Dilution: Priced Rounds vs Convertible Notes

There have been many posts by investors articulating the issues with convertible notes. Most recently, Fred Wilson wrote that one of his main issues with notes is that they “obfuscate the amount of dilution the founder(s) is taking.”

While there are more aspects of notes that entrepreneurs may not think about (see Fred’s post) I will solely focus on dilution for this post. I build out 2 examples (equity vs. notes) and 2 rounds within those examples (“pre-seed” and “institutional seed” rounds).

Example 1: Equity

Terms: $1M at $3M pre-money valuation, 20% employee option pool.

As you can see, the Founding Team owns 55% of the Company after the round. The rest of the cap table is clean and everyone knows exactly what they own.

Now, let’s assume that, about 18 months from Round 1, the Company demonstrates enough traction to raise a $2M round at a $6M pre-money valuation. The investors set the option pool to 18%, to be reflected in the pre-money share count (ensures new money in doesn’t get diluted by increase in option pool). Round 1 investors also take their pro-rata.

At the end of the 2nd round, the Founding Team owns 39.19% of the Company.

Example 2: Convertible Note

Round 1 Terms: $1M at a $4M valuation cap; 20% discount on the next round; 7% interest; 20% employee option pool at Company formation.

Here, the cap table reflects the investment (as debt), but does not effect ownership of in the Company. The Founding Team owns 80% on the cap table, but in reality it is somewhere much less than that (most likely around 55%). Depending on a variety of factors, though, the Founders really do not have a clear idea of how much of the Company they own. And as many have noted, this puts the Company in a slightly precarious situation.

Now, about 18 months later, the Company raises an equity round with the same terms as Example 1: $2M at a $6M pre-money valuation. In this case I simply doubled the employee option pool (which results in the same 18% ownership in this specific example).

Round 1 Investors converted at the $4M cap as opposed to the 20% discount. The Founding Team, though, end up with 36% of the Company, whereas in Example 1, they ended up with 39%.

The difference then, at the same terms, was ~3% extra dilution by taking a convertible note instead of equity.

This 3% can be substantially increased if founders take on more capital on the notes, offer a lower cap, or a larger discount. In a few different permutations of this model, the delta ended up being 6%-8%.

At the end of the day, the fact that founders are taking “extra dilution” is not the problem. It’s the fact that many aren’t realizing it. And when it comes to the date when this is realized, it can understandably be extremely unsettling.

So, if you’re a founder and want to play with the different scenarios, feel free to reach out to me and I can share this model with you.

Dilution: Priced Rounds vs Convertible Notes

NYC VC 2017

Be Happy

On a daily basis, I am inspired by blogs from the likes of Fred Wilson (AVC) and Brad Feld (Feld Thoughts) who consistently publish insightful and educational pieces for entrepreneurs, investors, and anyone who wants to better understand early stage investing and current technology trends.

From this inspiration, I’ve committed to be a more prolific writer in 2017 and beyond.

This morning, I was talking to a long time friend, advisor, and co-founder of Everplans, Adam Seifer about the ever changing landscape of early stage investing.

Specifically, we were discussing how NYC was become a more competitive market, with many of the micro-VCs now writing bigger checks ($500k-$1M) leaving less room for other firms and angels to participate in the seed round.    Most of the micro-VCs have well defined investment thesis’ and thus look to take a big position in early stage companies that fit their profile.

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NYC VC 2017

Welcoming Nisa Amoils

Be Happy

I am very pleased to formally announce that we’ve added Nisa Amoils to the Scout family as our newest Venture Partner. Nisa is an experienced attorney, media executive, and noted tech investor in the New York community. She has spent many years at companies pursuing entrepreneurial projects, including Time Warner and NBC Universal. She is also a regular judge/panelist on CNBC, MSNBC and Fox and a mentor at XRC Labs, Grand Central Tech and The Vinetta Project. Nisa’s background demonstrates the entrepreneurial and investing ethos that we admire and strive for at Scout.

Over the past six months, we’ve been working very closely with Nisa around expanding our efforts in frontier tech. She has proven to be incredibly insightful and her deep domain expertise in digital media, marketplaces and frontier tech make her the perfect addition to the team. Nisa will be leading our efforts investing in drones, AI, and…

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Welcoming Nisa Amoils

Olapic Acquired

Be Happy

Today, a company where I was the first investor was acquired.


