[Dave Heal's] Observations & Reports

Micah Baldwin wants you to break the bullshit curse

Forgive me if this post is a bit pedantic, but it’s not clear to me that Micah has identified precisely where the aforementioned bullshit is housed or how much of it there is. Of course, his general advice against bullshitting yourself and others is sound. But that in itself is not terribly instructive. And some of the situations that presumably gave rise to Micah’s post aren’t actually the kind of thing I’m guessing he would identify as bullshit upon further reflection.

The post starts out:

How are you?

In your head, how did you respond? Did you automatically blurt out “fine”?

My freshman English teacher, Mrs. Carter, once told me that answering the question “How are you?” with anything other than “I’m fine” was a waste of breath.

People don’t really care how you are.

It’s the same with honesty. People don’t want honesty.

Not to get all liberal arts here, but humans are complicated. One of the things that separates us from the blue-green algae, other than the extreme delight we take in captioned pictures of misbehaving cats, is our complex language. And Micah’s lead-in here is an example of one of those manifestations of linguistic nuance that cranky people adduce as evidence of rudeness or selfishness but which are actually just people being people. We make some noises with our mouths and they may sound like other noises, but there are all sorts of other cues we use to figure out whether someone is asking how we are or whether they are essentially saying “Hello.”

The latter use is what is known as “phatic.” Wikipedia, as always, has the authoritative example:

Similarly, the question “how are you?” is usually an automatic component of a social encounter. Although there are times when “how are you?” is asked in a sincere, concerned manner and does in fact anticipate a detailed response regarding the respondent’s present state, this needs to be pragmatically inferred from context and intonation.

So, no, the fact that you say how are you and someone says they’re fine is not sufficient evidence of a bullshit artist at work. Likewise if you ask somebody about their startup and they say “we’re killing it.” Now, that is a dumb thing to say because it has become a meaningless cliche in the startup world. You should probably maim that person. But if you are an investor in or advisor to that startup and that is the beginning and end of their response to your inquiry about how they’re doing, then that startup’s problem is not bullshit but simple interpersonal communication. And that might cause you to second-guess your investment in those people.

I guess if you’re a real hardliner about maximizing every breath you take on this planet, then you may have issues with the entire enterprise of phatic communication. But that strikes me as a different point altogether and also a battle not worth fighting. Don’t be that person who spends their life trying to convince people that we should say we drive on a driveway and park on a parkway.

The post continues:

“How’s it going with your company?”

“We’re killing it.”

Shut up.

I’ve taken to answering that question with “It’s interesting.”

Blank stares and fear that I am eliciting a response flow over faces.

“It’s interesting” is a more honest answer, I guess. But if that person’s intention was not to get into a long conversation—or any conversation—about the health of your company, then that may come across as needlessly aggressive or weird, especially if there’s no elaboration. This kind of communication may look like a question, but it is often our way of marking the beginning of an interaction by eliciting a short and mostly meaningless response. A way of establishing that the other person is listening to you and not still trying to commit to memory the lyrics of Big Rock Candy Mountain.

The more important point is that the people asking this question are not necessarily being insincere. Their blank stares are likely not because they don’t care about you or your company. People who want to have an actual, in-depth conversation will usually, if they’re at all proficient in the interpersonal arts, communicate as much to you.

Micah goes on to suggest that these kinds of answers (“We’re killing it!”) reflect self-deception, and that this contagion of bullshit goes on to infect a person’s relationships. Relationships with friends, family, investors and others who deserve more than a phatic “How are you?”

He ends the post with a call to action:

I challenge you to take a day and care. I dare you to listen actively and when you ask someone “How are you,” that you demand a deeply truthful answer.

When your employees, investors and friends ask about your business that you tell them truthfully whats going well, and areas you need help. It’s amazing. People, especially friends, by default, want to be helpful. It’s a gift to provide them the ability to participate in your happiness.

I think Micah’s right that people often preach but actually abhor honesty. Most people are afraid of being exposed as a fraud. That their companies are houses of cards, that they are less smart or fearless or whatever than they’d like other people to believe. And many of us will engage in pathological amounts of self-deception in order to avoid confronting even the notion that we might be less than we portray ourselves to be.

All of this is a problem in the startup world as well. Because it’s inhabited by humans. And Micah’s right to call attention to the need for honesty and sincerity and a willingness to listen to one’s friends and peers. But if his diagnosis of the problem is correct, and I suspect it is, the symptoms are not to be located in these routine moments of small talk but in the unwillingness to follow that up, at some point, with real substance.


Smanker: The Social Media Douchebag Gets His Politically Correct Wings

Francisco Dao of 50Kings, writing over at Pando Daily, is trying to make fetchsmanker” happen. That’s short for “social media wanker.” If you live in an area of dense tech startup activity or are a sentient human of employable age, you likely know That Person.

