The Year of the Startup Default
thefunded.com
thefunded.com
It's not like convertible debt was invented in 2010. I've seen many startups hit the end of the term of a convertible note before raising an equity round, and it has never once been a problem.
YC companies are likely to be in a stronger position for debt to get converted or extended than most startups. They're more likely than the general market to be good quality companies in a stronger negotiating position, and Angels aren't likely to burn YC. Plus it's fair to say that they have the cream of Angel investors, who are likely to act in a reasonable way.
I think Adeo's argument is about what happens to the bulk of the market - so applies more to all the others. YC companies have been the exception to many a rule.
I hope it proves to be wrong. But if there is a panic/bubble-burst and a herd mentality develops to rush out of the market, it's reasonable to expect many individual angels will lose their nerve and want out, at least beyond the top end of the market represented by the YC startups.
I know there have been cases where startups have decided to shut down and return their remaining cash to investors (including some YC companies, I think); what happens in the case where a convertible debt holder thinks a startup should take that option but the founders aren't ready to give up?
Or is it standard practice when a company raises a second round of convertible debt to extend the maturity of the first round?
In your experience, would most startups survive if their angel investors with convertible debt wanted out, even if the cash wasn't there to repay it anyway and there were no tangible assets to sell?
Adeo's post reads to me as being a warning about the potential fallout in a context where people want out. I don't think there is much argument that the Angels wouldn't recoup much anyway. But neither is that the case when people sell public stocks that they've acquired at the top of the market when it hits the bottom. But even professional investors do that too with predictable regularity.
Maybe I'm being a bit pessimistic, but this really sounds to me like "US housing prices have never fallen by X%".
Investors who fund a startup using convertible debt are not hoping the debt will be repaid, like a regular lender is; they want it to convert to equity.
I'm sure that this is correct at the point that they provide the funding; I'm less certain about the situation 18 months later. Do you really think that no investor will ever change their mind over the course of 18 months and decide that they'd prefer to cut their losses rather than extend the term of an investment in a company which no longer seems quite so hot?
http://news.ycombinator.com/item?id=2318164
cutting one's losses is not usually an option.
"First, startups with large debts on their balance sheet will have challenges securing loans, partnerships and vendor credit, impeding their growth. "
Debt by any other name is still debt on the balance sheet, so this is a great point.
Also:
"The majority of convertible debt deals have no mechanism to convert to equity without the occurrence of a Series A, and standard convertible debt deals come due in 12 to 18 months."
This is startling. If this is true then many startups are facing a big unknown i.e. how renegotiating their convertible debt will turn out. Will you lose control of the board? How much equity will you lose? etc. While a pat on the back and a "this has never once been a problem" may work for some, it wouldn't make me sleep better at night.
I think this is excellent advice:
"negotiations should start sooner rather than later about converting the debt to equity upon maturity with your debt holders"
Remove the unknown ASAP and give your company a more predictable and stable environment to operate in.
Naval Ravikant, who runs angel list states that there's been an additional $500M that has been invested in early stage startups last year.[1] Which is essentially a smallish VC fund.
Naval has also stated that 240 companies have received angel funding via Angel list this past year. If every company received $1M, that would still only be $240M invested in early stage startups.
I don't understand where the anecdotal $50B comes from.
Also..
Estimates are that there are now 10,000 angel financings per year, and as much as 70% of these deals are now convertible debt.
Naval Ravikant runs the angel list, and he's saying there are only 240 investments that got money via angel list last year. That's a big discrepancy.
I don't have a comment on whether the structure of convertible notes is good or not. I was just very surprised at the numbers Adeo brought up in the article, because they are several orders of magnitude larger than what I'm reading in other areas.
If he has other data sources, I'd love to read them. My instinct has been that Angel List has been at the epicenter of getting all these startups funded, and so I've been inclined to use Naval's numbers in my thinking.
ref:
[1] http://www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2011/03/04/...
Also, I think in a large percentage of cases, the angel can convert at the cap if there's no liquidity event, so it's not necessarily going to result in mass defaults. If the startup is doing really well, this seems like a more likely outcome than the angels calling back their debt.
If a startup is doing well, the worst-case scenario involves issuing stock to new investors in order to pay off the convertible debt.
The problem would come in the marginal cases -- where a startup is still running and still has cash in the bank, and the founders aren't ready to give up yet, but hasn't produced anything interesting enough to bring in new investors... or to convince the convertible debt holder to keep his money in.