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

Today, my partner Seth wrote a great piece on the merits of early-stage startups raising convertible debt rounds versus traditional preferred stock equity structures.  The piece was inspired by Paul Graham’s recent tweet that said:  “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.”

Seth’s piece is a must read in this debate that is only gaining more participants, including a nice follow up from Mark Suster about his thoughts.  I can’t do justice to either Mark’s or Seth’s pieces trying to summarize them, so I strongly encourage you to read them.

I’m going to go out on a limb and break out my old law bar card and bring up one issue that I don’t think is getting enough focus in the debate:  the use of debt fundamentally changes the fiduciary duties of managers and board member of the company.

If a company raises cash via equity, it has a positive balance sheet.  It is solvent (assets are greater than obligations) and the board and executives have fiduciary duties to the shareholders in the efforts to maximize company value.  The shareholders are all the usual suspects – the employees and venture capitalists.  Life is good and normal. 

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. 

How does this change the paradigm?  To be fair, I have had no personal war stories here, but it’s not hard to construct some weird and scary situations.

Let’s look at the hypothetical:

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.” 

Now I don’t want to get too crazy here.  We are talking about early-stage / seed companies and hopefully the situation is clean enough that my doomsday predictions won’t happen, but my bet is that few folks participating in convertible debt rounds are actually thinking about these issues.  And no, I don’t know of any actual cases out there, now.  But I’ve been around this business long enough to know that there is constant “innovation” in the plaintiff’s bar as well. 

  • Scott Edward Walker

    Hey Jason – I'm a big fan of you, Brad and & David; however, I think you missed this one. Please note the following:

    1) Your definition of “insolvency” is not generally applied by the Courts. Indeed, under North American Catholic Educ. Programming Found, Inc. v. Gheewalla, the leading Delaware case, “insolvency” is defined as (i) “an inability to meet maturing obligations as they fall due in the ordinary course of business” (the so-called “Equity Test”) or (ii) “a deficiency of assets below liabilities with no reasonable prospect that the business can be successfully continued in the face thereof” (the so-called “Balance Sheet Test”).

    Based on the facts of each case, the Delaware Chancery Court has applied either or both of these tests. Under the Balance Sheet test, however, a company’s assets must be “fairly valued.” Moreover, several Delaware courts have noted that defining insolvency merely as a corporation’s liabilities exceeding its assets fails to take into account emerging corporations that take advantage of business opportunities.

    2) In Gheewalla, the Court held that the fiduciary duties of directors in an insolvent corporation continue to be owed to the corporation.

    3) The Court also held in Gheewalla that the creditors have no right, as a matter of law, to bring a direct claim for breach of fiduciary duty against the corporation’s directors.

    • Well, I cant go into detail, but in CA, Im not seeing that, as we have some current matters that we are dealing with. DE law is massively important, but lets not assume that its applied everywhere and the same everywhere.

  • Trish

    In many cases, if the company was insolvent at the time the convertible debt was issued (likely with all early stage), a bankruptcy court may very likely recharacterize the debt as equity if the company imploded prior to conversion. Of course, the courts do look at multiple other factors in determining whether recharacterization is appropriate, but insolvency could be a big one – even when the initial convertible debt instrument isn't from an "insider".

  • The wind-down claims issue has never come up for me. In my experience the companies that have failed while convertible debt is still outstanding have not had enough assets to be worth creditors fighting over.

    Something that HAS come up a bunch is the situation where the company is unable to raise the subsequent round that would trigger conversion. The Notes come due and the investors technically own the entire business but if they were to make a claim on it the founders would probably leave. There follows a long awkward period where no one knows what to do. Companies with good management and supportive investors manage to renegotiate some kind of conversion but it is challenging because everyone ends up negotiating the same valuation issue they wanted to avoid earlier but with more at stake for both sides.

  • Matlock

    The doomsday scenario is academically sound. The true value of a business counsellor/attorney is to put a likelihood that risks identified will ever happen. Few attorneys ever feel comfortably saying single digit likelihood, greater than 50% likelihood, etc. On this path, issue-spotting and highlighting the potential pain without ascribing % likelihoo of that pain happening makes it impossible for a business owner to weigh the risk-scored downside against the upside. One thing that attorneys (I am a recovering attorney) often forget is that the plaintiff's bar generally have a better understanding of business risk than their in-house and external counsel counterparts. They usually don't chase lawsuits where the likelihood of recovery is low. If the likelihood of recovery is high, the company is probably not insolvent.

  • mikeschinkel

    On my gosh Jason, I can't even begin to tell you how you absolutely nailed this. I've lived through it and I wouldn't wish it on my worst enemies. This trend is indeed extremely troubling. Where do I begin?

