Many investors seem to be offering "convertible debt" investments. Without going into too much detail as to what it is, what are the ramifications if a startup fails? Are the founders personally responsible for paying off the debt? Both theoretical worst case, and practical outcomes would be handy.
If no one involved with the company offers any guarantees (be careful of overselling), the documents are drafted properly and no one does anything to break down the corporate shield, convertible debt holders are unsecured creditors. In all except rare cases the only thing they can and will do is take the write-off as soon as possible.
If anyone made guarantees, written or verbal, there may be personal liability if anyone pursues the claim.
Management probably takes a reputation hit no matter what.
If someone alleges fraud, debt is no different than equity.
If the company pledged assets to secure the debt, those assets belong to the creditors.
For investors, this scenario is one of many reasons convertible debt is unattractive. If they held equity they would be eligible for section 1244 tax write-offs at ordinary rates rather than regular capital losses at those rates.
In most cases when a start-up fails the debt goes away. Rarely do the founders guarantee payment if the debt is privately held. Banks and government agencies (SBA) require collateral and often a personal guarantee. The loan documents govern the transaction and no founder should issue debt or equity securities without a lawyer by his/her side.
It depends on how the note was written. If it is not guaranteed by any of the principals, it is treated just like any other debt. If the company has funds it pays liabilities, any cash left goes to the equity holders. If it has been personally guaranteed, then whomever provided the guarantee is personally responsible to pay regardless of what happens to the company.
From what I understand, convertible debt is debt. After a certain time, the investor gets to decide whether they want their money back, or get shares of your company. If your startup makes them nervous, they'll probably want to secure their debt as a loan. Once that happens, the only sure-fire way to relieve yourself of that if your startup fails is declaring bankruptcy. You should consider convertible debt if the investor offering it can supply services that you need for free or at a greatly discounted rate, or you can't get a straight-forward loan from a bank or the 3Fs.
A debt instrument that is 9 months or longer in duration may be a security. If so, under the federal and state securities laws of most states in the United States, the issuer and its selling-officers or directors can be personally liable (civil and criminal liability) for negligent misrepresentations or omissions of material facts during the offering of the debt instruments and/or personally liable if the applicable private offering exemptions from securities offering registration were not complied with. These are worst case scenarios.
Generally it is non recourse - but they end up with first claim to the assets including all IP. Check the document close for those two items.