I’m a part time CFO who’s always striving for a clean balance sheet for my clients, particularly my start up clients who are seeking second round financing.
It’s a good idea for entrepreneurs looking for outside investment capital to try and clean up their balance sheet. If an entrepreneur’s current stockholders put money into the company as debt, they should ask those stockholders if they’re willing to convert the debt to equity. Contemplating investors want to know their money will go into something that will move the business they’re investing in forward (ie machinery and equipment or research and development). Paying off or otherwise servicing existing stockholder debt is the last thing they want their money going towards. If they even think their money is just going to pay off stockholder debt, investors will immediately back away from the situation.
So as you may have already concluded, asking your existing stockholders to convert existing debt to equity is not easy. I know from experience, having done it myself before. You’re asking people who have already taken great risks for you to increase their risk again. Even worse, the stockholder probably had good reason to put money in as debt in the first place that converting that money might mess up. Still the fact remains that in order to go to the next level (or, depending on your circumstances, to survive), your company probably needs the new money, and cleaning up the balance sheet will help. A really good incentive for your stockholder to convert their debt to equity is if you do indeed need that new money in your company just to survive. Either way, if your stockholders do not convert and your balance sheet remains unattractive, it’s highly unlikely that your company will get its much needed investment capital, and highly likely the stockholder won’t be getting their debt instrument paid.
It’s true; a stockholder increases their risk by converting the debt to equity. But it’s also true that by converting the debt to equity, the stock holder potentially increases the value of their stock and gets the best chance of seeing the dream they originally put money towards your company for realized: your company going to the next level.