funding, financingMany investors seem to be offering “convertible debt” investments. Without going into too much detail as to what it is, what are the ramifications if a startup fails? Are the founders personally responsible for paying off the debt? Both theoretical worst case, and practical outcomes would be handy.
Ah, convertible debt. The magical structure of pre-seed startups.
I just had a meeting on this a few months ago, as one of our investors really pushed us to let him invest using convertible debt. Just some quick background on convertible debt for those who don't know:
It's better for most investors because of tax loopholes
It's better for founders because of the goal of 'losing less equity' and allowing the founders to keep control (at least until later rounds).
It's generally converted over a long course of time, and is one of the least-high impact forms of investment (often small amounts of capital over a long period).
Now, as for your question, the key word here is liability. For the rest of my answer, I'll be referencing an article by Entrepreneur that addresses your question directly in its third point:
There are three critical decisions to make when using convertible debt:
What will be the event that triggers the conversion? You can elect to specify an event (or set of events) such as a revenue threshold, a financing threshold or another business milestone. Typically, entrepreneurs and investors agree to set the conversion to occur at a financing event.
Will there be a discount upon conversion? It's a tricky decision to provide a discount to early investors. But if you don't provide a discount or set it too low, you might not get investors to commit before the next round is close to fruition. And if you set the discount too high (or if takes a long time for you to raise the next round and you don't place a limit on the discount), the next round's investor will factor in the discount when pricing the stock. Effectively, this may mean that you--the entrepreneur--will pay for your generosity out of your own shares! Be wary of this.
What will happen to the investment if the conversion event doesn't occur? If the debt is set to convert to equity when you raise $10 million, and if this never happens, what should happen to the initial investment? It could remain as debt. Or you could elect to add a clause that allows the debt to convert to equity at the discretion of the investor or the discretion of the company.
To boil it down, using the convertible debt method of financing with family, friends and angels essentially boils down to you saying, "I need money, and you have it. But I don't know how much my company is worth, so let's see if professional investors or the passage of time will set the value for us while giving you an upside that's more in keeping with the risk.
In plain words,
The contract is king here. You want to logically iterate through all possible outcomes with your investor, and talk about the liability. Depending on your business type, you may be liable to pay the debt if your company accrues it, but more than likely, your investor doing convertible debt will be friendly and you should try to agree on giving them equity if the company fails (they lost their money - it's a gamble, they'll understand - as long as the odds were good in the beginning). Good luck.
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