Varieties of Debt

The Oxford (American) English Dictionary defines debt as simply, “something, typically money, that is owed or due.”  The (British) English version of that same dictionary presents debt a bit more formally:

That which is owed or due; anything (as money, goods, or service) which one person is under obligation to pay or render to another. (link)

The latter definition of debt is more general and worth taking into consideration.  Debt is just an exchange of something for an obligation, and the terms of that obligation can and do vary.

In this note we will focus on financial debt, more commonly known as loans. We will begin be describing the features of a basic loan, sometimes called vanilla debt, and then move on to the features of convertible debt, a variety of debt that is common in the startup context.

Basic debt

Basic debt, or what can be affectionately dubbed “vanilla debt,” is likely to have three distinct characteristics: a term or schedule of payments, an interest rate (stated explicitly, or implicitly through the value of payments), and some assurance or collateral.

Term and schedule of payments

Unless you plan on permanently embracing an obligation to pay someone back from some amount you have borrowed, a loan should come with a term and/or a schedule of payments.  The term is simply the period of time over which you are obligated to payback the loan. The schedule of payments is most simply a statement of how often payments should be made (e.g., weekly, monthly, quarterly, or yearly), or more specifically the exact dates by which payments should be made.

For example: You might borrow $25,000, with payments to be made monthly over the next ten years.

Interest rate or payment amounts

The interest rate is that extra “je ne sais quoi” that the lender requires for the risk they see as inherent to the loan.  For example: You might borrow $10,000 at a 7% annual interest rate, to be paid back monthly in equal amounts.   At a rate of 0%, the sum of all payments would equal the amount first borrowed.

The payment amount would simply be the amount that is required to be paid in any period in order to remain current, or compliant, with the terms of the loan.  Given the amount borrowed, the interest rate, and the payment schedule you could calculate the expected payment amounts.  Alternatively, given the amount borrowed, the payment schedule, and the amount of each payment you could calculate the implied interest rate.

As you might expect, the riskier the loan is perceived to be, the higher the interest rate that will likely be associated with the loan.  Or, the more negotiating power the lender has, the higher the interest rate they may be able to associate with the loan. If you really need the money, you might pay just about anything to borrow it!

Assurances and collateral

Finally, the obligations of debt are often backed by some assurance—some thing tangible (e.g., your house) or intangible (e.g., another individual promising, or “guaranteeing,” they will pay if you cannot) that provides the lender with a sense that they will get something in exchange for this loan even if you stop making your expected payments.

Should you stop making payments, and no other resolution to the issue emerge, the lender has the right to take ownership of the tangible thing or start pursuing the payments from the intangible source (e.g., get the payment from whoever guaranteed the loan).

Additional Forms of Debt

Species beyond basic debt will have the three characteristics described above and then some.  Debt can be written in such a way that upon the holder’s (lender’s) decision, or the issuer’s (borrower’s) offer, the debt can be exchanged for, or converted into, shares in the company.  The type of shares into which the debt can be exchanged and the terms binding that exchange are a function of the contract and, therefore, up to negotiation.

Convertible debt

In a simple version of conversion, debt would simply be exchanged for equity.  This is not a religious conversion, but a financial conversion.  Oftentimes, this conversion is spoken of in dollar terms (e.g., a $1,000,000 loan that can be exchanged for $1,000,000 in stock), but can also be spoken of in share terms (e.g., a $1,000,000 loan that can be converted to 1,000,000 shares).

In early funding environments, such as seed rounds, it is not uncommon to see convertible debt as the method of financing.  While there are all sorts of reasons for this approach, the simplest explanation for and also the consequence of this approach to financing is it shifts the debate over valuation to the next round of financing.  Valuing an idea, or a product/service in prototype is a rather difficult endeavor, often requiring crystal balls and financial voodoo.

Therefore, many professional angels and seed-round financiers will simply leave this haggle over valuation until the product/service is further along and subsequent investors get involved.  The compensation these investors receive for their willingness to delay a more formal valuation (and a more explicit statement of their stake in the venture) is embedded in the terms of the basic loan, but more emphatically in the terms of the convertible aspects of the loan.

Debt with warrants

In a more sophisticated version, debt has a additional equity component through warrants.  Warrants are essentially options and provide the holder with the right but not necessarily the obligation to purchase the underlying or a subsequent series of shares at some price by some point in time.  In many cases, these warrants are separate instruments from the debt and, therefore, can be sold and exercised distinct from the debt.

Debt with coverage (or special warrants)

In the startup realm you might hear of warrants spoken of in terms of “coverage.”  Coverage, in this case, really translates to “bonus shares,” which means something a bit more special than a standard pile of warrants.

In the case of coverage, the bondholder has essentially pre-purchased some dollar value or number of shares in a subsequent round with the dollars loaned as part of the debt.  Since these share do no yet exist, however, they are attached to the debt as warrants.

Debt with 25% coverage implies that the exercise of the warrants offers the buyer a dollar value of stock equal to 25% of the dollar value of debt they previously acquired.  So a $1,000,000 loan with a 25% warrant coverage would lead to $250,000 of stock upon conversion.

.25 x $1,000,000 = $250,000 worth of shares

While it would appear that these warrants permit the holder to purchase shares in the next round at a price of zero, stating this observation out loud is not what respectable founders/investors do. Instead, this coverage is spoken of as additional shares offered to the investor in exchange for the risk embedded in their willingness to loan money to a startup.

Convertible debt plus warrants/coverage

And yes, of course, you will see straight conversion combined with warrants/coverage for the added reward for risk.

Convertible debt with a Discount

You may also hear of convertible debt that comes with a discount. Pragmatically, this discount is just warrant coverage expressed backwards, leading to a slightly different “bonus shares” effect. Furthermore, the discount likely means something slightly different than your initial instinct, and this difference matters.

“At a discount” really means that the conversion yields a great number of shares for the investor during the round, rather than the acquisition of shares during the round at a truly discounted price per share. In other words, the debt holder is not offered shares from the round at a lower listed price than other investors. Instead, this investor is offered a greater number of shares for their dollars invested (a lower effective but not actual price per share).

While the above distinction may make your head spin, the consequences are important—founders and prior shareholders are more significantly diluted through debt with discounts than through debt with coverage.

For example: A convertible debt holder also has a 25% discount at the next round attached to their $1,000,000 loan.  What they will get upon conversion combined with their discount will be $1,333,333 of shares at the next round.

$Y x (1 – 0.25 [the discount)) = $1,000,000.
$Y = $1,000,000 ÷ 0.75
$Y ≈ $1,333,333 worth of shares

Notice that in the example the holder of the debt received neither $1,000,000 worth of shares for $750,000 (while taking $250,000 off the table), nor $1,250,000 worth of shares for their $1,000,000 loan that was converted.  Instead, an extra 83,333 shares were offered to the investor holding a discount for their efforts.

Conclusion

To be written….

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For further reading:

Seth Levine (2010). Has convertible debt won? And if it has, is that a good thing? VC Adventure.
Mark Suster (2010). Is convertible debt preferable to equity? Both Sides of the Table.
Fred Wilson(2011). Financing options: Convertible debtA VC.