The column makes a valiant attempt to carve out some real estate for his coinage in between “smang it” and “smerd*” in the Gideons Portmanteau Dictionary. But ultimately his Foxworthy-style questionnaire falls short of the comprehensive test that we need for wider adoption. As the unacknowledged hero behind an unsuccessful, decade-long effort to bring back “Opposite Day,” I know well the Sisyphean task he has set for himself.

*Small nerd, e.g., “What up, smerds!”

Francisco, if you’re out there, consider this blog post my offer to help. If catastrophic but edifying failure is also a badge of honor in meme proliferation circles, I am your man. I can also contribute my small but enthusiastic reserve army, the Opposite Day Brigade (ODB). They’ll turn the t-shirts inside out, I promise.

On to his list:

  1. If you put your Klout score on your resume, you might be a smanker.
  2. If you think having a Tumblr page automatically qualifies you for a press pass, you might be a smanker.
  3. If you really believe the economy runs on “thank you’s” and not money, you might be a smanker.
  4. If you’re socially inept in real life, but popular on Twitter, you might be a smanker.
  5. If you think Mubarak was overthrown by Facebook and not by the blood of Egyptian revolutionaries, you might be a smanker.
  6. If your idea of an awesome vacation is going to 140 Conference, you might be a smanker.
  7. If you think “Liking” the Facebook page of a charity makes you an activist, you might be a smanker.
  8. If you’ve ever thought you could survive on Klout perks and social media schwag, you might be a smanker.
  9. If you claim to be an entrepreneur but six months in your “company” is still just a landing page, you might be a smanker.
  10.  If you’ve ever given the advice “be authentic and engage in the conversation,” you might be a smanker.

This is a fine list, as far as it goes. But I have some quibbles. Mainly that a few of the ten are strawmen and are also not quite at the level of hilarity required to warrant inclusion. As David Foster Wallace proved in his non-fiction, if your made-up observations are either LOL-inducing or plausibly true, your audience will forgive you.

Re: #2, I don’t know of anybody who feels that merely having a Tumblr entitles them to a press pass. And I am a much bigger loser than Francisco and so keep the company of people who, if this was a possible thing to feel, would be inclined to. Now, if your Tumblr is on the level of Bon Iverotica or Annals of Online Dating, I see no reason why our Founding Fathers wouldn’t have wanted to give you the freedoms and benefits that come with the designation of “press.” Hell, I’d likely rather hear questions from the person behind Kim Jong Il Looking At Things than most of the White House Press Corps.

#4 is rather harsh on the socially inept. Plenty of delightful, smart folks are better in writing than they are in person. That shouldn’t get them branded as a wanker, or even the final 5 letters of the word wanker.

#5 seems to imply that there are people out there who envision Facebook as a giant 800 million person-Transformer. I get up every morning hoping to meet this kind of big dreamer, but I haven’t. If anybody knows of a Colorado-based meetup for these high-octane imagineers, let me know.

And Francisco, let’s also workshop “smanker” a bit. I have some suggestions for punchier Portamanteaus that might really blow this whole thing open. What do you think of “smoser” (pron.: /’smuzər/ (IPA), SMOO-zer)? Or how about “smassclown”?

Finally, in the interest of being constructive, here are a few off-the-cuff additions I would make to the original list:

1.) If you earnestly use the hashtag “#startuplife,” you might be a smanker.

2.) If your total number of tweets is less than 2x the number of times you’ve retweeted the pithy startup wisdom from Aaron Levie and Shervin Pishevar, you might be a smanker.

3.) If you enthusiastically post and endorse every single infographic that you see, you might be a smanker.

4.) If you don’t currently have a job and don’t actually have any experience doing much of anything besides tweeting in your undies but maintain that you are looking for a job in social media, you might be the textbook definition of a smanker.

5.) If you love George Takei and it’s not because of Star Trek, you might be a smanker.

6.) If, on any social media profile, you self-apply any or all of the following labels (guru, maven, visionary, intellectual, rock star, thinker), you might be a smanker.


My Failed Application to Write for Groupon

Editorial Note: After a few months of feeling sad because the dillweeds at GoDaddy destroyed my blog and all my content—and the compounded sadness from realizing I wasn’t important enough for the Wayback Machine to have indexed more than a few posts—I’m committing to regular writing again. Here goes…

Like most people who think they’re good writers but don’t actually submit a ton of stuff for evaluation by professionals, I probably have an inflated sense of how good non-parental humans think my writing is. And it was with this naive but not entirely baseless confidence that, in the winter of 2011, I submitted an application to be a member of the zany brotherhood of Groupon writers.

At the time, I was pretty strapped for cash. And I had spent enough time groaning and rolling my eyes at Groupon’s schlocky Dad-humor that I finally decided to demonstrate I could do better or just shut up about it. I can’t remember precisely, but I’m sure there were elaborate fantasies of being the Groupon equivalent of Michael Clayton. I would get called in at inflated rates to pen 4 coruscating paragraphs selling a Brazilian Wax to a community of genetically hairless Iowans or some such.

