Posted 23 Dec 2008
I previously mentioned that convertible debt is a good way to raise capital for most startups. The main reason why convertible debt is beneficial for startups is that it delays coming up with a valuation figure at the seed stage–the valuation conundrum is essentially punted to the Series A (or “qualified financing” stage).
But what happens to the convertible debt if you sell rather than raise capital?
In most situations, the investor will receive more than the interest due + principal balance of the loan. I’ve seen anywhere from 1.5X-3X the outstanding principal amount of the loan due the investor upon the closing of the “change of control” event. This 1.5X-3X payment is, of course, made in full satisfaction of the startup’s obligations to the convertible debt investor.
In this unique situation, your startup essentially skips the “qualified financing” and goes straight to the exit. If the convertible debt investor wasn’t able to enjoy the upside in the event of an acquisition, such investors would be more reluctant to invest this way (and you’d be left to grapple with the valuation debate). Or worse, the investor would demand a higher interest rate. Or much worse, they would require their consent to prepay the convertible note before the qualified financing or maturity date of the loan.