Convertible Notes- The Phillips Screwdriver of Startup Financing Instruments

Contrary to what you might think, convertible notes have been around for a long time in early stage tech financing. What’s different today is that Y Combinator popularized it several years ago and since then, we’ve seen seed stage funding explode so these financial instruments have become pretty pervasive.

The problem these days is that there is lots of confusion and uncertainty when using them:

What percentage of the company am I buying?
What happens when you sell before a conversion event?
Does the note convert pre-money or post-money?

On the last question, see Brad Feld’s recent post:

We’ve been regularly running into another problem with doing a financing after companies have raised convertible notes. Most notes are ambiguous as to whether they convert on a pre-money or a post-money basis. This can be especially confusing, and ambiguous, when there are multiple price caps. There are also some law firms whose standard documents are purposefully ambiguous to give the entrepreneur theoretical negotiating flexibility in the first priced round.

With all this confusion, convertible notes seem like a pretty shitty de facto standard, if you ask me. Would you believe me if I told you things weren’t always this way? Once upon a time, there was more agreement and consistency when using convertible notes.

Here’s Seth Levine (Brad Feld’s partner) talking about convertibles converting pre-money in 2012:

The problem, of course, is that their convert is already a part of their capitalization – even though it’s not reflected on the cap table…

(in one case the entrepreneurs viewed the convert as a post equity deal event, meaning that they thought they were negotiating a round with us that would then layer on the debt conversion – exactly the opposite of how it actually works!).

When you raise $2M on a convert with a $6M cap you’ve sold 25% of your company (at least; 25% if this converts at the cap). And while your cap table may not yet reflect this in the numbers, your 40% founders equity stake is actually already 30% when you start the process of raising your equity round.

And here’s Babak Nivi on Venture Hacks (which leans founder friendly) saying the same thing (in a Youtube video on cap tables in 2008):

Your $6M pre-money valuation unfortunately includes the seed debt…

So we’ve gone from a time where we generally agreed to do something a certain way to a time where there’s lots of disagreement on how to do something.  It’s just a reality of where we are in this cycle and it’s a tough coordination problem to address with a market-based solution.

The complaints about notes are at an elevated level these days and there are a lot of investors who are shying away from them, for valid reasons (see Joanne Wilson).  However, we’re still seeing a lot of founders favoring them over equity or SAFE-style docs (and their choice is partly a function of what they think will work best for them in the fundraising marketplace).

De facto standards emerge when there is mutual gain in coordinating. When there’s a critical mass of founders, investors, and service providers using the same standards, it’s a beautiful thing (they are hard to establish and in my opinion, really under-appreciated!). But they are also difficult to replace when there’s something newer and better.

So just like the QWERTY keyboard, life goes on for convertible notes.  It may not be the perfect tool for pre-seed/seed stage financing, but it’s something that everyone in the game has in their toolbox.


Posted by John Ryu, Partner at Scout Ventures

Convertible Notes- The Phillips Screwdriver of Startup Financing Instruments

How To Raise $20.5 Million The Signpost Way

This post was originally published on Brad’s personal blog at 

This month our longtime portfolio company, SignPost, humbly announced the close of their $20.5 million dollar Series C.

The Company offers consumer marketing tools and manages its customers’ presence on sites like Yelp, while leveraging data from credit card transactions and social media to send targeted marketing messages that drive sales, referrals and reviews.

For Scout, it is a proud day because Stu Wall was one of our first entrepreneurs when we launched Fund I.   We were originally introduced to Stu through another one of our entrepreneurs, Dan Gellert.   Dan is another great entrepreneur with a special place in Scout’s legacy, as he was one of my first board seats.   He sold his company GateGuru to TripAdvisor which enabled us to make our first LP distribution in Year 1 and gave us the credibility to raise more money.

As I reflect on how proud I am of both entrepreneurs and the journey I’ve experienced with them as an investor, I think its important to reflect on how we got here and how to replicate this relationship with more entrepreneurs.

(1) Our best deals are normally sourced through our entrepreneur network.   This is why its so important to always treat an entrepreneur with a level of mutual respect.

(2) When you get to meet an amazing entrepreneur, have the mindfulness to identify their potential and don’t be caught up in the day to day to miss the opportunity.

