Convertible Debt: really Bridge Loans and Equity Replacement Debt

A post from Troy on Convertible Debt and how he thinks we should really be thinking about it…

Over the last few years, convertible debt has become a popular vehicle for early stage companies that are raising money.   A lot has been written about it from how it affects your cap table to how it is good or bad for both the investor and the entrepreneur.  But there is still a lot of confusion surrounding convertible debt and its uses.  The core of this confusion stems from the language we use and the fact that there are actually two entirely different use cases that get lumped together in that one vague term “convertible debt.”  I am going to be bold and propose that we eliminate the vague term from our vocabulary and adopt a new term for each of these:

-       Bridge Loans

-       Equity Replacement Debt

Bridge Loans are used when a company has a pending round of funding but needs a little help with cash flow between now and then (usually no more than 90 or 120 days) They will open up a round of debt financing where investors receive both interest on their money invested and a discount on the next round when it closes.  This is helpful to the company to solve their immediate cash flow problems and it is helpful to the investors as they are guaranteed to be in that next round and are rewarded with a discount for taking the risk of providing the capital before all the details and all of the capital of the round are solidified.

Equity Replacement Debt is something totally different; this is when the company decided to use convertible debt in place of doing an equity round.  The capital provided will typically provide 12 – 24 months of runway for the company.  These rounds typically have a “cap” in the valuation (and may have a discount too) as the investors are taking the risk today, based on the progress that the company has made to date.  Since the valuation on the investment will be made at the next round, in the future, after more progress has been made, many investors insist on a “cap” on that valuation (“My money will go in at a maximum pre-money valuation of $xxx”).

In my opinion as both an investor and an entrepreneur, I am fine with Bridge Loans – they solve a real problem for the company and reward the investor with a better price for the addition risk that he/she is taking by providing cash before the details of the round are complete.

The Equity Replacement Debt rounds have a host of problems with them.  First the “cap” is a misnomer, it really should be called a “valuation” because it is an attempt at placing a value on what the company is worth at the time of the transaction.  But, valuation is just one of many terms that go into an equity financing, is the equity participating preferred stock or convertible preferred?  Is there a preferential return?  What are the anti-dilution provisions?  Is there any board control specified?  All of these work together with the valuation to make a fair deal.  No experienced entrepreneur or investor would establish the valuation without knowing what the other terms were going to be.  YET, it is effectively done all the time with Equity Replacement Debt!  Recently, I have seen some term sheets that attempt to spell out some of these details in the convertible debt document, inching the process closer and closer to a real equity round both in its complication to execute and its cost to complete, reducing the benefits that most entrepreneurs site for doing it in the first place.

As you see just how different these two use cases are, it is no wonder that there is confusion and debate around the issue of “Should we use convertible debt?” If we would be more specific in our language we could provide a lot more transparency and focus our energy less on fancy investing vehicles and more on building great companies!

If you agree, then PLEASE start being more specific and let’s start talking about Bridge Loans and Equity Replacement Debt rather than using a vague, generic term that just confuses the issue…

 

Filed under: Status Updates — Tags: — November 26, 2012