Nivi · May 15th, 2007
Summary: Seed investors often argue that debt doesn’t incent them to (1) help the business and (2) increase the share price of the eventual Series A. Actually, (1) debt does incent investors to help the business and (2) equity may also incent investors to decrease the Series A share price. That said, you can make your debt much more attractive to investors with a few concessions.
Although convertible debt is often the best choice for a seed round, investors often argue that debt does not incent them to contribute to the business:
Debt holders are incented to help the business.
Your response to an investor’s claim that “(1) debt doesn’t incent me to help the business”:
“If you buy $100K of debt, you get $100K worth of shares in the Series A, plus some shares for your discount. You’re not losing money by contributing to the business—the Series A share price may go up but your share value remains $100K, plus a discount.
“And… as you contribute to the business, the company’s risk goes down, opportunity goes up, and the net present value of your debt goes up. You’re still incented to help the business when you buy debt.”
That said, equity incents an investor even more. If an investor buys $100K of equity in the seed round and locks in his share price, he makes a paper profit if the share price increases in the Series A.
Note to entrepreneur: You don’t need to make this argument on your investor’s behalf.
Equity holders are also incented to decrease the Series A valuation.
Your response to an investor’s claim that “(2) debt doesn’t incent me to increase the eventual share price of the Series A”:
- Insensitive to the next round’s price if they plan to maintain their percent ownership,
- Incented to increase the next round’s price if they plan to decrease their percent ownership, and
- Incented to decrease the next round’s price if they plan to increase their percent ownership.
(We’ll explain how the math works in the comments.)
Some seed stage funds maintain or decrease their percent ownership in the Series A. These funds tend to focus on seed stage companies.
Other seed investors try to increase their percent ownership in the Series A—if the company is doing well. These funds tend to invest in most stages of a company’s growth.
Ask your investors about their track record and strategy for follow-on investments. If they like to increase their percent ownership in their best investments, they have an incentive to drive down your Series A valuation whether they buy debt or equity in the seed round.
Make your debt attractive to investors.
Rather than debating the finer points of your investor’s incentives, you can make your debt much more attractive to investors with a few concessions (ordered from small to large):
- Don’t let the company pre-pay the debt. Your investors don’t want you to repay the debt just before you raise a Series A or sell the company.
- Anticipate a potential sale before the Series A and negotiate your investor’s share of the sale price. Your debt investors want to make money if you sell the company before the Series A.
- Increase the discount by a fixed amount and/or 2.5% per month, up to a maximum that can range from 20% to 40%. A higher discount yields a higher return for your investors. For example, a 40% discount guarantees your investors a 1.7x return on paper when the Series A closes.
- Set a maximum conversion price for the debt.
The debt could convert at the lesser of (1) $X/share and (2) the actual Series A share price. This cap effectively sets a maximum valuation for your debt investors and protects them from a high Series A share price. This is a great way to maintain the benefits of convertible debt while rewarding your debt investors for investing early. The maximum conversion price can be significantly higher than any valuation you could negotiate easily.
How have you made debt attractive to investors?
Use the comments to share your experiences and questions on making debt attractive to investors. We’ll discuss the most interesting comments in a future article.