I was sort of surprised the first time I learned that anyone would give you financing for debt. Even at a 20% discount rate, it seems like a successful startup should be increasing their valuation by a lot more than 20% between rounds.
Conversely, debt seems like a really bad deal for investors. They only get a 20% discount when the company goes into Series A financing, in return for the risk that the company will go belly up before then and they lose it all.
How does this square with the (admittedly problematic) conventional wisdom that investors look for a ~10x return on their money and expect ~1/10th of companies to fail?
Funding startups with debt is extremely risky, unless it's convertible debt, which is just a hacked form of equity.
The reason is that a typical loan will be secured by the company's stock. If you fail to repay it when it's due, your company will be forfeited to the lender. It's bad to make deals like this in a situation where things can change so fast. Viaweb was almost destroyed when we couldn't repay a bridge loan that we'd taken in order to see us through an acquisition that then didn't happen.
I believe this article discussed only convertible debt, and only regarding seed-round funding.
No matter what the situation, though, aren't the investors going to own your company if you really run out of money? And if your company is doing just fine, shouldn't it be easy enough to get another loan/investment to keep the creditors at bay?
This is a good question. The other investors may already be in control of the company and just attempt replacing the founders with professional management. They may liquidate, since sunk costs are sunk.
According to Paul's essays, the software of Viaweb was powerful because it was written in a high-level (but bottom-up) way. It seems like besides this being an edge over your competitors, it would also make your investors leery of getting rid of you. Who else would want to buy it if the Viaweb team wasn't there to walk them through it? And wouldn't that consideration also be true for lenders? I recall reading something about Trump's period of declining fortunes years ago - to whom, exactly, were the banks going to sell his gaudy yacht and other outrageously expensive and virtually unsellable properties? They were better off pretending he could still be successful for a while, and they got lucky.
Even convertible debt can be dangerous if you don't raise a Series A before the debt comes due. The solution is to negotiate the right to convert the debt to equity at the company's option if the Series A doesn't occur before the debt comes due. We'll discuss this in an upcoming hack.
Conversely, debt seems like a really bad deal for investors. They only get a 20% discount when the company goes into Series A financing, in return for the risk that the company will go belly up before then and they lose it all.
How does this square with the (admittedly problematic) conventional wisdom that investors look for a ~10x return on their money and expect ~1/10th of companies to fail?