How Convertible Debt Kills

There is a reason that SAFEs (simple agreement for future equity) are popular now, but a few years ago, Convertible Debt was all the rage. I can say that it had a hand in killing my last company, and I wanted to share the story so that others can avoid the same pain.

Debt is one of those things that is important for a business. It allows for transactions to happen independent of the day to day cashflow, and it is a tool that can be leveraged to grow faster and take on larger transactions than your pool of cash would allow. Convertible debt is a structure that is a loan at its heart with an option to convert to equity in the company that owes the debt given specific conditions. If you read through the documents, the original intent is to give a loan holder a way to take ownership of a company in lieu of taking that company through a credit claim process in the courts, and for the original intent, it makes sense.

Fast forward to the last few decades, angel and venture capitalists invested more and more into early stage startup companies, and there are many times where you may want to not issue equity to investors right away, usually to defer setting the valuation to a later time, like in a bridge round. Someone at some point said, “Hey, I have this document that converts a loan into equity, let’s use this.” In the absence of other options, it makes sense, but the structure of the convertible debt note leaves a lot to be desired when the long term intent is to do an equity investment.

First off, it is debt, period. On the books, it is debt that shows up just like any bank loans or credit lines from vendors. So, if you go to a bank and try to arrange a loan, it doesn’t matter that you and your investor know that it will be converted sometime in the future and wiped off the books, the bank sees it as a debt and that may make it difficult for you to get additional financing approved. Second, it just misrepresents the intent of the transaction and puts the emphasis in the wrong place. But, that misrepresentation can come back to bite you at the worst time.

Looking back, Makible was a very successful venture, but ended up in a bad way due to a lot of different reasons. One of those reasons was that at least some of the investors had debt notes instead of something like a SAFE, and at least one or more of them with those debt notes made threats to claim that debt right when the company hit a cash crunch that lead to suspending operations. One of them was simply listening to their lawyer and sent the notice to just establish their right, but it didn’t matter why in the end. When trying to raise additional funds to resume operations and we got to potential risks of bringing the new money in. Having some of the creditors state that they might try to claim against the company is a show stopper, unless the outstanding debt is only a very small portion of what is being raised. This wasn’t the case with Makible, we only needed a relatively small investment to resume operations, but the total outstanding debt including investments, vendor credit, and outstanding orders was significantly more. As long as any of those creditors were acting aggressively, there was no sensible way to bring in cash to restart operations.

This is just a small part of the Makible story, and I plan to share more of it and help others learn from it. Hopefully this will help someone that might still be considering using a convertible debt note to use a non-debt structure that reflects the intent of the investment better and perhaps save some potential headache and heartache in the future.