Worthwhile musing about the effect of so much convertible debt in startup land:
Both startups and angels have recently favored convertible debt, particularly in the United States. Startups like debt deals because they are quick and cheap to close by avoiding price negotiations for equity. Angels like debt because it is the most senior security in a company. Estimates are that there are now 10,000 angel financings per year, and as much as 70% of these deals are now convertible debt. The majority of convertible debt deals have no mechanism to convert to equity without the occurrence of a Series A, and standard convertible debt deals come due in 12 to 18 months.
Here is the problem. The number of seed-stage Series A deals led by venture capitalists have fallen from 400 in 2007 to 241 in 2010, and it’s declining further. Series A deals for any type of early-stage company declined from a total of 961 to 741 first-time financings in the same time (NVCA). Billions of dollars of angel debt across thousands of investments is coming due in 2011 and 2012 without any ability to be repaid or any prospect of conversion. The numbers are hard to come by for angel deals, so a lot of this is based on macro-trends and conversations with attorneys and startups, but maybe 5% of convertible debt will experience a proper conversion event.
This is a serious *potential* problem for startups. First, startups with large debts on their balance sheet will have challenges securing loans, partnerships and vendor credit, impeding their growth. Second, it will be nearly impossible for a startup with outstanding senior debt to secure additional angel financing, which is the most likely source of capital today due to the decline in venture. Third, it only takes one or two jittery angels to call their note on maturity, rather than re-negotiate, and bankrupt the startup, even if the startup is doing fine. If one jittery angel pulls out of 10 deals at once, a chain reaction is possible, and there are many more angels than ever before with varying levels of sophistication.