(3) Each and every relationships between an entrepreneur and investor is based on trust and communication.  Without these two key variables, its difficult to build a company that can win.

(4) As an investor, as soon as you find a kick ass entrepreneur don’t hesitate in helping them build and motivate their team.   No great entrepreneur can build an awesome company without a supportive and passionate team.  Stu asked me to talk to the entire Signpost team (now 213 strong!) the day before we announced to them the news of this raise.  I was inspired and I think the team was pretty fired up as well.

Building great companies is hard to do and it takes a really, really long time.

Don’t rush.

Value each entrepreneur and spend your time making a difference, not being a pain in the ass.

***This post is dedicated to the memory of a new and dear friend.  All of our hearts are a little less full tonight.  We love you Kelsey.***

How To Raise $20.5 Million The Signpost Way

Talking Tech With MeetAdvisors: Do VCs Read Business Plans?

This post was originally published by Brad Harrison at

I was recently invited over to MeetAdvisors for an interview with one of their hosts, Rachel Pollard. MeetAdvisors is a great platform where entrepreneurs can search for, find, and network with advisors and fellow entrepreneurs.
Rachel and I spoke about the recent history of startups, the genesis of Scout Ventures, how we view where technology is going, and about a very pressing question: do venture capitalists read or care about business plans?

Click here to watch the interview!

Talking Tech With MeetAdvisors: Do VCs Read Business Plans?

You are the product until the product is ready


This post was originally published on Medium.

I meet with lots of founders who are quick to give me their startup elevator pitch. Yesterday, I was at an event where most of the founders I met were pre-product. They were all ready to get right into the pitch right as soon as we shook hands (this wasn’t a pitch event). I found myself saying “Great, I’d love to check it out when it launches” and the conversations continued on for a bit but they all pretty much ended there.

If you’re pre-product, I’d suggest a completely different way to approach these conversations — focus the story on yourself because you are the product until the product is ready.

Talk about who you are and what you know. Display your passion. Develop the story to show why you’re the right founder to be solving the problem you’re focusing on. Use this approach to build relationships so that when your product is ready for demo, investors will remember you and have context.

You are the product until the product is ready

Three Things That Kill Early Stage Companies


This post was originally published at Brad’s personal blog,

As a VC, we spend a lot of time thinking about where we want to invest our money.   Last night, I was with my friend Pedro Torres-Pincon who recently presented “How to Build an Investment Thesis”  providing good insight into determining how and where you decide to invest your money.

But writing the check is the easy part.    The real challenge in entrepreneurship is to build a meaningful and sustainable company.   To that end, one of the things we like to discuss at Scout with our founders is how to avoid the pitfalls that can kill an early stage company.

(1) Don’t run out of money.    I know this seems like a simple rule but it’s amazing how many entrepreneurs under estimate how much time and money they will need to build their business.   In most case, we see financial projections that too aggressively forecast revenue growth, while underestimating the cost of building a scalable product.    The other issue that tends to crush entrepreneurs is not allocating enough time to raise the next round of capital; fundraising is time consuming and requires a focused effort.    So beware – forecast more conservatively and budget more time to raise your next round of capital.

(2) Don’t make a bad critical hire.   We often invest very early in a company when they haven’t hired all their critical team members.  In many cases, our capital is being used to expand the team and help the founders grow their vision.  If the Company hires a rock star then everything will get much better, but if they hire a dud then the Company is sure to suffer.   The two areas that are most often affected are  technology and sales.    If the company is in the process of building a new product and their new CTO drops the ball, then it’s almost impossible for the company to meet any of their deadlines or achieve the metrics necessary to secure the next tranche of capital.    Likewise, if the Company hires a revenue generator like a VP of Sales and they fail to achieve their revenue goals, it’s often a devastating blow to the company’s forecasts and thus also hurts their ability to raise additional capital.

