How to sell debt to investors
venturehacks.com
venturehacks.com
Many startups are interested in using a convertible note for their early funding. I've heard three reasons:
1. It's less paperwork than preferred stock
2. VCs would rather do a Series-A than a Series-B (one solution is to name this first round "Series-Seed")
3. It lets them avoid having to determine a valuation
The first two reasons seem fine to me, assuming that they are true. The third reason is bad.
These convertible notes typically convert into preferred stock upon the next major financing (presumably the Series-A led by some VC), usually at some discount to what the VC pays (perhaps 20%). Sometimes there is a cap on this conversion price. If that cap would be a reasonable pre-money valuation today, then third reason doesn't really apply, since a valuation was in fact determined.
However, if there is no cap on the conversion price, or that cap is very high, then you are asking investors to give you money today, but not giving them the upside between now and then next major funding (which probably won't occur for another 6 - 12 months). During this 6-12 months you will build and hopefully launch a product and begin to prove it's market potential, or not. That's a lot of uncertainty.
Put another way, I'd rather wait 6-12 months to see what you build, how successful it is, and how well your team executes, and then decide whether or not to invest. And I'd gladly pay an extra 30%. However, if you need the money today, then it needs to be at today's valuation, not next year's.
There are lots of benefits to doing debt in a seed round. We discuss them in detail here: http://www.venturehacks.com/articles/debt-benefits
Here's a summary from the article: "Convertible debt is often the best instrument for a seed round. You can close the debt cheaply and quickly and then turn your focus back to your customers. That's good for the company and its investors since speed is a major competitive advantage of a startup. If you or your investors are veering away from convenience, low cost, and speed, you are missing the point of seed stage debt!
"The seed stage is the worst possible time for the founders to negotiate an equity financing. The company is nebulous, the founders are inexperienced, and the company is starved for cash and time. The team should be testing hypotheses about their business, not negotiating complicated term sheets."
See the article for details: http://www.venturehacks.com/articles/debt-benefits
A cap doesn't determine a valuation. It just sets a cap. Setting a valuation implies buying preferred stock, I assume you don't want to buy common stock in the business. That means negotiating investor rights--that is a pain in the ass. (I've never seen this but I suppose you could defer negotiating investor rights and just say that the seed investors will get the same rights as the eventual Series A investors. Anybody want to chime in?)
A cap can be closer to the founder's high minimum expectations and avoids a long road show. A cap avoids setting a high valuation and then doing a down round in the Series A. A cap avoids setting a low valuation and then being unable to substantially increase the valuation if you do a Series A soon afterward.
If you want more of a reward, we suggested increasing the discount. A 50% discount guarantees you a 2x paper return on your money. A 40% discount guarantees a 1.7x paper return. You can also have the discount increase over time.
As always, our hacks are generalized and should be tailored to the specific circumstances. And your deal is mainly determined by your leverage, nothing else: e.g. every deal that closes is a "good deal".
Consider these two possible series-A investments:
- Sequoia at a $5M pre
- Some lame VC at a $15M pre
As a seed investor, I would probably prefer Sequoia (obviously the other details matter, but on average), meaning that if they went with the lame VC I would get double-hurt with uncapped debt (I get a smaller percentage of a company that has a smaller chance of success).
"I'd rather wait 6-12 months to see what you build, how successful it is, and how well your team executes, and then decide whether or not to invest."
doesn't this assume the angel investor has the option to invest in either the convertible debt seed round or wait and invest in a series A? Who says the entrepreneur is going to be as interested in the angel money comes series A, once the application is launched, momentum is underway and the deal is becomming more interesting to other investors? Is not one of the benefits of an early seed round to an angel, that of access to an exciting team and concept before they take off? And yes, if the team really executes and delivers a huge valuation come series A, the angel gets diluted. But they got in on a big opportunity with a discount, with a greater liklihood of participating again in series A. Maybe this isn't ideal from an investor standpoint, but isn't this still interesting versus waiting on the sidelines and potentially not particpating at all, if you believe in the idea?
If you had the opportunity to invest in a seed round, and they were only willing to accept financing in the form of convertible debt with no cap on valuation, would you reject that opportunity 100% of the time? (Acknowledging a cap is superior from an investor perspective).
And if so, are you not concerned about losing opportunity to invest in the series A (assuming you love the idea)? Not because VCs are superior, just based on there potentially being greater competition come Series A. Bird in hand so to speak?
In essence, I am asking if this is an absolute position from your perspective or are there not scenarios where a convertible debt investment with no cap could be interesting?