[Dave Heal's] Observations & Reports

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.

Conclusion

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