“Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”
I have to say that I didn’t take the question to mean that convertible debt had won for the entire market, but either way it’s clear that convertible debt has become an increasing trend. I’ve written about the topic of convertible debt at length before specifically about how angels & entrepreneurs should think about pricing.
Convertible debt is an investment that “converts” into equity in the future usually at a discount to your next funding round price and sometimes has a “cap” (maximum price).
Clearly this is is a trend and a topic that is interesting entrepreneurs. Funnily enough I just answered this question yesterday on Quora when somebody asked,
“Why would an early-stage investor specifically NOT prefer a convertible note structure to straight equity (e.g. a priced/valued preferred stock financing)?”
Here is my answer with some minor editing:
Why many early-stage investors DO price rounds (e.g. prefer equity to convertible debt):
- If you’re an early stage investor (e.g. angel, seed) you’re taking the most risk. If you’re the “first money in” usually there is still product risk, market risk, financing risk and execution risk
- So from basic econ 101, the higher the risks, the greater the failure rates, the higher the returns need to be to accomodate for those increased failures and the higher risks taken
- Your goal as an early stage investor is specifically to lock in the most fair early-stage valuation you can
- You clearly don’t want to price it so low that the founders don’t feel incentivized so it’s not about the lowest possible price but more about guaranteeing a certain cap
- 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?
How early-stage investors have learned to accomodate convertible debt
- The mechanism that people use to resolve this conflict is a “convertible debt with a cap” meaning that while the funding instrument is still debt when it converts it has a maximum price – a “cap.” Make no mistake – this IS a priced round. In fact, in some ways can be worse for the entrepreneur. It basically sets your maximum price rather than your actual price. Example: If you do a convertible note raising $400k at a $3.6m pre money you’re ceiling is that you’ve given away 10% of the company ($400k/$4m post money). But your actual next round might come in at $2m pre money. You might have been better just negotiating an agreed price in the first place. Not always, but sometimes.
- So why do people do convertible debt with a cap? 1) it can be cheaper to complete the round from legal expenses 2) emotional. Entrepreneurs are increasingly trained to think convertible debt is better (when it’s not always the case)
- I’m OK to fund companies with a convertible debt with cap model for small investments – no problem. In my mind the deal is priced.
Should entrepreneurs ever prefer a priced equity round to convertible debt?
- If you have a choice between pricing a round and not pricing a round for the exact same investors then it is in the entrepreneur’s best interest not to price it and I could understand why one would do this.
- That said, I have seen times where convert with no cap was done and the entrepreneur slightly regretted it EVEN when the got a big up round in the next financing. I know that sounds crazy, but the situation is – you got people that you like, trust, respect as angels that really, really help a lot. You then get a big VC to invest at a high price and you realize that means your angels are going to be unhappy with how much they own of your company after the financing relative to what they THOUGHT they would own. The reality is that as an entrepreneur you really do want to try and keep all of your investors happy and it really is fair that early investors who were willing to take a risk on you before you were a BIG DEAL should really be compensated.
- Also, f you have 2 competing offers from different investors and one has “convertible debt no cap” and the other has a “priced round.” If the second firm or people were much stronger investors I’d take their money all day long even thought it’s priced as long as the valuation / price range was “fair” (e.g. 20-25% dilution). I’d optimize for success vs. exact ownership. Most companies fail and most entrepreneurs who raise money don’t make a return. Therefore anything you can do to turn this into a 1 vs. a 0 is a smart move IMO.
Why would an angel agree to a convertible note with no cap?
- Simple: he/she feels the deal is “hot” and therefore competitive. He/she is hoping to “get in on the deal” whatever the terms may be. I personally don’t believe this makes for a good long-term investment thesis but that’s not for me to decide.
- In frothy markets (like we’re seeing in August 2010) this happens more frequently. In down markets more deals are priced.
- YCombinator might determine that it is best for them but they’re not the typical angel investor. YCombinator runs a program where they get a really wide group of companies involved for which they invest in each one. That’s not the typical angel investor
What about “super angel” funds?
- I think super angel funds may be more willing than angels or VCs to do convertible debt. Super angel funds usually want to invest at really early stages and are putting small amounts of money to work. Therefore if they put $250k into your company and it’s not priced it’s not the end of the world to them (on a $40 million fund) if the eventual round gets done at $8m pre-money vs. $3 million pre-money.
- The reason they might feel this way is that they’re really just placing an option that if you succeed that they’ll have the inside track to invest a larger amount in your next round. I’ve heard at least one super angel tell me this.
- I can understand this investment philosophy since as an investor like this you’re really trying to optimize for finding the few really big deals and price (within reason) will be less relevant. If they got in at $3m pre vs. $8m pre doesn’t matter if the company sells for $500m.
- True that this logic COULD be applied to angels. But angels typically don’t have as deep of pockets and therefore don’t do as many deals and don’t follow as much as do angel funds.
Maybe we should move towards “convertible debt with a price?”
- Thinking about it some more – the biggest reason I keep hearing cited is that the process is so much quicker & cheaper legally than an equity round.
- As I’ve cited the problem I see for investors is the risk of not pricing and for entrepreneurs “convertible debt with a cap” gives them a maximum price but not a minimum.
- In larger rounds I think equity makes sense so that everybody agrees to the terms up front
- On smaller rounds, why don’t we just do “convertible debt with price” and everybody can be happy?
In summary – I don’t believe the “convertible debt” has “won” in the market – especially not “convertible debt with no cap.” The market is frothy right now so terms are bending toward entrepreneur-friendly terms. But as you’ll see in my next post – I dont’ believe this will last for long.
** Image courtesy of 22Dollars.com
(Cross-posted @ Both Sides of the Table)