Every few weeks there's a topic that just rampages through the venture capital blogosphere. Last week it was the topic of convertible notes and their future. I pulled out the most pertinent quotes so that readers could quickly see the main points. If you're an entrepreneur, investor, or just interested in more, the links have been included for more indepth reading.

Mark Suster defined the concept well: "Convertible debt is an investment that “converts” into equity in the future usually at a discount to your next funding round price and sometimes has a “cap” (maximum price)."

Paul Graham, YCombinator founder and prominant thought leader, kicked off the discussion with a tweet:  “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.” ...and continued with a more in-depth essay: High Resolution Fundraising

The reason startups have been using more convertible notes in angel rounds is that they make deals close faster. By making it easier for startups to give different prices to different investors, they help them break the sort of deadlock that happens when investors all wait to see who else is going to invest.
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Raising an old-fashioned fixed-size equity round can take weeks, because all the angels sit around waiting for the others to commit, like competitors in a bicycle sprint who deliberately ride slowly at the start so they can follow whoever breaks first.

Convertible notes let startups beat such deadlocks by rewarding investors willing to move first with lower (effective) valuations. Which they deserve because they're taking more risk.

Then Seth Levine jumped in with: Has convertible debt won? And if it has, is that a good thing?

Clearly in the short run this trend is positive for entrepreneurs because it has the effect of both deferring an often difficult conversation (around valuation) and ultimately increasing early stage company values and as a result decreasing entrepreneur dilution (by the way it’s also good for Y-Combinator, TechStars and other similar programs since the shares the program gets of each company act as founder shares in this financing equation). And I have no doubt that there will be many entrepreneurs who benefit from this trend. But it’s not clear to me that it’s sustainable (just as it wasn’t a decade ago). Ultimately investors need to be compensated for the risk they take in making their investments. With capital being relatively fluid (and the angel markets being finicky) as companies run into trouble, as valuation caps begin to be disrespected, as overall return profiles decrease because of higher early stage prices, money will flow out of the asset class. And ultimately this doesn’t benefit entrepreneurs either.

Mark Suster follows with: Is Convertible Debt Preferable to Equity? Since Mark's analysis is so detailed and comprehensive (and therefore you should read it yourself), I'll leave you with only his conclusions and encourage you to digest his thoughts yourself:

In summary – I don’t believe the “convertible debt” has “won” in the market – especially not “convertible debt with no cap.”  The market is frothy right now so terms are bending toward entrepreneur-friendly terms.  But as you’ll see in my next post – I dont’ believe this will last for long.

The Convertible Debt Debate – An ex-Lawyer’s Twist on the Argument

However, if a company is insolvent, the board and company now owe fiduciary duties to the creditors of the company.  By definition, if you raise a convertible debt round, your company is insolvent.  You have cash, but your debt obligations are greater than your assets.  Your creditors include your landlord, anyone you owe money to and folks that you might owe money to you, like former disgruntled employees and founders who have lawyers. 

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Assume the company is not a success and fails.  In the case of raising equity, the officers and directors only own a duty to the creditors (landlord, etc.) at such time that cash isn’t large enough to pay their liabilities.  If the company manages it correctly, even on the downside scenario creditors are paid off cleanly.  But sometimes it doesn’t happen this way and there are lawsuits.  When the lawyers get involved, they’ll look to try to establish the time in which the company went insolvent and then try to show that the actions of the board were “bad” during that time.  If the time range is short, it’s hard to make a case against the company.

However, if you raise debt, the insolvency time is forever!  Not just when cash got below the ability to pay liabilities like the equity situation, because the company has never been solvent. 

What does this mean?  It means that if your company ends up failing and you can’t pay your creditors, landlords, etc. that their ability for a plaintiff lawyer to judge your actions has increased dramatically.  And don’t forget, if you have any outstanding employment litigation, etc., all of these folks count as creditors as well.   

The best part of all of this is that many states impose personal liability on directors for screwing up things while a company was insolvent.  Read this to be:  “some states will allow creditors to sue directors personally for not getting all of their money they are owed.”

Well, those are the most interesting arguements I've seen so far. If you've read one I haven't, email me at andrew@aonetwork.com.