    I was running a successful company (#123 Inc 500 in in 1999) and I came about the need for capital and had a "well meaning" "investor" (one of my vendors at the time) offer to invest $500k (we were at a run rate of $12 million/year with gross margins of around 16%.) After spending 6 month in due diligence he pulled the zinger and backed out unless we converted it to debt.

    He had promised he would invest so I had been operating with the expectation of getting the money (damn was I a fool, but then you know what they say about those who learn from experience?)

    The next years were the most painful in my life. I simply had no mentor to tell me that if I let it fail it wouldn't be a personal failure but a great learning experience so I kept trying. After 6 years of trying I finally walked away from the company I had built and turned it over to the vendor/"investor" as a shell of it's former existence, and with leaving was stuck with the personal liabilities I had naively taken on 10 years prior. (And he has since run it into the ground so we were both fools.)

    Here's what I learned about the very topic you write about:

    – If an entrepreneur gets a true equity investor they will have committed their funds to illiquidity with the expectation that the company will succeed enough that they will get a very good return on investment. In most case they become a true partner in a company's potential success doing everything they reasonably can to ensure success and typically only limited by their time and or ability to help.

    – If OTOH a person or firm "invests" by becoming a lender then take on a very different mindset. They view their interest payment as a "right," and their overriding concern becomes ensuring their principle is protected. The value of the company becomes secondary in their minds and they begin to view themselves more as outsiders looking in and judging management actions than as partners in success.

    – Companies will debt on the balance sheet will become pariah to any other investors because no other investors will be willing to pay off earlier investors except for in extremely rare cases.

  • mikeschinkel

    – If a company takes on debt then it will be as you say insolvant and that creates so many problems I can't even begin to prioritize them so I'll just rattle some of them off.

    – If there is a need for a signifcant amount of credit card processing the fees for processing (what they ironically call the "discount rate") will be extremely high and they processor will likely hold a week or two of processing "in reserve" and they probably won't even tell you they are doing it until you've bounced checks (for us it was $50k.)

    – It will become very difficult for a company to get credit for large expensives even when those expense are costs of goods for a large sale. We printed a quarterly catalog filled with advertising which costs us about $50k each time and generated about $250k in advertising but we found ourselves having to pay for the catalog in advance even though we couldn't get our advertisers to pay us in advance.

    – Banks will look at a company's balance sheet and will not provide working lines of credit no matter how strong the business is operating. And to make it worse the loan officers will waste the company executives time pumping them full of sunshine and tell the CEO how they will look at everything but ultimately then will always say "no" they just repeat the following as if a robot: "Sorry, but your balance sheet just wasn't strong enough." It happened time and time again to us, so much that I finally gave up on trying.

    – With a company taking on debt one of the worst case scenarios for the CEO/management team/founder(s) are they will be sued personally if the company fails. But the best case is also that they will be sued personally and likely be forced into personal bankruptcy.

    Many founders who make a go at a startup do not have large cash reserves (i.e. they are not like Mark Andresseen with untold wealth from a prior exit) but instead they are hand-to-mouth entrepreneurs who are swinging for the fences. If their startup fails they will be struggling to to pay their rent/mortgage let alone pay the $10k, $25k, $50k, $100k or greater legal fees to defend the inevitable creditor lawsuits because when creditor lawyers start suing they cast a very wide net in hopes to find someone will pay up. So even with zero legal liability there will still be pay tens of thousands on legal fees to defend. Or the CEO/management team/founder(s) can just go bankrupt.

    – To restate the prior point more succinctly, if an entrepreneur's startup accepts significant debt and fails they entrepreneur will eventually be forced into bankruptcy. Period.

    After having spent 5 years in heaven followed by 7 years in hell I can tell you the worst thing for a company (ignoring outliers) has to be insolvent debt. If an entrepreneur has a startup that fails with significant debt it will often be so painful and take them so long to get back on their feet they will likely never attempt another startup again.

    So the only thing I can think of that could punish risk taking more and be worse for growth in the economy from innovative startups would be to bring back to debtor's prisons.

    • Bill Burnham

      Wow. I feel your pain! Great examples of the downsides of convertible debt that can only be learned the hard way. I think most Silicon Valley people would say "well, this doesn't sound like a start-up and no one I know would pursue a debt like that" but what they don't realize is that it only takes one note holder to cause problems and it is *much* easier to cause problems when you are a noteholder vs. a shareholder.

      • mikeschinkel

        @Bill: "I think most Silicon Valley people would say "well, this doesn't sound like a start-up and no one I know would pursue a debt like that" but what they don't realize is that it only takes one note holder to cause problems and it is *much* easier to cause problems when you are a noteholder vs. a shareholder."

        Exactly! Thanks for the comment reply.

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