Question: Why would I, as a founder, prefer priced shares (Prefs or Equity) over a Capital Note?
Answer: If the context of this question is the Founder’s company doing a capital raise, and the company is a startup (or even a more mature company being evaluated for investment by non-institutional investors), I would prefer to raise money through an issuance of convertible notes—with the notes being convertible into equity under identified circumstances and terms sometime down the road. This method results in less intensive legal procedures and costs on the uptick, and kicks the “valuation” can down the road until the institutional investors are involved. They are better equipped to make an evaluation decision that will “stick” with later investors. Angels and friends and family are notorious for providing evaluations that too high—which goes down nice in the beginning, but gives you a real hangover later on when you seek true VC investment.
Question provided by – Dean Collins, Director of Cognation and Live Chat Concepts.
Answer provided by – Peter Rothberg, Partner at Duane Morris, Ultra Light Startups sponsor and counsel.
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Legally are convertible notes the same as convertible debt?
Legally are convertible notes the same as convertible debt?
This post on “18 Pros & Cons of Professional Angel Investors” by StartupAlley.net touches on the topic as well. The post seems to indicate the entrepreneur would generally prefer to avoid valuation through priced shares (as opposed to convertible notes) in early rounds.
http://startupalley.net/2010/03/19/hells-angels-pros-cons-of-professional-angel-investors/
This post on “18 Pros & Cons of Professional Angel Investors” by StartupAlley.net touches on the topic as well. The post seems to indicate the entrepreneur would generally prefer to avoid valuation through priced shares (as opposed to convertible notes) in early rounds.
http://startupalley.net/2010/03/19/hells-angels-pros-cons-of-professional-angel-investors/
Peter,
I’m very curious at your response, why is getting a better capitalisation rate for your current round of investment a bad thing if it is decided at a fixed price now?
If a startup is in a position to determine “When” they take an investment eg. i wont take an investment if it’s not priced at something i feel is acceptable; if you aren’t in a desperate situation for the next round it just means you need to shop around for a VC who can meet your next round of capitalisation.
Founders should learn to say no occasionally and not put themselves into positions where they are forced to accept money “Except” on their terms.
Peter,
I’m very curious at your response, why is getting a better capitalisation rate for your current round of investment a bad thing if it is decided at a fixed price now?
If a startup is in a position to determine “When” they take an investment eg. i wont take an investment if it’s not priced at something i feel is acceptable; if you aren’t in a desperate situation for the next round it just means you need to shop around for a VC who can meet your next round of capitalisation.
Founders should learn to say no occasionally and not put themselves into positions where they are forced to accept money “Except” on their terms.
Graham Lawlor, thanks for the confirmation of my position.
Austin, your insight on convertible notes vs convertible debt is correct.
Dean, I don’t disagree that entrepreneurs should say “No” to a bad deal. But the use of convertible notes as opposed to straight equity sale based on a calculated valuation provides a timing benefit. An angel or seed stage VC can like the company, but find it very difficult to come up with a cogent argument for a valuation decision at an early stage–particularly when you’re pre-revenue or in a brand new and exciting space. To push the valuation discussion at that time can delay the deal while the log rolling over valuation goes on–and delay is not your friend. Using convertible notes allows a much faster close with an interested funding source, and also allows the funding source to obtain equity at a price that is discounted to the next round– obtaining risk credit for being earlier into the deal. Most VCs I know are very comfortable with this arrangement.
Peter
Graham Lawlor, thanks for the confirmation of my position.
Austin, your insight on convertible notes vs convertible debt is correct.
Dean, I don’t disagree that entrepreneurs should say “No” to a bad deal. But the use of convertible notes as opposed to straight equity sale based on a calculated valuation provides a timing benefit. An angel or seed stage VC can like the company, but find it very difficult to come up with a cogent argument for a valuation decision at an early stage–particularly when you’re pre-revenue or in a brand new and exciting space. To push the valuation discussion at that time can delay the deal while the log rolling over valuation goes on–and delay is not your friend. Using convertible notes allows a much faster close with an interested funding source, and also allows the funding source to obtain equity at a price that is discounted to the next round– obtaining risk credit for being earlier into the deal. Most VCs I know are very comfortable with this arrangement.
Peter
This is an interesting discussion, and I have to bow to Peter’s greater experience, but I always thought convertible debt to be the worst of both worlds for entrepreneurs (and the best for investors, so of course VCs are “comfortable” with it). Personally, as an entrepreneur I would tend to favor capital in the following order from best to worst:
1. pure debt (as long as I have revenues to make payments; unsecured is obviously better than secured for me) — predictable obligation, and no need to give up control except in bankruptcy or maybe for some restrictive covenants; might not be appropriate for pre-revenue startups
2. warrants / options convertible into common equity
3. pure common equity
4. convertible preferred equity
5. convertible debt — allows investors to have downside protection as a creditor, with upside participation upon conversion if things go well; secured convertible debt is a particularly good deal for investors, like having their cake and eating it too.
The context where I would take convertible debt is where a highly desirable investor requests it, and in light of the relationship and the offered valuation, I think it’s a fair trade. But I definitely think it’s a trade.
I’m not convinced about deferring the valuation discussion. How do you determine the conversion price for the convertible note without having a valuation discussion? Are you making the note non-convertible until a future investment round can establish value? Or are you setting up milestones that affect the conversion price? Or…?