As a second job, it was close to ideal. I could work remotely and do as much as I had time for. And because I tend to write quickly, I was fairly certain I’d be making a mint in no time. Step 3: Profit!

I even had relevant blurb-writing experience. Back when I worked at The Prague Post (The World’s Most Respected Czech Republic-based, English-language newspaper), I spent a few hours each day surveying the Czech newswire and writing 50-word briefs. I also have photographic evidence of having, on at least one occasion, uttered a sentence amusing enough to make another person laugh with their whole face. And while Groupon insists that “[a]chieving Groupon Voice [ed: incidentally, how creepy and corporate is “Groupon Voice,” all capitalized and without articles] is not about being inherently funny,” it seems that their writers use most of the real estate not dedicated to boring deal details for swing-for-the-fences attempts at being funny or quirky.

The Groupon application consists of a mock write-up for a deal and an online quiz that has both fill-in-the-blank and multiple choice sections. The quiz, which you can find online here, comprises both grammar/style/diction questions and questions designed to ferret out if you can determine what is funny and what is not. Or, more accurately, which choice conforms to the “Groupon Voice” and which does not.

A sample question (and answer key) from the NYT article linked above:

The kitchen is statistically the most dangerous room in a home because it contains the highest concentration of knives, open flames and …

A. cereal killers

B. spoiled fruit

C. mothers-in-law

D. pots of semi-living lobsters

Nearly half the writers pick A, but the correct answer is D. Puns are not allowed, spoiled fruit isn’t even remotely funny, and defaming mothers-in-law could irk mothers-in-law.

This question, like many of the questions, can cause problems for applicants that either haven’t adequately internalized the Groupon Voice or are actually funny and as a consequence lack imaginative access to the elusive GV. On the quiz, as with my sample deal write-up, I tried to put myself in the headspace of someone writing the reviews I’d been reading in my inbox for months. I thought I could achieve the appropriate tone by submerging my head in ice water for 7 minutes and then composing my response by trying to conjure Woody Allen on his worst day.

At the risk of sounding like that high school classmate that maintained he did poorly on certain SAT questions because “there were no good answers,” those answers all suck. And it’s not even close to obvious why one sucks less than the others. “Cereal killers” is an atrocious pun; “spoiled fruit” is wimpy and dumb and yet may be so wimpy and dumb that it’s actually funny; “mothers-in-law” is hackneyed, and mean without any payoff; and “pots of semi-living lobsters,” the supposed right answer, is aggressively stupid. And not because lobsters aren’t funny, or because the idea that pots of lobsters already submerged in boiling water would be dangerous is nonsensical and also unfunny. It is actually, I think, a candidate for the worst answer because of “semi-living.”

Maybe this is a personal bugaboo, but I see a lot of writing—mostly from folks under 40—in which people use  “semi-” and “quasi-” carelessly and with really lame results. These modifiers usually just make the intended thought less precise and/or more confusing. Here it just makes me want to poke my eyes out. It sounds like a lazy teenager describing lobster-zombies. Except less funny than that.

The idea behind D being the correct answer is presumably, if you’ve read that NYT piece by now, that it is “incongruous” that “semi-living” lobsters would be dangerous. And so even if it’s not funny, this is the correct answer because of the incongruity. Or something.

Here are a few other questions from the actual quiz I took. See if you can pick the right answer. I actually can’t help you out here since I don’t have my responses to the multiple choice. I scored an 82, for whatever that’s worth. I believe that’s out of 100? Which strikes me as not terrible but also was not enough to get me the job.

Select the most compelling, verifiable descriptor.

A. state-of-the-art
B. top-notch
C. phenomenal
D. licensed and certified

Which is the most interesting way to describe a 4,700 pound chandelier?

A. blinged out
B. more brilliant than a studious Christmas tree
C. a death trap
D. really big and shiny

Select the most enticing descriptor for a devil’s food cupcake.

A. delicious
B. sure to go straight to your hips
C. ooey-gooey
D. velvety

And here are the questions and my answers to the fill-in-the-blank section, followed by my mock write-up for a kayaking tour. I tried to ape the Groupon Voice while demonstrating a bit of originality as well. I was actually pretty pleased with how the deal write-up turned out, and especially so given that I wrote it in under 30 minutes. It seemed slightly stupid, mildly and occasionally funny, and it contained all the relevant details for the deal I was asked to sell.

18. Complete the sentence with an engaging verb:

[titillate] taste buds with the tangy ceviche.

19. Complete the sentence with an engaging verb:

The soft caramel light of two fireplaces [radiates] across the oak dining area.

20. Add an adjective:

The lights on the dance floor are set to a/an [subterranean] dim.

21. What are three synonyms for ‘customer’ that you might use when describing a boating tour?

passenger, client, Gilligan-wannabe

22. In one sentence, describe the décor and ambiance of this restaurant’s dining room:

ed: My answer here gave me douchechills, but I bravely submitted it anyways. [With lush brown drapery, elegant overhead lighting, and a regal burnished wood table, [X restaurant]’s interior is so nice one would be forgiven for not taking in the beautiful floor-to-ceiling views of the city at dusk.]