(3) Avoid bad investors.   The early stage landscape is much different today than it was when I started in this industry as there is more seed stage money than ever before.   Accredited investors are jumping into early stage investing with angel groups, accelerators, and equity crowd funding platforms like SeedInvest. This coupled with significantly lower barriers to entry means that it’s easier than ever to start a new company and raise a small amount of capital. The resulting increased competition among early stage companies has created a shortage of follow-on funding as described by Josh Kopelman of First Round Capital.    But more hazardous than the shortage of Series A capital, is the impact inexperienced investors, often from other industries who are looking to dabble in venture as an alternative asset class, can have on an early stage company.    The worst case scenario for a young entrepreneur is to get lured by an investor who is offering capital but wants to add terms and provisions inconsistent with standard early stage venture rounds.    These terms vary greatly but the most dangerous are the right to ask to get paid back, asking for too much control and/or the need for the investor to consent to future financing, etc.    It breaks my heart when a young team is crushing it only to have a disgruntled early investor call their $100,000 note – which represents a significant chunk of operating capital.    Smart money is always the best way to go.

Three Things That Kill Early Stage Companies

What is determining value in startups right now?


Here’s a timeless quote from Bill Janeway on how value is determined in startups:

The value now is driven by supply and demand amongst speculators who have liquidity and will not have to stick around to find out what the fundamental value turns out to be over time.

The overall point of view is critical but the core idea to understand is that startup valuations are always supply and demand drive.  So what does this mean?

Because of this phenomenon of bubbles more risk will be taken, more capital will be mobilized than would be the case if investors were strictly investing based upon the net present value of the expected future cash flow, which as I began by saying cannot be determined in plausibly rigorous manner. Now having said all that, one of the laws of life is, as I used to tell my young colleagues, nothing ever sells for 50 times earnings for very long. So when it does, you, who are in a position of influence, have a positive obligation to raise all the cash you can as cheaply as you can, and then distribute as rapidly as you can the liquid securities, which you happened to own.

In other words, understand the context of the early stage tech environment and adapt to it as necessary.

Source:The Future of Venture Capital, Tech Valuations and the Fate of Tech Incumbents – Conversation with Bill Janeway

What is determining value in startups right now?

Game Changing: New JOBS Act Rule To Allow Raising Money From The General Public

Kiran Lingam is the General Counsel & VP Business Development at SeedInvest, an equity crowdfunding platform that connects accredited investors to high-quality start-ups and small businesses seeking funding.  He explains how this breaking development from the SEC has the potential to disrupt the fundraising landscape for early stage and growth companies.  This article originally appeared on the SeedInvest blog.  You can follow SeedInvest on Twitter here.

In a stunning development earlier today, the SEC released final Regulation A+ rules under Title IV of the JOBS Act that pre-empts state law, paving the way for $50M unaccredited investor equity crowdfunding. Growth companies will soon now be able to raise up to $50 million from unaccredited investors in a mini-IPO style offering serving as a potential alternative to venture capital or other institutional capital. Imagine Uber or AirBnb, instead of going to big institutions for capital, now offering their stock directly to their drivers, riders, renters and tenants as well as the general public.

When the JOBS Act was passed in April of 2012, many believed that Title IV would actually be the most powerful change, but given that there was no deadline for implementation of the rules, most ignored Title IV as too remote to pay serious attention.  There was also concern about the same problem that haunts existing Regulation A, namely state securities laws that would require registration in every individual state where securities are sold, making it too expense/complicated to be workable. The infamous example of this was in 1980 when Massachusetts deemed the offering of Apple Computer stock to be “too risky” and did not allow its citizens to participate in the offering.

Last November, however, the SEC shocked the securities community by introducing Proposed Regulation A+ rules that, through a clever legal maneuver, pre-empted state securities regulation.

Since that stunning announcement, there has been great uproar about “pre-emption,” whether it is legal and whether it is appropriate for a federal agency to pre-empt the states in this manner.   Most in the pro-business community ardently support pre-emption and argue that securities offerings constitute interstate commerce and that state by state regulation is antiquated in a world where the internet blurs state lines. Many regulators, investor protection groups and even one crowdfunding platform opposed such pre-emption, arguing that state review adds value and necessary investor protections.   In response, the states introduced a coordinated review process, which was designed to address these concerns. Critics argued that this was too little, too late and only resulted from the states being forced to act by the threat of pre-emption.

