting their time and energy flogging dead startup horses; horses with complex capitalization tables that would make financing problematic even if by some miracle they came back to life. And risk capital investors, who might otherwise be ready and willing for other entrepreneurs to tap, have been tapped out – psychologically, if not monetarily. Thus, making the market that much tougher for GoodCos with sensible Convertible Securities stories to crack.

It’s the new startup addiction, and the high-risk/reward entrepreneurship and investing community must address it. How? For entrepreneurs, it’s about staying away from Convertible Security deals that don’t fit the paradigm model; and for investors, it’s all about just saying no to deals that don’t fit that paradigm.

It’s madness and it has to stop!

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