23. Humorously complete the sentence:

A hand-written note has the capacity to change minds, break hearts, or [elicit a sizable ransom]. 

ed: Full post-mortem disclosure: I thought “elicit a sizable ransom” alone was going to get me the job.

24. Humorously complete the sentence:

Black Magic Salon treats toes with the respect normally reserved for fingers and fingers with the respect normally reserved for [Oprah].


Kayaking Deal Write-Up

Do you resent the internal combustion engine? Think motor boats are for chumps? By taking advantage of today’s Groupon from Sea Kayak Georgia you can live out your Luddite water transportation fantasies with a half-day, all-levels kayaking tour for $25 (a $55 value). The 3-hour coastal tours are available year round and are offered every day. From March through October you have the option of 9am -12pm or 1:30pm -4:30 ; choose November through February and you’ll be spared the early morning wake-up with an 11am start. Orientations takes place 30 minutes before the posted start time.

Sea Kayak Georgia has been owned and operated by locals Marsha Henson and Ronnie Kemp since 1994. Both are ACA (American Canoe Association) and BCU (British Canoe Union) certified instructors and actually live on Tybee Island, the area you’ll be touring. You can develop your paddling skills, if you have them, or simply get out into what your Eastern European friends may call “The Nature” for a relaxing flatwater jaunt. Most trips go to Little Tybee Island, an undeveloped State Heritage site complete with beautiful, craggy trees and the occasional lighthouse.

Sea Kayak Georgia provides everything you need and no experience is necessary, although they do specify that you must bring your own clothes, shoes and snack/water. You’ve been warned: no showing up naked.

So there you have it. The point of this post was not to dwell on the rejection, which does still feel raw and commensurately stingy. And it was not to try and articulate why Groupon’s writing is actually kind of lame. Because that is both obvious and boring. The main idea was to leave a record of my abject failure so historians and/or Deities can make a fully informed judgment of my worth as a human, and so anonymous Internet commenters can call me a no-talent assclown. Which I quite enjoy.

At some point I may write a longer post with some actual substance that more directly addresses why Groupon’s whole schtick (distinct from their business model) is bad for businesses. Which reason is, in part, because it lacks sincerity, which is the fundamental element of good sales and why I would not want my business associated with the company. Unless I was in the unfunny Ironic T-shirt business. Which I am not. Yet.

The Tao of Boulder: Or, how to network without being an asshole

Be desireless. Be excellent. Be gone. – The Tao of Steve

I moved to Boulder last August and until recently mostly thought “networking” was so much bullshit business school glad-handing. And it is, kind of. Or it can be. But, fundamentally, it’s a way of talking about building relationships. I don’t know that I’m the paragon of networking success, but I didn’t screw it up badly and in the past year have learned a fair amount about what not to do when you move somewhere new.

Be present

This seems obvious, but you can’t network properly unless you live in the place. There’s a limit to the success you can have on Twitter or on forums or in blog comments sections. And the harder you try to make yourself known remotely, the more likely you are to come across as desperate and overbearing. You can create a real solid foundation using social media, but it’s not a substitute for interacting with people across the full spectrum of neighborly human interactions. Nobody has solved the borrow-the-milk-over-IP problem yet.

Be helpful (more often than not)

I stole this “be helpful” mantra from Chris Sacca’s Foundation interview with Kevin Rose, and I think it’s the hardest but most important piece of advice.

Boulder has a culture of generosity that makes it easy to get undeserved meetings with Important People. The kind of meetings where the idea that you might provide anything of value to the person is nearly laughable. This is OK. But go in with a plan. Have something specific you want to talk about or ask and make it quick. Learn as much as you can about the person, but more importantly learn how to deploy that information. Dave Heal Coffee Meeting Heuristic #1 is if, at any point, it sounds like you’re reciting a Wikipedia page, you’re doing it wrong. Your research should merely inform the discussion, not constitute it.

This is mostly revisionist conceptualizing–I guess some might call it “learning”–but I think of most networking as a pyramid. You need to prove your value to people along the base in order to get referred up the pyramid. Occasionally you’ll get shunted a few levels up because you’ve been particularly impressive or the person is particularly well-connected. In those situations especially it’s important not to be afraid to ask for things.

I’ve talked with a lot of people who assume this stance of preemptively apologizing for wasting someone’s time. No, you will likely not be able to give the local hotshot Ruby developer tips on how to write more elegant code. But maybe he (or she!) also likes rugby, or industrial design, or needs help writing an OK Cupid profile. Worst case scenario is you have nothing to offer immediately but you ask intelligent questions, listen attentively and graciously exit. This is a perfectly fine outcome for some substantial percentage of encounters with people you hope to eventually have a more balanced, reciprocal relationship with.