In the final rule release, the SEC settled the dispute through a brilliant compromise by confirming pre-emption for Tier II Regulation A offerings up to $50M but also increasing Tier I Regulation A offerings from $5M to $20M and leaving pre-emption intact, thus giving “coordinated review” a chance to prove itself.   This appears to be the result of an extensive negotiation between Commissioner Stein who opposes pre-emption and several of the other Commissioners. In coming to this decision, the SEC noted that:

  • Coordinated review is new and unproven and pre-emption is necessary at least until there is a track record of a functioning coordinated review program
  • Coordinated review has great potential if the states can stick together and maintain a seamless process
  • NASAA may appoint an individual to serve with the SEC internally on implementation of Reg A+
  • States will retain full enforcement and anti-fraud jurisdiction in all cases

Now, with pre-emption under Tier II and coordinated review under Tier I, it looks like Title IV (Reg A+) could make Title III Crowdfunding a relic. 

Regulation A+ will likely go into effect 60 days after publication in the Federal Register (June 2015). Here are the highlights of the new Regulation A+ exemption:

  1. High Maximum Raise:  Issuers can raise up to $50,000,000 in a 12 month period for Tier 2 and $20,000,000 for Tier 1.
  2. Anyone can invest:  Not limited to just “accredited investors” – your friends and family can invest.  Tier 2 investors will, however, be subject to investment limits described below.
  3. Investment Limits: For Tier II, individual investors can invest a maximum of the greater of 10% of their net worth or 10% of their net income in a Reg A+ offering (per offering). There are no investment limits under Tier 1.
  4. Self-Certification of Income / Net Worth:  Unlike Rule 506(c) under Title II of the JOBS Act, investors will be able to self-certify their income or net worth for purposes of the investment limits so there will be no burdensome documentation required to prove income or net worth.
  5. You can advertise your offering:  There is no general solicitation restriction so you can freely advertise and talk about your offering, including at demo days, on television, and via social media.
  6. Offering Circular Approval Required:  The issuer will have to file a disclosure document and audited financials with the SEC.  The SEC must approve the document prior to any sales.   The rules indicate that the Offering Circular may receive the same level of scrutiny as a Form S-1 in an IPO. This is the biggest potential drawback of using Reg A+.
  7. Audited Financials Required:  For Tier 2, together with the Offering Circular, the issuer will be required to provide two years of audited financial statements. Tier 1 offerings require only reviewed financials (not audited).
  8. Testing the Waters:  An issuer can “test the waters” and see if there is interest in the offering prior to spending the time and money to create the Offering Circular.  This would be “Preview” mode on SeedInvest where investors can express interest, but can’t yet invest. This is important so that companies don’t have to gamble on their fundraise and can see if there is interest prior to investing in legal and accounting fees.
  9. Ongoing Disclosure Requirements:  For Tier 2, the issuer will be required to make an annual disclosure filing, a semi-annual report, and current reports, each of which are scaled back versions of Form 10-K, Form 10-Q and Form 8-K, respectively.  These reports will also require ongoing audited financials.  These disclosures can be terminated after the first year if the shareholder count drops below 300. There are no ongoing disclosure requirements for Tier 1.
  10. State Pre-Emption:  As discussed above, the old Regulation A (now Tier I) was never used because it required registering the securities in every state that you make an offer or sales.  New Reg A+ Tier 2 preempts state law – again – this is huge. Tier 1 Reg A+ again does not have state pre-emption but will be a testing ground for NASAA Coordinated Review.
  11. Shareholder Limits:  In a welcome departure from the proposed rules, it appears that the Section 12(g) shareholder limits (2,000 person and 500 non-accredited investor) will not apply to Reg A under certain circumstances. This fixes a major problem from the proposed rules which would have limited the potential for very small investments (i.e. $100).
  12. Unrestricted Securities:  The securities issued in Reg A+ will be unrestricted and freely transferable, though many issuers may choose to impose contractual transfer restrictions. Many believe this will pave the way for a secondary market for these securities in the form of Venture Exchanges.
  13. No Funds: Investment companies (i.e. private equity funds, venture funds, hedge funds) may not use Reg A to raise capital.
  14. Integration:  There are several safe harbors so it seems that you can use Reg A+ in combination with other offerings.  There are safe harbors for the following:
  • No integration with any previously closed offerings
  • No integration with a subsequent crowdfunding offering
  • No integration where issuer complies with terms of both offerings independently – can conduct simultaneous Reg D – 506(c) offering.

