Convertible Debt: Should Entrepreneurs Consider This Option With Angel Investors?

One common approach with seasoned Angel Investors, known as "convertible debt," can be a sweetheart deal for the angel, but the question is, Is it good for the entrepreneur?

Convertible debt is the best of both worlds for the angel investor, but is it for the entrepreneur?

The risk for an angel investor is they invest money in an entrepreneur's business and find the company's stock is worth nothing in a few years and they lose their money. The failure of the business could have been one or a combination of several circumstances. The entrepreneur may have driven the business into the ground. It may have been the wrong timing for the business. Whatever the reason, the risk is there for the investor and it's something they want to hedge against if at all possible.

One common approach with seasoned Angel Investors, known as "convertible debt," can be a sweetheart deal for the angel, but the question is it good for the entrepreneur? I've worked with several angel investors who love this approach because it does provide a level of protection for their investment.

An example of "convertible debt" works like this: The angel investor loans the entrepreneur $100,000 at 8.5% for two years with interest-only payments. At the end of the two-year term the angel investor has the option to either call the note to be paid in full at that time or to convert the debt to equity based on the current value of the business.

This is great for the Angel Investor. If the business isn't making payments on time or struggling in any way, the investor likely doesn't want to own equity in the business. Instead they ask to be paid back the principal. The investor likely will have collateral attached to the $100,000 note, so if the business can't pay it back the investor will collect on the collateral to make sure they get paid.

On the other hand, if the investor enjoys working with the entrepreneur, payments are being made on time and the business is showing signs of becoming a success, the investor will convert the debt to equity in the business. They will now own a percentage of the company and the business won't have to pay back the $100,000 debt. The investor will buy a percentage of the company for the $100,000 based on the current market value of the business (the valuation method would have been outlined in the agreement).

This is a great option for the investor, but is it a good option for the entrepreneur? I'd argue yes! There certainly is the disadvantage of selling a percentage of a business that looks like it's ready to take off and do well. Why would you want to sell when you know the company is growing in value? You can't predict the future, so there is no guarantee it's going to grow even though you have all indicators showing it will.

In addition, you company may have never been in a position to grow if it wasn't for the investment by the angel investor two years prior. The investment made by the investor likely was a contributing factor to growing the business to the new level. The entrepreneur now owns a business worth more and they don't have a debt to pay back.

Convertible debt is a good option for investors and entrepreneurs and should be considered when working with Angel Investors.

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David Gass is an Entrepreneur, Angel Investor and Buying and Selling Website Expert. He founded Business Credit Services in October of 2000 and sold the company in 2008 to The Company Corporation. Mr. Gass is a sought after national speaker on the subjects of small business financing, business credit and buying and selling websites.

[Image: Flickr user angies]

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2 Comments

  • Dhanur Grandhi

    Like everything, this isn't for everyone. 

    But it is a fantastic option,- In a downturn economy- If you're sitting a on a great idea but currently lack the team or selling firepower that will impress VCsEven better if the entrepreneur can negotiate for- A cost of debt that is lower than other sources of debt-financing (this should be possible because of high up-side for the angel)- Partial, instead of fully convertible debt - An equity buyback option (at market value plus a premium) that explodes in, say, the number of years in which you expect to break-even.