Be interesting

Have hobbies, pursue them passionately, meet others who do them. Repeat. The best relationships–and this is especially true in a town like Boulder where everybody is doing stuff all the time–don’t emerge from meet-ups or events. Or at least they aren’t sustained by these interactions alone.

You should be into at least one discipline or area of inquiry so intensely that you can communicate a sense of expertise to someone who is merely an enthusiast. And you should participate in one group activity or sport (even if that “group” is just a lonely two-person Turkish Oil Wrestling club) where you can have interactions without the temptation to indulge in shameless careerism.

Be everywhere (but not all the time)

People need to know who you are. But you also need to make other folks do some of the work for you by talking about you when you’re not there. Give people, the scene, etc., some room to breathe. If you are at every event, you better have a very finely tuned sense for how you’re coming across.

Also, make sure to hang out with people who aren’t like you; they are more likely to need you. Community manager meet-ups serve a purpose. But especially early on in your career, you’re much more likely to be valuable to people with complementary not overlapping skills. Mere competence in an area where others are incompetent is often enough to get you into a conversation. When the local hadoop meet-up organizes a frolfing team, you can be their coach. Think The Mighty Ducks, but for data nerds.

At some point you will have to be excellent at something, but you can work into that if you get a foot into the right door. I know more than a handful of lawyers that have floundered through learning the on-the-job nuances of business because they were adequate contract writers or simply just knew who to talk to when an entrepreneur didn’t.

Be humble

Don’t be a dick. And own your place in the ecosystem unapologetically. This includes not talking incessantly about your own “hustle.” Business people and aspiring non-technical co-founders have become obsessed with justifying their existence by referring to the fact that they’re constantly flitting about from one physical location to the next. Just do the thing and let the rest of the world apply the obnoxious buzzword du jour. “Hustler,” to paraphrase The Big Lebowski, is not a name people self-apply where I come from. Everybody knows you can’t code (yet?). That’s why you’re excellent at selling and marketing and talking to customers. It’s fine.

In the end, patience is key. It’s possible to network effectively and efficiently, but the most useful relationships are just that. Relationships. You can’t will somebody into trusting you enough to give you a meaningful referral to their friends and mentors. And most of us aren’t so obviously incandescently talented that one brief encounter is enough to get a meeting with the people that can help you the most.

The Convertible Debt v. Equity Financing Omnibus

Shortly after I moved to Boulder in mid-August last year I became obsessively interested in the local VC/startup scene. I’d filled my RSS reader with some of the obvious must-read blogs, ordered a few nerdy books from Amazon, and jumped in hoping to meet some entrepreneurs and venture types and soak in as much information as I could. One of the nice things about the tech venture scene is that it’s relatively small, and the magic of the Internet makes it feel smaller. The big players are rabid techophiles and many of them blog and tweet regularly. So when Paul Graham tweeted that “convertible notes have won,” it triggered a massive response. As someone just starting to learn the intricacies of venture financing, this was great timing. But the sheer amount of text I had to wade through was overwhelming, and some of the best distillations of the issues were to be found buried in the comments sections.

This post is not an attempt at a comprehensive diagnosis. Instead, I’m aiming to create a resource for folks that want to understand, fundamentally, the terms of the discussion surrounding convertible debt v. equity financings in angel/seed rounds. I’m less interested in whether Paul Graham is right and more interested in what VCs and entrepreneurs are and should be thinking about when deciding how to structure their first round of financing.

World’s Briefest Executive Summary: aka The “tl;dr” Version

Convertible debt is arguably better for the entrepreneur in the short run, much less good in the long run, and often bad for the investor, which badness often redounds upon the entrepreneur thus canceling out some of the benefits.

What are we actually talking about?

Convertible Debt

Convertible debt is a security that involves issuing a promissory note to investors–a loan to the company, essentially–that automatically “converts” to equity in the company after a triggering event. This event is usually what is referred to in the documents as a Qualified Financing, which is normally (but does not have to be) a Series A Preferred Stock issuance. The Note will specify both the amount of money that will trigger the conversion and the amount of stock that the debt has been converted into, expressed in the form of a discount rate. For instance, a discount rate of 20% entitles the holder of the debt instrument to shares at 80% of the per share price. Ryan Roberts, who blogs as The Startup Lawyer, has a good, simple illustration of the process:

Here’s the basic outline of how convertible debt works:

(1) Joe Angel invests $100,000 in Startup.

(2) Startup issues Joe Angel a convertible promissory note for $100,000. The convertible promissory note has an automatic conversion feature at $1,000,000 (the “Qualified Financing”) with a conversion discount equal to 20%.

(3) Startup closes $1,000,000 Series A Preferred Stock round (the “Qualified Securities”) by a VC at a Series A Preferred Stock price of $1.00 per share.

(4) Since the Automatic Conversion feature in Joe Angel’s convertible promissory note is triggered by the Series A round, Joe Angel’s convertible debt will be converted to Series A shares at a per share price of $0.80.