The Fate Of Title III

Interestingly, the SEC did not mention Title III Equity Crowdfunding a single time either in this meeting or in Chairman White’s recent testimony before Congress. This furthers the belief by many that Title III Equity Crowdfunding is dead in the water as it currently stands and may only be revived by an act of Congress.

Equity Crowdfunding Rules Comparison Chart

Check out this chart comparing Reg A Tier 1, Reg A Tier 2, to Reg D: Rule 506(c) and Regulation Crowdfunding. Choosing among the various options will require careful consideration by issuers and their counsel.

Regulation A Equity Crowdfunding

You can also download the PDF version of the Comparison of Equity Crowdfunding Regulations.

Which exemption would you use?

This is all subject to the final rule announcement to be published later today.

We will endeavor to update this post and chart based on the text of the rules.

Game Changing: New JOBS Act Rule To Allow Raising Money From The General Public

Is venture capital under attack?

Cross posted from

I am an early stage technology investor.   It’s what I love and I wouldn’t want to do anything else.

And with the job title of VC comes a few primary functions:

(1) Be great at finding, cultivating, and investing in amazing entreprepreneurs building disruptive companies.

(2) Successfully raise money for our funds from high net worth individuals/angel investors, family offices and institutional investors.

(3) Build profitable companies by providing advice, mentorship and access to our network.

(4) Have exits and distribute money to investors.

While that sounds pretty straightforward, it’s not.  It’s really, really hard and very few firms build enduring brands that survive multiple boom and bust cycles.   At Scout, our goal is to build a great firm that lasts.

Recently, there have been a lot of discussions about what value VCs really bring?   The discussions focus on two key areas: (1) Performance and (2) Access to Deals.

Unfortunately or perhaps fortunately, venture capital as an asset class is under attack. Organizations like the Kauffman Foundation are questioning the returns and structure of the industry arguing that most fund managers don’t beat the public markets and still charge management fees and carry.   In Kauffman’s May 2012 report “WE HAVE MET THE ENEMY… AND HE IS US” they state that they believe smaller funds (less than $400M) with partners that consistently beat the public markets and invest 5% of their own money are the right firms to back.

Furthermore, the very closed nature of venture capital is changing drastically with the emergence and expansion of accelerators, incubators, co-working spaces and online platforms.  Historically, VCs differentiated themselves through their “proprietary” access to the best deals.   But in recent years, entrepreneurs are experiencing an unparalleled level of access to potential investors through online platforms like SeedInvest and Angelist.   Additionally, accelerators and incubators have become masters of the overly produced “Demo Day” where I actually saw a pitch with dancers in silver sequenced dresses. Regardless, entrepreneurs and investors have many more ways to more effectively connect in person and online.   Again, another argument that VCs no longer have their unique closed access to deals.

While this might seem like a good thing, I’d argue that the more experienced, smart money is and will always be more valuable than money from some finance guy that thinks he is going to write 5 checks and find the next Google.    Often these investors have no idea how to value a start-up, how to structure a deal (equity or convertible debt) and more importantly they have no experience building early stage companies.  They simply lack the skill set and required experience.

The people with that experience – VCs.

Now, I definitely think there are some amazing entrepreneurs that sell their companies and become valuable early stage investors, but they are the exception.   Most angel investors simply are not that sophisticated and can’t add the same value that Fred Wilson can add.   Fred is one of the most knowledgeable and successful VCs and he spends a ton of time educating entrepreneurs and investors alike.    He can do that because of his years of experience as a VC.

Almost everyone knows that people are the key to making early stage companies great.  A common mistake that kills early stage ventures is hiring the wrong key people.   If you need a CTO, then obviously hire someone with technology and management experience.   If you need a great VP of Sales, then hire someone with a track record of building a sales team and growing revenue.

This seems obvious, right?

Then why wouldn’t the same hold true when entrepreneurs need money and guidance to build their company.   If you are looking for an investor – it has to be more than money.    You want someone with the experience and track record of building successful companies.  VCs have a tremendous amount of experience in building teams, building products, scaling businesses, securing subsequent rounds of financing, access to potential customers, partners and potential acquirers.

I am definitely not saying that I love VCs, because their are plenty of assholes in VC.   But if you are fortunate enough to attract a VC with a good reputation and track record – you should figure out how to get them involved with your company.

We can make a difference.

Is venture capital under attack?