What makes this so special is that these are just some of the most amazing guys I’ve had the opportunity to work with – ever.

And Olapic, like many start-ups, had several pivots before they found their product – market fit.   And it was the personalities and determination of these intelligent and happy founders that attracted an amazing group of advisors, mentors and investors.

I couldn’t  be more proud.  This is why I do what I do.

Congrats to Pau, Jose and Luis – you deserve everything!

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Olapic Acquired

How to actually make America great again

Be Happy

I original drafted this post prior to the incidents in St. Louis, Louisiana and Dallas that rocked our nation last week…

As I reflect on this 4th of July celebration, I am overwhelmed with the realization that as a “people,” we have lost touch with the ingredients that actually made this an amazing country.  The country I have loved from my earliest days.  The country I swore an oath to defend against all enemies foreign and domestic.  The country that is supposed to be the land of the free and the home of the brave, America, where anything is possible.

Well, I think its fair to say that we’ve totally screwed that up and if we don’t fix it now, we are likely to experience continued civil unrest, increased violence and turmoil until we implode.

At the root of our current troubles is the fact that most of Americans forget that we were all once immigrants (except Native American…

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How to actually make America great again

Good day

Be Happy

The other day was a rough day.

One of our companies failed to find a buyer and let all their employees go.

Over dinner my dear friend Joey Hundert provided support and counsel while reminding me that as entrepreneurs our lives are full of peaks and dips.

He assured me it’s okay to be genuine in the emotions we feel when companies fail. And I was sad and disappointed.

Then yesterday I was reminded of the emotions when companies succeed.

And that is being proud of our entrepreneurs

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Good day

The Dreaded Call

Be Happy

Last night I called one of my favorite entrepreneurs.

And about ten seconds into the call, I could hear him crying.

At that point, I knew the Company we had invested in, that had pivoted with hopes of rising like a phoenix from the ashes, was actually much more likely to crash and burn.

Although we had spent the last six months trying to recapitalize and refocus the business after losing the co-founder, it became clear it wasn’t going to work.   It was now time to switch from being an investor to being his friend.

Money comes and goes, but the relationships with my entrepreneurs should last a lifetime.

So I immediately realized what he really needed was support, not beratement. He already felt horrible for failing and losing people’s money.

And I am a VC. We expect to lose money trying to innovate and build great companies.

Thus, we…

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The Dreaded Call

Benchmarking Atlassian’s S-1 – How 7 Key SaaS Metrics Stack Up

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Tomasz Tunguz wrote a great post recently about the Australian software maker, Atlassian. It is a fantastic example of an Australian flywheel SaaS company that has experienced tremendous growth, as seen from its S-1.

Tomasz’ post can be viewed in its original form here.

Founded in 2002, the Australian software maker Atlassian is an exceptional company in many regards. But foremost, Atlassian is one of the best examples of flywheel SaaS companies yet. Atlassian counts 1600 employees and sells five products JIRA (bug tracking software), Confluence (project management), HipChat (internal chat/collaboration), BitBucket (code repository) and JIRA Service Desk (help desk software. Yesterday, Atlassian filed their F-1, a document preceding their IPO, and revealed how efficient a software company they have built. In 2015, the company will generate $320M in revenue.

The chart above details the revenue growth of the business compared to the median of the 50+ publicly traded SaaS…

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Benchmarking Atlassian’s S-1 – How 7 Key SaaS Metrics Stack Up

The Ugly Unicorn: Greed

Be Happy

There has been much discussion these days about the changing landscape of early stage investing and how it impacts valuations and exits, so I wanted to share a brief story I heard yesterday from an investment banker.

As a pre-cursor to the story, I want to re-iterate my own thoughts on generating returns for LPs.  As we all know, the early stage asset class is defined by making a series of investments, seeing most of those investments fail, and then having one or two exceptional companies generate most, if not all of the returns.

At Scout, we’ve realized a few things that help us outperform the industry:

(1) The fewer complete failures we have, the better the overall performance of our fund.  This means that when our companies experience challenges or fail to deliver the product or revenue to become a great company, we try to figure out how to find…

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The Ugly Unicorn: Greed