[trominos]

Thanks for the explanation. One thing that's confusing me: if the company gets a Series A round, convertible debt is worse than the equity you would've gotten because you've essentially chosen to invest as a VC rather than an angel (which means you're investing, in all likelihood, at a higher valuation). This isn't true if the valuation cap is sufficiently small, but then why not just get equity out the door?

If the company goes bust convertible debt is worth nothing, like equity.

Where's the upside? Convertible debt seems like a strictly worse investment than stock.

[patio11]

Investing at a valuation of $1 million is a strictly worse investment than investing at $500k, from the perspective of the investor, but that doesn't mean $500k is on the table.

Here's the metagame: investing traditionally sucks for founders. Founders at the top tier of companies now have market power. A betting man might predict it is going to start sucking less for them.

Of course, somebody has to explain the game has changed to investors. Preferably, a respected someone with no immediate need of their money, whose favor investors rely on desperately for deal flow. If he is a really good communicator, he might even get them to agree that this is in their interests, since successful startups are cheap at any price and unsuccessful startups are overpriced no matter what the terms were. If he can credibly claim to represent mostly successful startups, well then, no harm to investors.

whistles

[BerislavLopac]

Hm, doesn't that mean that the investors would be better off to go seek for interesting startups in the parts of the world where the investors are so rare that the founders don't have that kind of market power? And would accept nearly any valuation just to get funding?

Or it's still just easier to sit and wait for startups to fall in their mouths, accepting whatever terms they might ask?

[ra]

Assuming all other things being equal, yes. However all things aren't equal and many people live in a particular place because they like the lifestyle, or their family lives there or their kids have great opportunities etc...

You're right though. It's the corollary of startups moving to SF because that's where the investors are.

[btilly]

If the company goes bust convertible debt is worth nothing, like equity.

Not entirely true. Convertible debt is subordinated debt, which means that you don't get the first choice of pickings in bankruptcy court. But you are a creditor, and so there is a possibility of getting some money returned from bankruptcy proceedings.

Where's the upside? Convertible debt seems like a strictly worse investment than stock.

Paul Graham's answer is that convertible debt is worse for the investor but better for the founder. Therefore when founders have power they will choose convertible debt, and the upside for the investor is that they have the option to participate in a potentially profitable deal that otherwise they couldn't.

If pg's theory is correct then entrepreneurs with power should choose convertible debt, and investors should express a preference for equity. And indeed it is not hard to find articles like http://www.avc.com/a_vc/2010/08/some-thoughts-on-convertible... where investors make it clear that they don't like convertible debt, and try to convince entrepreneurs that they shouldn't either. (Note, when you're negotiating with someone who is trying to convince you of what you should think, you don't have to look hard for a hidden agenda.)

In abstract theory, the extent to which investors don't like convertible debt should be reflected in their offering worse terms on convertible debt deals. Bias the terms enough, and the investor should become indifferent. However my reading of pg's observation is that different terms are being offered to different investors. So the parallel trend is that a few top angels potentially get better terms than the old equity deals, but most angels get worse terms. Which makes most of the angels even less happy.

As confirmation I note that http://www.sethlevine.com/wp/2010/08/has-convertible-debt-wo... raises the experience of an anonymous super-angel and says a year ago these caps “approximated what I’d pay in equity” that they’re now “33% higher than what I’d normally agree to pay now.”