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

Three Things That Kill Early Stage Companies

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

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

Trends Move Fast In Venture

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I recently found some old browser bookmarks from about a year ago and clicked to see what they were about. They were all articles about firms focusing on “post-seed” stage investments– a stage that became relevant and potentially valuable because of a funding gap caused by the Series A Crunch.

Fast forward to March 2015 and the thing that’s all the rage in venture capital these days is “pre-seed” stage investing.  The rationale is that seed has gotten so big that now there is a funding gap between angel and seed investors.  One thing’s for sure is that capital is liquid in the early stages and it flows into all the high potential spaces and crevices it can find.

In the startup and venture capital world, things happen so fast that a year’s time can provide a fun look back to see how things were different compared to today.

 

 

Trends Move Fast In Venture