Often when startups who have raised venture capital need another round of financing they will turn to their existing investors to give them money before raising from outsiders. This happens when the company has been making steady progress but hasn’t built enough “proof” to raise its next round of financing from external investors.
The traditional way that this type of financing is offered is what is known as “convertible debt.” This means that the investment does not have a valuation placed on it. It starts as a debt instrument (e.g. a loan) that is later converted to equity at the time of the next financing. If no financing happened then this “note” may not be converted and thus would be senior to the equity of the company in the case of a bankruptcy or asset sale.
If a round of funding does happen then this debt is converted into equity at the price that a new external investor pays with a “bonus” to the inside investor for having taken the risk of the loan. This bonus is often in the form of either a discount (e.g. the loan converts at 15-20% discout to the new money coming in) or your investor will get “warrant coverage” which is similar to an employee stock option in that it gives the investor the right but not the obligation to invest in your company in the future at a defined priced.
There is a primary reason that inside investors give companies convertible debt rather than just giving you the money as equity. VC’s money comes from mostly institutional investors called LPs (limited partners). They trust the judgment of the VCs to source, finance, help manage and then create some sort of exit for the investments that they make. They also trust VC’s to determine the right price to pay for the company securities that they buy.
But when a VC is already an investor in a company and when they can’t raise external money it would set off a potential “red flag” with LPs. ”Why weren’t they able to raise external capital?” Or more importantly, “How do I know you’re paying the right price to invest in the company? Maybe the market views this as not worth the price you paid? Or maybe you’re biased and just investing because you’ve ‘fallen in love’ with the company and lost your objectivity.” Whatever the case, VC’s usually don’t want to be seen to be driving price on a deal in which they’ve already invested.
So by offering convertible debt you can avoid a price discussion in the same way that angel investors sometimes do in order to win competitive early-stage deals. The industry jargon for convertible debt is a “bridge loan” or “bridge financing.” It’s called a bridge loan because it’s meant to provide enough capital to bridge you from your last round of funding until your next round of funding. Basically it is supposed to give you enough runway to prove some milestones and make it easier for your to raise money from an outside source.
But I used to jokingly refer to bridge loans as “pier” loans. You know, because they give you a bit of runway but somehow it never seems like enough money to get you to the other side of the river. I understand the mentality of why investors do this. They want to give you enough money so that they don’t have a bankruptcy on their hands but not so much that if you eventually struggle to raise money they have lost even more money. Basically they get the chance to see how you perform “on a short leash” and if they feel you’re doing well they can just keep extending the length of the pier 1-2 months at a time.
For me Pier Loans fall under the category of “penny wise, pound foolish.” What VCs who have never been entrepreneurs and have therefore never been on the receiving end of small bridge loans don’t realize is that they skew the behavior of startup management teams in ways that can be self destructive. You can only really know this for sure if you’ve been in these shoes. You get the bridge in place so you breathe a sigh of relief that you’re going to live to fight another day but suddenly you because overly cautious. You don’t want to be staring at a payroll that you don’t know if you’ll make again. You don’t want to have a perpetual tin cup in your hands begging for scraps to exist.
So startup CEO’s in this position make compromises that don’t necessarily benefit the long-term potential of the company. They might not replace an engineer or two that quits. They might put the kibosh on company travel and not attend some key meetings or conferences. They might decide to delay new product features or upgrading technology infrastructure. They likely are extending payments to debtors way beyond that expected payment terms and start damaging supplier relations. And equally damning is that the culture inside the company drifts insidiously from confidence to cautiousness. From pragmatic risk taking to risk aversion. And startup CEO’s can often suppress the anxiety that goes along with the funding uncertainty – even to themselves. But no doubt their bodies feel the stress. And it adds up.
So my view is that VCs and entrepreneurs need to make tougher choices. The sh** or get off the proverbial pot judgment calls and the answer isn’t always “let’s fund.” I had a friend recently call me who had been offered a pier from his VC. He had raised about $500,000 in seed funding that lasted a long time. He got a good degree of user adoption but clearly hadn’t proven his model. He talked to his investors about a $250,000 bridge loan (7-8 months of runway). Initially they acquiesced but when it came time to funding they only offered him $100,000. This is literally what I said to him (almost verbatim)
“Honestly, [name], I wouldn’t take the money. You’ve been busting your arse on this opportunity for the past 18 months. You’ve kept a really low burn rate and paid yourself a very small salary. That’s the risk you’ve accepted and the commitment you’ve made. I’ve seen the progress you’ve made but you clearly haven’t knocked it out of the ball park. If you think you can still get a good return for your investor you should respectfully request that the minimum amount you’ll take is $250,000.
Tell them that if they’re not confident enough to put the whole amount in you’d understand. The business hasn’t been an unmitigated success. But if they do put in the money you’ll work your butt off to do everything you can to make this company a winner. If they don’t have the confidence that you can pull this off then you’d be happy to help either shut the company down in an orderly fashion, sell the assets to somebody on the cheap or help transition the company to somebody else to run it.
I told him that if they’re going to drip feed you (at $100k he’d have less than 3 months of cash) it wasn’t worth staying. His scarcest resource was his youth and the energy he had to put into startup ventures when he has no kids, no mortgage and no major encumbrances. He had already given things his best effort.”
Frankly, if investors weren’t willing to write the $250,000 check that they had promised it seemed clear to me that he had lost their support or that they weren’t convinced in the future. These aren’t angel investors or family friends for whom $250k might be a big deal. These are institutional VCs. I couldn’t see any reason for him to continue to kill himself in that context.
So there you have it. Sh** or get off the pot. Have the conviction to back your companies enough to really give them a chance to prove themselves. I’m not talking about endless amounts of money but at least funding 6 months gives them 3 months to show progress and 3 months to fund raise. Better even still if there’s a way to fund 9 months. It’s legitimate to ask for cost cutting if you think the bridge won’t last long enough at the current burn rate.
But if you’re tempted to offer a pier (or if you’re tempted as a startup to take it) I think you’re better off looking in the mirror and asking yourself the tough questions about why you lack the conviction. You might have legitimate concerns that warrant not funding the ongoing operations. But piers are often counter productive.
(Cross-posted @ Both Sides of the Table )