The Wall Street Journal reports that Spotify has raised $1 billion in convertible debt with this telling analysis:
Music-streaming site Spotify AB has raised $1 billion in convertible debt from investors, a deal that extends the money-losing company’s runway but comes with some strict guarantees, people familiar with the matter said.
Private-equity firm TPG, hedge fund Dragoneer Investment Group and clients of Goldman Sachs Group Inc. participated in the deal, which has been signed and is expected to close at the end of this week, these people said.
Tech startups are increasingly turning to convertible debt—bonds that can be exchanged for stock—as investors push back on rich valuations amid a volatile stock market and economic uncertainty.
By raising debt instead of equity, Spotify adds to its war chest without the possibility of setting a lower price for its stock, which can sap momentum and hamper recruiting.
That last paragraph is very telling. As I have warned about before, the main reason for any privately held company to take on convertible debt, particularly large amounts of convertible debt, is to avoid a “down round”, meaning a round of investment at a lower valuation than the previous round. This means the new investors buying in the down round pay a lower price per share, and receive certain rights and preferences that are superior to the rights of the previous rounds’ investors.
The main reason for existing stockholders (like the major labels and Merlin in Spotify’s case) to avoid a down round is to protect the preferences that the prior investors have built into their stock ownership. Those preferences can require the company to issue more shares to protect the percentage ownership of the insiders and key executives, for example, and that can lead to washout financings and recapitalizations to incentivize investors in the down round (who often are not, as one might say, “babies”).
Down rounds are also one indicator that a bubble is about to burst but that investors have not yet capitulated. (Down rounds are a precursor to failed capital calls, which are the real sign of a bubble bursting.) Down rounds were very common in the dot bomb bubble burst.
An example of down round protection would be lowering (or “resetting”) the strike price of a warrant if the company issues securities at a lower price in the future–the down round. In any event, the company must sell more shares than in the previous rounds in order to generate the new investment, so down rounds will almost inevitably dilute existing stockholders even if they give up their preferences.
So why did Spotify raise convertible debt? To avoid a down round, which means that there is a good possibility that the company was told either that their proposed valuation that they wanted to get in their next round of finance was too high or that their last valuation (over $8 billion) was too high.
Convertible debt is secured debt. That means holders of convertible debt will be at the head of the line in a bankruptcy. This is almost certainly going to create a new hierarchy overnight and should start every royalty recipient thinking differently about Spotify because it introduces the concept of preferences in bankruptcy. And if you find yourself thinking that Spotify could never go bankrupt, welcome to bubble mania.
Get what you’re owed out of the company as fast as possible. You are now looking at a senior secured creditor who will almost certainly take the lion’s share of any recovery from a bankrupt Spotify after washing out all the equity the labels gave up in return for discounted royalty rates (which would be Daniel Ek’s last laugh on the music business). I’m using Spotify as an example, but it could be any of them–Pandora also has a large debt financing.
Audit Early and Often: The first thing that should happen is that instead of auditing at the “bankers hours” pace that the industry usually operates at (every three to five years), everyone who is owed royalties by Spotify should conduct a royalty compliance examination every year. The longer you wait, the greater the chance that you will become known as an unsecured creditor. This is true of artists, songwriters, labels, publishers, PROs, the lot. Unions that have any residuals based on streaming? Get in there.
Contractors, Get Your Money: If you’re an independent contractor for Spotify, get your money paid. Don’t wait. Ask any independent contractor for a dot com that’s gone under and they’ll tell you–kiss that delivery payment goodbye after the whip goes down. This especially includes lawyers–you will be the first to go.
Employees, Don’t Count on Bonuses: Employees should take some advice on how protected they are on bonuses or deferred compensation. And of course, your common stock will likely get washed out completely in order to protect the holders of preferred stock.
Settlements and Preferences: Get the money, get the money and be sure you get the money. Consult with bankruptcy counsel to determine whether you are receiving a preference that can be undone in a later bankruptcy filing.
Fiduciary Duties of Officers and Directors: When a company becomes insolvent, there is a point along that path where the primary fiduciary duty of officers and directors shifts from the stockholders to the creditors. Get smart about this.