Beware the Convertible

Below is the “Tip of the Week” transcript from the Podcast Episode 13: The Convertible Note (Bill Payne)

Let’s first touch on the Advantages to using Convertibles vs. a priced-round, from the seed-investor standpoint.  From a startup standpoint, in some cases the advantages and disadvantages are reversed.  The below factors can significantly impact a startup’s and an investor’s situation.

Advantages:

1. The Bridge: When a bridge is required. So, the subsequent investor has been identified but more time is needed to complete diligence and terms. At times, a startup may be out of cash and need some working capital in the interim, before the deal closes. In this instance they can be advantageous b/c the “bridge” investors get a discount on the valuation, the startup is able to keep the lights on and the subsequent investor can focus on completing the true fundraise round.

2. Early-Stage: They have value for very early stage deals that are hard to price where maybe there’s no product and limited to no market validation.

3. Cost: Less costly from a legal standpoint. The contracts are much simpler and straightforward… you’re essentially punting on terms and will inherit whatever terms are set during the subsequent round

4. Speed: This of course, also makes the negotiation and fundraising process quicker, as there’s less to haggle over.

5. Claim on Assets: As discussed, debt is senior to equity. So if the company has some tangible assets, such as patents, then the convertible debt investors can receive these in the case that the startup fails.

6. Anti-Dilution: Implicit in any convertible, is a full-ratchet. Recall from our episode on the Term Sheet with Brad Feld, we discussed full-ratchets, which are an antidilution provision that secures an investor’s equity position in a down-round. So, if a startup raises money at a lower valuation than previous, the early investors get their stake at the lower valuation. Because this is a convertible, the investors may even apply their discount in the event of a down-round. On the whole, I’d expect these situations are rare. An early-stage company that uses a convertible and can not raise at a better valuation has typically experienced challenges and often can not raise at all. However, let’s say the startup does well but capital markets dry up. This could lead to a down-round and a convertible provides that down-side protection. This may seem counter-intuitive. Remember the discussion I had with Jeffrey Carter in our episode on Valuation. As Jeff articulated, the investor is almost rooting against success for the startup b/c that is the only scenario where they got a good deal. When the startup does well, then the cap often applies, and the investor got a bad deal or too high of a valuation for a seed-stage investment.

Disadvantages:

1. Valuation: Bill explained that if the Cap on valuation is equivalent or less than what the equity round valuation would be set at, then he believes that it’s a fine instrument to use. But, he’s never seen a case where the convertible cap was lower than the standard seed-stage valuation, which is around $2.5M. So, if the company does well, and raises a subsequent round at a higher valuation, then the seed investors got a bad deal b/c they should have received equity for a $2.5M valuation, for example, but with the standard cap being higher than the standard equity valuation, maybe it was $3M or $4M… the seed investors receive less equity for their money upon conversion.

2. Liquidation Preference: We talked a little earlier about liquidation preferences for events that happen prior to a subsequent fundraise. We did not, however, talk about their affects in the event of a subsequent fundraise. Mark Suster cautions that another hazard of the convertible is that seed-investors get a multiplier on their liquidation preference. So, very simply, if the seed investors get in at a $3M post-money and the A investors get in at a $12M post-money, the seed investors are issued shares at the A Round, post-money valuation and thus the total number of their shares issued are 4x higher. While I understand his point, and encourage you to read his article on the subject, I do not agree with him here. This may be a disadvantage, in a way, to the Series A or B Venture Capitalist, but it’s table stakes for the seed-investor. Let me explain… When evaluating a convertible, I think you have to compare it against doing a traditional priced-round at the seed stage. If the seed investors, in this example had done a priced-round at $3M then their liquidation preference, for the percentage of ownership is exactly the same as if they do the convertible. I view this more as a watch-out for seed-investors that use someone else’s convertible note template that somehow tries to separate classes of preferred and common stock that one will receive upon conversion.