(5) The Startup issues Joe Angel 125,000 shares ($100,000/$0.80 per share) of its Series A Preferred Stock. The convertible promissory note is cancelled.

And boom! Everybody’s rich! Errr…wait.

The other relevant feature of these convertible notes is the price cap. Many (most?) angels (Yuri Milner and some others excepted) will not invest without one, and the debate that Paul Graham ignited I think implicitly carries the assumption that convertible debt rounds contain a cap :

To provide upside protection, angel investors like to put a “price cap” on the convertible note discount. This price cap is expressed in terms of a pre-money valuation and effectively acts as a share price ceiling. Thus, an automatic conversion discount with a price cap might read something like this:

“The conversion discount shall be the lower of (i) a 25% discount to the Series A Preferred Stock share price, or (ii) the price per share if the Series A premoney valuation was set at $[10,000,000].”

The latter valuation figure is typically north of what the valuation would have been had the investor and company agreed on a firm price for the debt financing but lower than the best case Series A valuation. It should be obvious that this can backfire on the entrepreneur depending on how the second round of funding goes. If the investors put in $500k convertible debt at a $4.5 million pre-money valuation, at best they stand to get 10% of the company. But that next round of financing might turn out to be less than that first valuation. Essentially, the lower your pre-money Series A valuation, the larger the share of your company the investor gets.

Example from Ryan Roberts:

EXAMPLE 1: If a VC invests $2,000,000 at a $5,000,000 pre-money valuation ($7,000,000 post money) and an angel investor has a $100,000 convertible note with a 25% discount, the angel investor will own 1.9% of the startup immediately after the Series A round.

EXAMPLE 2: But if the VC invested at a $15,000,000 pre-money, the same angel investor would own 0.78% of the startup right after the Series A.

Because of this quirk, an angel investor may not have much incentive to help increase your pre-money valuation before a Series A…regardless of the conversion discount. Meanwhile, you and your co-founders are doing everything possible to increase the startup’s valuation.

What’s the alternative?

There are obviously quite a few permutations available as an alternative, but the standard equity financing usually referred to in the debate is a priced Series A preferred stock financing. Preferred stock comes with rights that are senior to the company’s common stock (usually what is issued to founders and employees) and usually entitles the holder to any number of other attendant benefits. Preferred stock normally comes with, inter alia:

1. Liquidation preference: The LP is generally what is meant by “senior to” above. This gives “preference” to the preferred stockholder in the event of a liquidation event and means that they will get their money before the holders of common stock. This can include a company sale, merger, or, on the opposite side of the emotional spectrum, dissolution of the company. It does not include an IPO, in which all preferred stock converts to common stock. Relatively straightforward stuff at its most basic level. Liquidation preferences can get much more complicated, so if you want the advanced tutorial, check out Yokum Taku’s post.

2. Anti-dilution protection: Like the LP, this is a basic concept with a great potential for complicating nuance. This provision is used to protect the investor in the event that the company raises money at a lower valuation than previous rounds.

Yokum Taku:

Preferred stock is normally convertible at the option of the holder at any time into common stock, usually on a share for share basis, and is typically automatically converted upon the occurrence of a qualified initial public offering. Price-based anti-dilution adjustments involve increasing the number of shares of common stock into which each share of preferred stock is convertible. In addition, an anti-dilution adjustment will affect the voting rights of the company’s stockholders because the preferred stockholder is almost always entitled to vote on an as-converted to common-stock basis. The primary difference between the various anti-dilution formulas to be described in upcoming posts is the magnitude of the adjustment under different circumstances.

For a brief course in Intermediate Anti-Dilution, check out Brad Feld’s Term Sheet Series post [covering weighted-average and ratchet-based anti-dilution provisions].

Preferred stock comes in a “participating” flavor as well. Whereas generic preferred stock gives the investor the choice between getting their money back or taking the equity share of the company they purchased with that money, participating preferred stock essentially gives the investor both.

Brad Feld:

A PP is the right of an investor, as long as they hold preferred stock, to get their money back before anyone else (the “preference” part of PP), and then participate as though they owned common stock in the business (or, more technically, on an “as converted basis” – the “participation” part of PP). It takes a preferred investment, which acts as either debt or equity (where the investor has to make a choice of either getting their money back or converting their preferred shares to common), and turns it into something that acts both as debt and equity (where the investor both gets their money back and participates as if they had converted to common shares).

To illustrate, let’s take a simple case – a $5m Series A investment at $5m pre-money where the company is sold for $20m without any additional investments being made. In this case, the Series A investor owns 50% of the company. If they did not have a PP, they would get 50% of the return, or $10m. With the PP they get their $5m back and then get 50% of the remaining $15m ($7.5m), resulting in $12.5m to the Series A investor and $7.5m to everyone else. In this case, the Series A investor gets the equivalent of 62.5% of the return (rather than the 50% which is equivalent to their ownership stake). The PP results in a re-allocation of 12.5% of the exit value to the Series A investor.

