Should your start-up consider a convertible debt deal?

Recently a new friend and prospective client asked me about a financing opportunity that had been presented to his bootstrapped start-up. He asked me the advisability of accepting a convertible debt offer versus straight equity financing. The answer I provided was general, as the question was general, and because I was not familiar with his company's valuations or deal specifics. I am familiar, however, through my experiences with other clients and mentees, and through teaching a small business course, with the options.

Fortunately, my friend’s question was whether or not he should even consider a convertible debt deal, not advice on whether he should actually take it. (That took the pressure off of me.) I assured him that it was in fact a common practice for a firm at their level of maturity and it was likely to be a more favorable solution for them. This wasn’t financial advice (I’m a marketing guy, after all) but I thought I’d share my reasoning more broadly.

Firstly, however, let’s define our terms.

Equity financing is financing by issuing shares of the company. While rumored to be the simpler of the two approaches, at least for mathematics challenged types such as myself, in fact the tricky part for early stage start-ups is determining the valuation of the company. There are as many approaches to this as there are founders and investors (and stages of growth), but through several formulations and more than a little guesswork, ultimately the company value is “simply” the figure investors and founders agree that it is.  Post-investment value is just the pre-investment value plus the investment. It can all contained within simple t-chart accounting.

Convertible debt is borrowing money where your intention, and that of the investor, is not to pay back the loan with interest as in a typical loan, but to convert the debt to equity in the company at a discount (typically 20%). The terms, timeframe, discount, any valuation caps, are all negotiable, and vary widely. The debt also has an option to be paid prior to maturity with an outright cash payment should circumstances change.

So which is better?

To quote my old graduate B-law professor, “it depends” (such was his answer for most hypotheticals).

A main advantage for equity financing is that it doesn’t require repayment like debt would, and is a simple calculation - assuming you can settle on an acceptable valuation. Disadvantages include the need to determine valuation (difficult for young companies) and a loss of some management control.

Convertible debt, alternatively, does not need to have a valuation upfront (it converts based on a valuation from a subsequent round of investment when presumably valuations are easier to calculate) but will need to be repaid, like debt does.  While interest will not (usually) need to be paid in cash each month, there is a limited timeframe before it needs to be repaid, or convert automatically into equity at previously agreed terms. If the latter option isn’t part of the agreement, the repayment requirement can lead to unintended fire sales forced by holders of the debt. Still, as most founders believe their start-up will be worth more at a later date, this approach will result in less dilution, by issuing debt and leaving the valuation flexible in order to meet the requirements of the company and those of later investors. I also understand that this is a faster and cheaper transaction when compared to the legal paperwork of an equity play.

In the end, I recommended he welcome a discussion of convertible debt. But I hope he (and you, dear reader), remember this fine print: I’m a marketing guy. I’ve been brief here, and your circumstances will vary from your neighbor’s start-up, and even change as your company matures. Each company and each stage of growth requires a different type of financing. Ask a professional. Whatever you decide, try to limit the dilution, retain majority voting rights, and use your brain, but leave your ego at the door.

(Finance guys who want to clarify any points in this post are asked to comment.)