The absolute worst thing about convertible debt

You've probably have heard that convertible debt (SAFEs and Convertible Notes) are a lot less favorable to founders compared to equity.If you don't know why read Mark Suster's post.

With equity, it is clear how much of the company you sold. With convertible debt what exactly do you owe to the investor is to be determined.

We've recently had an M&A (a fancy industry term for an acquisition), and one of the Techstars NYC portfolio companies got acquired. In this  transaction we have truly seen the worst of convertible debt.

What happened is seemingly unusual case, where the company raised 4 rounds of convertible notes, and then got acquired.

That is, all the convertible notes were outstanding. Each convertible note had a different cap, and the cap on the earlier notes was low, while the cap on the later notes was high.If you convert debt during an equity financing, the conversion price is usually set to be pre-money valuation. On M&A, the conversion price of the note got set to be the actual price at which the company got bought.

Because the notes have never converted, each note holder got the number of shares equivalent to the price of the acquisition divided by the note cap.  Here is an example in plain English (the numbers aren't the actual numbers from  transaction).

Suppose the company is acquired for $30MM and raised 4 sets of notes - first on $3MM cap, then on $6MM cap, then $10MM cap and finally on $15MM cap.

Back of the envelope (not exact, but to give you the idea) calculation is that $3MM cap note is going to get $30MM / $3MM or a 10x multiple! $6MM cap will get a 5x, then $10MM cap will get 3x and finally $15MM cap will get 2x.

So if you raised $100K on each of these caps, then these $100K will roughly become $1MM, $500K, $300K and $200K in this transaction respectively. This was both really surprising, and incredibly dilutive for the founders.

So what is going on here?Because the company has never had an equity financing, all the notes were still unconverted. Now here is the critical insight - unconverted note doesn't get diluted. Jason Seats, a Chief Investment Officer at Techstars has put it best:

Unconverted note is shielded from dilution.

The earliest note, the $3MM cap one, is the worst offender here. If the company had done an equity financing at a $6MM valuation, instead of raising another note, then a very different scenario would have unfolded.

First, $3MM cap note would have gotten 2x value at $6MM valuation, and after that, that equity would be diluted by all follow on financings.  So the result, would have been very different from 10x return in the other scenario.

You already knew that convertible debt is bad, but the stack of convertible debt that aren't converted to equity until M&A is truly terrible for the founders.

While the situation with a Techstars company may seem unusual - 4 rounds of debt and then M&A, it may not be that uncommon. Many founders raise their pre-seed, and seed financings using convertible debt.

Also, many founders don't get to series A and have to raise seed extensions - typically done as convertible debt if the seed round as done as debt. So you get roughly 2-3 sets of notes or SAFEs are stacked on top of each other.So what do you do about this?

First of all, if you are just raising capital now using convertible notes or SAFEs, add a clear M&A clause that caps the return of early investors at 2x for an exit within 1 year, and then some kind of increased multiple as time goes by. 

Alternatively, it could be a max of 2x OR the cap of the follow-on debt note. In other words, add the handling for the case of M&A happening and you having stacked convertible debt.

The truth is the investors aren't investing in your company today thinking about stacked convertible notes scenario. When it happens, of course, they are happy to rip the benefits of this bug, but this is not the path to the 10x outcome they are looking for.

The early investors should be fine with 2x money back in cases like this, so spell it out in your notes.

Secondly, if you already have a bunch of debt that's outstanding, work hard to convert it to equity. Just bite the bullet and convert now. If you raised 2 rounds of debt, have the conversation with your investors and convert to equity.

Do it well ahead of an M&A. Justify it as having stacks of convertible debt is a bad practice. Agree to a lower valuation if investors push back.

Remember that the tricky thing about a situation like this is that you don't realize it until the convertible debt converts.

Thats the general problem with convertible debt - you just don't know how much your business you sold.