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When cash is urgently needed and an equity financing is impractical or unavailable, founders of start-up companies often turn to debt financing in order to prevent cost cutting or to protect their progress in moving their business forward. Prior to the implosion of the dot-coms at the end of the 1990s, convertible debt financings were used by start-ups as a short-term loan usually made by existing equity investors (bridge financing) in anticipation of a subsequent round of equity financing in the near future. Since then, however in addition to using this approach for bridge financings where appropriate, convertible debt financings have increasingly been used to fund very early-stage start-up companies. There are several reasons for opting to consummate a convertible debt financing, including valuation uncertainty, conversion certainty, and investor preference for debt.
Valuation uncertainty. It is often very difficult to value early-stage start-ups, particularly those that are pre-product, pre-product market fit, and/or do not have many users/customers to gauge the growth and success of the business. As a result, where there is still significant doubt about the ability of the start-up to succeed, notwithstanding the existence of an impressive management team, a good business model and a very large potential market, a convertible debt financing is ideal because it allows the start-up and the investors the opportunity to defer valuation until one is determined during an equity financing.
Conversion certainty. In today’s market, many investors believe that the outstanding debt of a convertible debt financing, will, with reasonable certainty, convert into preferred stock in the next round of equity financing. You should note, however, that the foregoing has led some leaders in the venture capital space, such as Y-Combinator incubator and others, to discard debt-based financings as the first round of financing for very early-stage start-ups, in favor, instead, of a simple agreement for future equity.
Investor preference for debt. Sometimes, especially in situations where the start-up’s financial situation is extremely precarious or the investor is a financial institution (principally banks and similar financial institutions), rather than a venture capital firm or an angel investor, the investor is interested as much in the debt features of the investment as it is in the convertibility feature. In making the decision to invest, such investors use the debt features of payment of interest, priority over equity and, in some situations, the existence of a security interest in assets of the start-up as a way to justify the investment, using a risk versus benefit analysis to decide upon the required terms of the transaction. In so doing, such investors secure for themselves additional compensation (i.e., the potential equity kicker that the convertibility feature affords) for the level of risk they are assuming by investing in a financially troubled enterprise.
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