Preferred stock, while it almost always comes with anti-dilution protection & liquidation preferences, can also include rights to block or compel certain actions (company sale/IPO, increase the option pool, appointing senior executives, etc.)

Who likes what and why?

Why do entrepreneurs and/or VCs like convertible debt?

In summary, the conventional wisdom (which is increasingly superannuated) is that a convertible debt financing is faster and cheaper and likely to provide more favorable terms financial terms to the entrepreneur. It’s also (dubiously, some might say) attractive because it allows the entrepreneur to punt on a firm valuation until their next round and who doesn’t like procrastinating!

  • Keeps legal costs down (reality: increasingly less so)

This is often repeated as a reason to do debt instead of equity. But most observers recognize that while this may be true up front, all this does is frequently defer the legal fees until a later round/spreads the fees out over a longer period of time. And with the emergence of a variety of streamlined seed documents, a priced equity round can be done for about the same price (~$5k with these non-negotiated “light” docs according to Fred Wilson, ~$15k with Series Seed according to Yokum Taku). For smaller rounds (

  • Faster/more expedient (reality: true but increasingly less so)

In a convertible debt financing, the entrepreneur and the VC don’t have to sit down and wrangle over what the company is worth now. The common refrain is that while the pricing conversation around the cap may be similar to a true valuation, the cap discussion takes place at a level of abstraction that reduces the potential for contention. This often results in the entrepreneur getting a better deal, but as we’ll see below that “better deal” often results in misalignment with the interests of their investors, which ultimately creates its own set of problems.

Entrepreneur Lateef Johnson of Deckerton adds:

One thing I’d like to add is that delaying pricing not only shifts risk, it also protects the cap table, which may be more important. Angel investors chafe at the idea of getting worse deal terms than earlier investors, so delaying pricing means that all investors convert at the same terms, which reduces due diligence and speeds up the deal. Faster deals are probably more beneficial to some entrepreneurs than shifting risk.

  • No control/rights issues to negotiate (reality: an issue, but the non-negotiated seed docs are, like convertible debt docs, mostly about economic structure)

Debt investing typically gives investors economic rights only. You’re loaning the company X amount of dollars. Equity investments, as discussed above, typically come with a variety of control rights written into the documents (board seats, right to block certain actions, etc.), and the laws of the state of incorporation will also prescribe a basic set of shareholder rights.

In a “blubble” environment like we have now, VCs might prefer convertible debt documents because they don’t particularly care about the control rights and simply want in on the deal. In Chris Dixon’s post on the subject he relates a bit of wisdom he learned from Ron Conway:

To the extent that I know anything about seed investing, I learned it from Ron Conway. I remember one deal he showed me where the entire deal was done on a one page fax (not the term sheet – the entire deal). Having learned about venture investing as a junior employee at a VC firm I was shocked. I asked him “what if X or Y happens and the entrepreneur screws you.” Ron said something like “then I lose my money and never do business with that person again.” It turned out he did very well on that company and has funded that entrepreneur repeatedly with great success.

You can hire lawyers to try to cover every situation where founders or follow on investors try to screw you. But the reality is that if the founders want to screw you, you made a bet on bad people and will probably lose your money. You think legal documents will protect you? Imagine investors getting into a lawsuit with a two person early-stage team, or trying to fire and swap out the founders – the very thing they bet on. And follow on investors (normally VCs) have a variety of ways to screw seed investors if they want to, whether the seed deal was a convert of equity. So as a seed investor all you can really do is get economic rights and then make sure you pick good founders and VCs.

Mark Suster chimes in in the comments to talk about a deal that he lost to Sequoia when he had a term sheet all but agreed-upon except for some “niggly founder issues” and Sequoia came in and swiped the deal without any fuss. Especially when it comes to smaller investments, VCs might be inclined to do a debt deal simply in order to avoid negotiating control issues. The “light” non-negotiated documents that Fred Wilson favors, however, look more like your standard debt documents and deal mostly with economic structure.

  • Rolling fundings

Angel investor Chris Hobbs notes in a comment on Seth Levine’s post:

Another advantage of a convert is if you are going to fund in dribs and drabs. With a step up over time in the conversion discount, you can do a rolling funding more cheaply with a convert, and still have some accommodation for risk. I personally don’t like rolling fundings, however, as the founders tend not to get any work done when they are focused on raising money.

Why do entrepreneurs and/or VCs like priced equity rounds?

First let’s start with the hard sell from Ted Wang for his Series Seed documents:

· Costs should be roughly the same (if not cheaper) than using industry standard debt documents. There are a number of different convertible debt documents out there and there will likely be some back and forth whereas these are standard documents.

· Same point for speed. If parties agree to Series Seed Documents, should be faster than debt documents since there is some negotiation with debt documents from sophisticated investors.

· Series Seed Documents are transparent: no hidden gotchas can get served up in definitive documents. You can review them right now if you want.

· Equity documents give investors more clear definition around rights, more stability and less potential squabbling in the next round.

