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This may not be a new debate, but it's one worth revisiting as the competition for stakes in capital-efficient early-stage startups pits angel investors against venture capital firms. Knox Massey, head of the Atlanta Technology Angels, writes on his blog that he's seeing more entrepreneurs ask for convertible debt rather than an equity investment.

Convertible debt of course converts to equity if or when a venture capitalist invests in a company. In some cases it can be repaid with interest if a startup has the means. VCs often favor convertible debt because it allows them to value a startup at a later date without having to worry about angels valuing a company too high or too low.

Angels may bristle at the implied critique of their valuation abilities, but convertible debt can also come back to haunt them if a startup doesn't succeed. If it fails, the angels are left without an ownership stake and can only reclaim their investment, rather than any of the startup's intellectual property or assets.

As Massey argues in his post, the convertible debt model worked fine a few years ago, but stopped being beneficial to angels after venture firms pulled back on offering them discounts for participating in a Series A round, thus requiring angels to buy in at more expensive levels or risk having no equity in the startup. In effect, angels were taking a risk of loaning the startup their money, but received no discount, or reward, for doing so.

For a counterpoint on the convertible debt and equity debate, check out Evolving VC, a blog penned by early-stage venture capitalist Ted Driscoll (right). Driscoll, a venture partner at Claremont Creek Ventures and an angel investor, says that if an entrepreneur plans to raise a venture round they should use convertible debt. Driscoll addresses Massey's fear of losing out on the Series A round by saying,
 

I can clearly state that the VCs I have worked with will respect the greater risk that the seed capital took, and will accept a discount or warrant to reward that risk. They will appreciate the effort angels took to make the deal follow-on financing-friendly.

It may not be legally binding, but at least Driscoll put it in writing. - Stacey Higginbotham

See Nov. 26 post from Common Stock Not
See Oct. 14 post from Evolving VC

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