Convertible Debt: Valuation

As I noted in my post, Converitble Debt:  Mandatory Conversion, a savvy reader sent me an email about my post, Convertible Debt:  Delaying Valuation.  I thought our exchange was worth sharing.

He wrote: I saw your comments on convertible debt and had a couple of questions for you about a convertible note with a “mandatory” conversion:

• As you mentioned, convertible debt is a way to postpone valuation until the next round. But what if the convertible note has a mandatory conversion at a certain price after three years? Is valuation still “postponed”, or is the conversion price stipulated for three years down the road an indicator of present value?

It is common for notes to include a pre-determined max conversion value to reflect the maximum potential current valuation. In my opinion, you are right - while the conversion is delayed investors ultimately are buying assets at the price that is appropriate when they invest the capital. Sophisticated investors do not want to put money at risk now only to buy shares at the higher future valuation that likely reflects a lower risk profile. As a result, entrepreneurs and investors should be careful to think about this conversion price as a measure of current valuation. Otherwise they may encounter some of the challenges that companies face when they are overvalued.

Ultimately investors vary how they structure investment vehicles. Unfortunately, some are better than others about creating advantageous structures. As a result, it’s worthwhile for entrepreneurs to know enough to sanity check investment structures.