· Equity gives investors the opportunity to get long term capital gains tax treatment if early exit.

· With minor manipulation, Series Seed enables multiple board structures without tortured and non-functioning agreements (a real problem for convertible debt documents); and

· Entrepreneurs get price certainty instead of the lower of two different prices as with capped debt.

In sum, Series Seed creates a level playing field between capped debt and equity documents in terms of speed and cost. When one studies the (admittedly highly technical) benefits of Series Seed vs. price debt, Series Seed is a better solution.

  • Alignment of interests

As we saw above, your standard convertible debt instrument includes a discount rate with a cap. But when intended as a bridge to a Series A round, something strange happens. This arrangement means that the incentives for the entrepreneur and investor are now at odds. The entrepreneur obviously wants the Series A round to the priced as high as possible, but the investor now wants the Series A round to be priced as low as possible because the conversion price is based on that round.

As Mark Suster puts it:

As an investor when you do convertible debt you’re usually pricing the round when the next money comes in. But as an angel you’re usually not only taking risks but also helping the company succeed (through introductions, social proof, coaching, recruiting). So think about it – why should you be penalized for helping a company to get a higher valuation in the next round and thus your money gets converted at a higher price?

If an entrepreneur wants an angel/seed investor who’s going to actually add value, doing a convertible note (without some pro-investor protection like warrant coverage or a discount rate that gets progressively more investor-favorable over time) might ultimately make less sense. The blogs of all of the prominent VCs I read reflect a unanimous desire to add value and so the choice of a financial instrument that might get in the way of that desire should not be taken lightly. As an entrepreneur you want your VC to want to help you, especially at the angel/seed stage.

Seth Levine’s take on why convertible debt might be bad for entrepreneurs:

Clearly in the short run this trend is positive for entrepreneurs because it has the effect of both deferring an often difficult conversation (around valuation) and ultimately increasing early stage company values and as a result decreasing entrepreneur dilution (by the way it’s also good for Y-Combinator, TechStars and other similar programs since the shares the program gets of each company act as founder shares in this financing equation). And I have no doubt that there will be many entrepreneurs who benefit from this trend. But it’s not clear to me that it’s sustainable (just as it wasn’t a decade ago). Ultimately investors need to be compensated for the risk they take in making their investments. With capital being relatively fluid (and the angel markets being finicky) as companies run into trouble, as valuation caps begin to be disrespected, as overall return profiles decrease because of higher early stage prices, money will flow out of the asset class. And ultimately this doesn’t benefit entrepreneurs either.

Yokum Taku also notes, regarding convertible debt deals:

Investors may request aggressive terms. For example, investors may require the company to grant a security interest in all of the company’s assets, personal guarantees from the founders, drastic measures upon an event of default (i.e. the equivalent of getting your arms broken if you don’t repay), etc. In a Series A financing, there seem to be some established norms on what is typical. In a convertible note bridge financing, creative investors may suggest some unusual terms.


So, in the end, what did we learn?

With the advent of the Series Seed and other “light” documents, a lot of the cost and time associated with equity financing has been reduced to levels that are competitive with a debt deal. There are still good reasons why both entrepreneurs and VCs might want to push the valuation discussion down the road, and protections can be built into the debt documents to make them more equity-like and therefore satisfy the VC. But most entrepreneurs taking seed financing want active, enthusiastic investors. And most investors want to be strategically involved in their portfolio companies. However, a vanilla convertible debt financing can misalign the parties’ interests in a way that will ultimately hurt the entrepreneur more than a low but reasonable valuation might have.

EDIT: Scott Edward Walker of Walker Corporate Law Group has a post that cautions entrepreneurs, especially ones at the helm of “hot startups” against agreeing to the Series Seed documents as-is. Solid advice that hopefully is rather obvious, but read the entire post.

Response to Paul Graham Link Round-up:

Seth Levine (Foundry Group): http://www.sethlevine.com/wp/2010/08/has-convertible-debt-won-and-if-it-has-is-that-a-good-thing

Yokum Taku (Lawyer at Wilson Sonsini): http://www.startupcompanylawyer.com/2011/01/09/is-convertible-debt-with-a-price-cap-really-the-best-financing-structure/

Mark Suster (GRP Partners): http://www.bothsidesofthetable.com/2010/08/30/is-convertible-debt-preferable-to-equity/

Jason Mendelson (Foundry Group): http://www.jasonmendelson.com/wp/archives/2010/08/the-convertible-debt-debate-an-ex-lawyers-twist-on-the-argument.php

Fred Wilson (Union Square Ventures): http://www.avc.com/a_vc/2010/08/some-thoughts-on-convertible-debt.html

Chris Dixon (Hunch): http://cdixon.org/2010/08/31/converts-versus-equity-deals/#comment-73535965

Ben Siscovick (IA Ventures): http://bsiscovick.tumblr.com/post/1043177410/advocating-the-move-from-entrepreneur-friendly-to