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Comment by pg | Hacker News Reader

This is written as if convertible debt financings were like regular debt, where if you can't pay a loan back by a certain time, you're in default and bad things happen to you. That's not how it works in practice. 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. So in practice if there's no equity round by the end of the term, the debt either gets converted or the term gets extended.

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.

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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.

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?

As I explain here

http://news.ycombinator.com/item?id=2318164

cutting one's losses is not usually an option.

It only takes one or two investors to pull out of one company, and that company faces bankruptcy. With so many newbies entering the angel market, you just never know.

kind of like a bank run on startups? scary thought

Right now, Paul, convertible debt is not a problem today and was not a problem in 2010. Most startups with debt negotiate an extension when the note comes due if there is not a Series A. However, the amount of debt is ballooning, and there are many new angel investors entering the market. The signals are not good. This is a preventable problem with a better angel investment structure that gets widely adopted. I am just pointing out the problem.

YC companies are the cream of the crop and have YC's backing, so are in a different position to many other startups also getting funding.

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.

No one could "rush out of the market" even if they wanted to. Adeo's article is about the case where the startup doesn't have the cash on hand to pay back the angel. At best (or rather worst) a panicking angel could get the startup's IP, and good luck selling that without the people.

You seem to be assuming that startups will run out of cash at exactly the moment that their convertible debt becomes due -- maybe this sometimes happens, but I can't help thinking that it would take exceptionally good planning (or a lot of luck).

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?

In practice it usually amounts to that, because the term of a typical convertible note is a bit longer than the amount of time a typical funding round is expected to last.

Ok, but what if a company takes two rounds of convertible debt? Wouldn't the first one expire while the company is still burning through the second round?

Or is it standard practice when a company raises a second round of convertible debt to extend the maturity of the first round?

Two rounds of convertible debt does not really happen, practically, since debt is the most senior security in a company. An investor doing more debt at a later point would not have much advantage over an investor that did debt in the first place. As a result, there is no premium for coming in earlier, when it is more risky. Early debt holders block issuing more debt, generally.

As cperciva mentioned too, it's about the potential desire to cut losses and get out, and the damage that could do. I don't disagree that the Angels trying to cut their losses would get little back and there would be no value in rushing out. But in a panic logic is seldom the driver.

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.

I actually thought this post was brilliant. A few items I liked:

"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.

Thank you for explaining this. I had a few misconceptions about these transactions.

Since when is Angel investment a loan, anyway?

It was an honest question. Pro tip: try answering a question even if you consider it to be stupid. Don't just vote down. Not cool.

The original link describes the situation pretty well if you read it. A convertible debt is a form of loan, and as the post points out, this is currently the popular way that angels put funds into startups.

I would prefer not to see HN real estate wasted on redundant answers that were already available in the linked articles. Answering questions that didn't need to be asked encourages laziness and hurts signal/noise.

Since when angels started using convertible debt instead of straight equity purchases.

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