This is an interesting discussion, and I have to bow to Peter’s greater experience, but I always thought convertible debt to be the worst of both worlds for entrepreneurs (and the best for investors, so of course VCs are “comfortable” with it). Personally, as an entrepreneur I would tend to favor capital in the following order from best to worst:
1. pure debt (as long as I have revenues to make payments; unsecured is obviously better than secured for me) — predictable obligation, and no need to give up control except in bankruptcy or maybe for some restrictive covenants; might not be appropriate for pre-revenue startups
2. warrants / options convertible into common equity
3. pure common equity
4. convertible preferred equity
5. convertible debt — allows investors to have downside protection as a creditor, with upside participation upon conversion if things go well; secured convertible debt is a particularly good deal for investors, like having their cake and eating it too.
The context where I would take convertible debt is where a highly desirable investor requests it, and in light of the relationship and the offered valuation, I think it’s a fair trade. But I definitely think it’s a trade.
I’m not convinced about deferring the valuation discussion. How do you determine the conversion price for the convertible note without having a valuation discussion? Are you making the note non-convertible until a future investment round can establish value? Or are you setting up milestones that affect the conversion price? Or…?
Zeke,
Totally understandable question in your last paragraph — and one almost everyone has until they actually sit down and read a properly-drafted note purchase agreement and convertible note.
For your benefit (and the benefit of everyone else who’s confused by the deferral-of-valuation issue), here’s a somewhat over-simplified hypothetical that explains how it often works in practice. Note that there are situations not explained by the following scenario, which I can explain to you further offline.
You need money. I loan you $50k. We agree upon a discounted conversion rate. Call it 15%. I write you a check. A year later, Famous VC comes calling. Famous VC puts $1m into your company based on a valuation set *at the time of Famous VC’s investment*. Here’s the kicker: my $50k converts into Famous VC’s round *at the valuation that Famous VC has negotiated* (subject, of course, to the discount, that I negotiated).
Basically, I get about $58k of buying power for my $50k investment (courtesy of the discount) and get to put that money to work at the valuation that we both agreed that Famous VC would negotiate with you, whenever he came along.
In other words, I get the right to buy in at a slightly better price than Famous VC will buy in at (whenever he shows up), and you get your money now, which, presumably, is when you need it. It’s a clever way to avoid setting the valuation either too high (bad because it often result in a later down round) or too low (bad for obvious reasons), and should probably move up your list as a consequence.
Josh
Zeke,
Totally understandable question in your last paragraph — and one almost everyone has until they actually sit down and read a properly-drafted note purchase agreement and convertible note.
For your benefit (and the benefit of everyone else who’s confused by the deferral-of-valuation issue), here’s a somewhat over-simplified hypothetical that explains how it often works in practice. Note that there are situations not explained by the following scenario, which I can explain to you further offline.
You need money. I loan you $50k. We agree upon a discounted conversion rate. Call it 15%. I write you a check. A year later, Famous VC comes calling. Famous VC puts $1m into your company based on a valuation set *at the time of Famous VC’s investment*. Here’s the kicker: my $50k converts into Famous VC’s round *at the valuation that Famous VC has negotiated* (subject, of course, to the discount, that I negotiated).
Basically, I get about $58k of buying power for my $50k investment (courtesy of the discount) and get to put that money to work at the valuation that we both agreed that Famous VC would negotiate with you, whenever he came along.
In other words, I get the right to buy in at a slightly better price than Famous VC will buy in at (whenever he shows up), and you get your money now, which, presumably, is when you need it. It’s a clever way to avoid setting the valuation either too high (bad because it often result in a later down round) or too low (bad for obvious reasons), and should probably move up your list as a consequence.
Josh
After educating myself a little bit, I agree that the terms you describe are typical for a convertible note financing of a tech-focused startup these days. But the feature many people describe to recommend this device — the deferred valuation — could be built into other instruments as well, such as convertible preferred equity, right? All else being equal, I’d rather not give up more rights than I have to in an offering. But yeah, if I need the money and investor connection, and it comes attached to a convertible note — I would keep an open mind.
After educating myself a little bit, I agree that the terms you describe are typical for a convertible note financing of a tech-focused startup these days. But the feature many people describe to recommend this device — the deferred valuation — could be built into other instruments as well, such as convertible preferred equity, right? All else being equal, I’d rather not give up more rights than I have to in an offering. But yeah, if I need the money and investor connection, and it comes attached to a convertible note — I would keep an open mind.
Zeke, having an open mind is important. You’re right, that many of the features built into the convertible note structure can be built into a preferred equity offering. But the beauty of the convertible note structure is its greater simplicity (e.g., Translation: cheaper to put into place) and its recognition in the marketplace. Rather than try to make a preferred equity structure, with all its attendant documentation (and its usual provision of control aspects to the preferred equity holder as you point out), look like a convertible note I think you’re better off going with the original: a convertible note structure that can be tailored to your immediate situation.
Zeke, having an open mind is important. You’re right, that many of the features built into the convertible note structure can be built into a preferred equity offering. But the beauty of the convertible note structure is its greater simplicity (e.g., Translation: cheaper to put into place) and its recognition in the marketplace. Rather than try to make a preferred equity structure, with all its attendant documentation (and its usual provision of control aspects to the preferred equity holder as you point out), look like a convertible note I think you’re better off going with the original: a convertible note structure that can be tailored to your immediate situation.
If anyone is interested, I have started a Google group for shared practice info and curated legal docs. You would be more than welcome to submit a convertible note form and anything else you want to share, or just join up to have access to others’ submissions. The group is currently empty and I hope to get some initial useful forms up over the next month or so. Please e-mail me at zeke.vermillion at gmail if you would like an invite.
If anyone is interested, I have started a Google group for shared practice info and curated legal docs. You would be more than welcome to submit a convertible note form and anything else you want to share, or just join up to have access to others’ submissions. The group is currently empty and I hope to get some initial useful forms up over the next month or so. Please e-mail me at zeke.vermillion at gmail if you would like an invite.
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