Angels Should be Cautious of Convertible Debt

Posted by Glenn Bachman | May 3, 2016 | Education | No Comments on Angels Should be Cautious of Convertible Debt tags: , , ,

Many early-stage venture capitalists and sophisticated angel investors refuse to invest in seed and early-stage ventures using convertible debt because of the associated risks.

All Those In Favor Say Aye

Those who argue in favor of using convertible debt will claim it is a fast, cheap and easy way to create funding documents. Additionally, it delays valuation arguments until a larger professional round prices the deal. Reputable accelerators across the country use convertible debt, because the discount rate and valuation cap compensates early investors for taking early risk.

The Truth Will Set You Free

Entrepreneurs don’t want to take a lower valuation. They are passionate believers who naively overvalue their business and undervalue your risk. They are hopeful that your capital, connections and coaching will drive up valuation.  New ventures have little capital, and convertible debt documents are a low-cost method often recommended by attorneys forming new client relationships.

However, an uncapped deal is bad for investors. Forced conversion pre-priced caps are all over the board and usually too high.

Accelerators prepare pre-seed deals which involve lots of pivots, but they lack any real intrinsic value. It isn’t practical for these accelerators to spend resources determining and negotiating valuation for each new venture applicant.

Get Leverage or Run for the Hills

Would you invest in a stock today where your share price is unknown until after the company has time to drive up your price? Your pre-negotiated financial incentives are not guaranteed, as the last money in ultimately dictates your deal terms despite what the existing documents state. When a venture needs additional capital and is low on cash, you lack leverage and adequate investor protection as compared to a Series Seed preferred terms.

It is important for angel investors to capitalize on winning investments. Convertible debt undervalues risk capital as compared to the next round of funding. Join an angel group and invest in co-syndicated pre-priced ventures with professional terms. Otherwise, run for the hills when you hear the pitch “Convertible Debt.”