3. Struck Provisions: While I have not experienced this myself, we have discussed before on the podcast that really aggressive investor terms can limit a startups ability to fundraise. At times a VC may require an aggressive term to be struck or they will not proceed with the Series A. I have heard from others that these terms can be removed in the case of a convertible whereas it wouldn’t happen in a priced-round. This is because the convertible depends on a future event and the party with the most power at that future event can exert it how they see fit. For example, an early-stage investor that enters a priced-round at a $2M valuation, gets their equity at that valuation. It belongs to them, they’re not giving it back and they may even maintain their percentage through pro-rata. That same investor let’s say negotiated a convertible with a $5M cap and a 20% discount that escalates 20% every 6-months until the Series A close. If the startup takes off, but it takes 18 months for the subsequent close, this investor group is now sitting on a 80% discount. Assuming the VC establishes a valuation at $10M, they may threaten to walk if the seed investors don’t adjust-down their discount.

4. Preference: This is more of a watch-out as opposed to a disadvantage, but as an investor, make sure that your note is a “Convertible Preferred.” This just means that, upon conversion, the investor is granted preferred stock instead of common. This is the standard and we have talked about preference in the past, so we will not recap it here, but it should be a requirement for any investor and could be a major oversight, if not accounted for in the terms.

5. Pro-Rata: Another weakness can be pro-rata… which is not always stipulated in the converible. We talked about the importance of pro-rata on prior episodes with Brad Feld and part two with Jeffrey Carter. Pro-Rata is not automatically granted to convertible note holders, it must be specified. I was recently engaged in a series of tweets with Dave McClure and others where he cited his frustration with VCs that were not extending pro-rata to him for convertible note agreements where it wasn’t specified. Hi message was, “We will remember and may not work with you again.” Dave and 500 Startups have a lot of credibility that, I’d imagine, many VCs heed. However, even in his case and certainly in my case this will not be extended if I don’t have the right written in.

Some investor’s love them and others hate them. Regardless, there is a place for the convertible and it’s more important that seed-investors and startups know why, when and how to use them. Otherwise, like most things in this industry, it can be a bad outcome for both.

UPDATE*

*The below update was not included in the original episode on The Convertible Note

Disadvantage  6. Pre and Post Money Caps: Another watch-out for investors is that many convertible note caps apply to the pre-money valuation, not the post.  Remember that Bill talked about how the standard post-money valuation for a seed stage company is $2.5M, yet the caps are often higher than $3M, so this is a bad deal for the investor.  Well, if the conversion occurs at pre-money, than it is an especially bad deal for the investor.  Not only did they miss out on the $2.5M valuation, but now they are paying for equity at $3M + the amount of the Series A raise.  Here is an example:

Standard Priced-Round

Seed:

  • Pre-Money Valuation:  $2M
  • Raise:  $0.5M
  • Post-Money Valuation:  $2.5M
  • Investor Equity:  20%

Series A:

  • Pre-Money Valuation:  $6M
  • Raise:  $2M
  • Post-Money Valuation:  $8M
  • Seed-Investor’s equity is diluted by :  25%
  • Assuming no further investment, seed-investor equity stake is now:  15%

Convertible (cap is at post-money valuation)

Seed:

  • Cap (post-money cap):  $3.5M
  • Raise:  $0.5M
  • Discount:  20%
  • Interest:  0% (for simplicity)

Series A:

  • Pre-Money Valuation:  $6M
  • Raise:  $2M
  • Post-Money Valuation:  $8M
  • Cap or discount applies?:  The Cap of $3.5M applies
  • Post-money Valuation for the seed-stage investors:  $3.5M
  • Assuming no further investment, seed-investor equity stake is now:  14% ($0.5M  / $3.5M)

Convertible (cap is at pre-money valuation)

Seed:

  • Cap (pre-money cap):  $3.5M
  • Raise:  $0.5M
  • Discount:  20%
  • Interest:  0% (for simplicity)

Series A:

  • Pre-Money Valuation:  $6M
  • Raise:  $2M
  • Post-Money Valuation:  $8M
  • Cap or discount applies?:  The Cap of $3.5M pre-money applies
  • Post-money Valuation for seed stage investors:  $5.5M ($3.5M cap + $2M raise)
  • Assuming no further investment, seed-investor equity stake is now:  9% ($0.5M  / $5.5M)

 

 
   

   

Listener Feedback

Pete Maglio

The takeaways to end this episode are fantastic! Thanks @TheFullRatchet & @BenEinstein! pca.st/Fey4 #smartHardware #startups