Much of my understanding of startup investing has come from reading articles on Bill’s website and we’re really lucky to get him here sharing his knowledge today. Bill welcome to the show.
Bill: Thank you. It’s my pleasure to be with you today.
Nick: So let’s start out with, how did you get into Angel Investing and the venture space?
Bill: Well first of all I was an entrepreneur. I exited my company by selling it to DuPont back when the earth was cooling in 1982.
Nick: (laughs)
Bill: And served out my indentured servitude that would be my 4 year contract with the DuPont Company. In fact indentured servitude sounds so negative that I must tell you it was a wonderful experience. I really enjoyed my years with DuPont and was trying to decide what was next in my life.
And saw a couple of entrepreneurs that needed some finance and joined together with a few other folks and provided them with financing. And probably about 5 checks in I said, “What am I doing?” You know is this an investment class? You know how does this fit in with the rest of my investments? And decided that yep it’s something I was very interested in continuing to do.
And in fact it was about that same time that a gentleman from the University of New Hampshire came up with the expression Business Angels. So clearly I didn’t know what I was doing because there wasn’t even a name for it.
Nick: (laughs)
Bill: When I started doing it. Made my first 2 investments in 1980
Nick: Wow! Back in 1980! Those are some of the earliest I’ve heard.
Bill: Well there were some who say Queen Elizabeth, I’m sorry Queen Isabella funded, provided Angel financing for Christopher Columbus so;
Nick: (laughs)
Bill: Maybe there were some that did it before I did.
Nick: Very good, very good. Okay so today we’re talking convertible notes. Relatively new instrument in the grand scheme of things but more simply Bill can you start us out with what is a convertible note?
Bill: A convertible note is a debt instrument that is designed intentionally to become equity upon some triggering event. So it’s usually an interest bearing debt security. But the intent is that if the company is successful it will be converted into equity at some later date.
Nick: So an Angel Investor for example might use this in lieu of an equity round or a price round. The convertible note would be instead of that but would also be a contract with the entrepreneur by which you’re providing an investment?
Bill: Yes. It’s a vehicle to provide entrepreneurs with financing. It’s just different than buying the equity direct. Or some advantages and disadvantages but it is a debt instrument.
Nick: Got it. And what are some of the key elements in terms included in a convertible note that are often negotiated?
Bill: I would say the; I mentioned earlier the triggers to conversion. And I think that the; those are the key issues. You could have some debate I suppose over the interest of the earned or whether or not it is interest bearing. But most of the negotiation is over the conversion triggers.
In other words, win – may the debt instrument be converted into equity; who can trigger that, can it be triggered by the entrepreneur side or the investor’s side or both. And what’s the nature of the triggering element. It could be time; it could be a subsequent investment. There are several possible triggers.
Nick: What are some of those other triggers? What would be qualifying events beyond the ones that you just mentioned?
Bill: Well those are the primary 2. So if the entrepreneur and board of directors of the company subsequently raise money and usually there would be a stipulated minimum. So the company has to raise at least a million dollars, let’s say as an example, within the next couple of years.
At that point then the debt would be converted into equity. There are other elements related to the conversion feature besides the amount of money. And we can go into those if you’d like.
Nick: Okay. Got it. You know the other day I received an email from a founder. He was pitching his startup for investment and he had already drafted a convertible note. But the email he sent me had 3 bullets. It had discount; it had an interest rate; and it had a cap. Can you walk us through what each of those 3 things are?
Bill: Okay so the first is discount. And what this means is – because the earlier investor who has purchased the debt security or the convertible debt has invested in a time when there’s more risk involved in the company because the company is at an earlier stage. Then that investor deserves some kind of a discount off of the pricing of the subsequent round.
And typically that discount might be 10% or maybe as high as 30%. I’m not sure I’ve seen it much higher than 30 but it’s possible. So let’s say if there is a 30% discount off of $6 million pre-money valuation that was negotiated for the subsequent round; then the investors would be pricing their share conversion at a 30% lower price than the subsequent investors that triggered the conversion.
Nick: Got it. So they get hat discount for taking the earlier round; taking on more risk at an earlier round then they can lock in a better valuation for them in a later round.
Bill: Yes that’s correct. And then the interest rate is simply as we would probably calculate in a bank account. So it’s a, it’s the interest that’s earned on that note for the amount of time that prior to the conversion.
And the cap; the cap is an interesting feature that says, “Okay we’ll, the investors will provide x amount of debt financing to the entrepreneur but the conversion price can be no higher than let’s say 5 million or $3 million”. So if the investor, the entrepreneur and the board of directors are successful in you know hitting a lot of milestones and find subsequent investors who are willing to invest at a 10 or $20 million valuation. But the earlier investor who financed the debt round has included a cap then their shares will be triggered at that point with that at that capped amount. Let’s say $5 million.
Nick: Got it. Okay. So if we had let’s see; if we had a scenario where let’s say there was a 20% discount and the subsequent fundraising round was $10 million. When you apply the discount to that that means that the previous investors would get an $8 million valuation.
Bill: That’s right. Their shares, their debt would be converted up to equity at a pricing of $8 million, however;
Nick: Except if the cap was
Bill: $5 million then it would be converted at the lower
Nick: of the 2.
Bill: of the discount or the cap.
Nick: Got it. Then just recapping the interest piece if there was interest as well then more than just the investment of the entrepreneur but both the principal and the interest would go toward that?
Bill: Go towards the purchase of equity. And the interest rate is of mild interest to investors because they’re primarily interested in converting to equity and the discount that’s involved off the next round. But; and considering that this note usually is not in place for more than 18 or 24 months at most reasonable interest rates it’s not going to amount to a ton of additional shares. But there could be an interest rate involved in it and it could become significant if the conversion doesn’t happen for let’s say 3 years or so.
Nick: Got it. Okay. So before we drill down into some more of these terms and the pros and cons can you illustrate? Or let me start that again; can you talk about when convertible first began to be used and why?
Bill: Convertible debt has typically been used to bridge a company, the entrepreneur and the company from and let’s say for a period of a few months to perhaps as much as a year while they’re securing a very large round of financing.
So as an example let’s assume that an entrepreneur has raised a half a million dollars. They’ve really hit their milestones. They’re doing very well and Venture Capital discovers them and decides, “Wow these guys can really make a go of this company and create tremendous amounts of value. So we’re considering investing you know 5 to $10 million in the company”.
But the entrepreneur could become; you know start running low on cash and the Venture Capital investors are taking longer to complete their due diligence.
So with the permission or the agreement of the Venture Capital investors the entrepreneur might go back to the investors and say, “Look I need a couple of hundred thousand dollars to get us through the next quarter because it doesn’t appear that Venture is going to close on this round for another 90 days. So let’s bridge this gap in financing that we have. You guys put up another $300,000 we’ll give you a, let’s say 10% discount in the pricing”.
And of course that would probably have to be agreed to by all parties including the new investor. The earlier investor put up the $300,000. When the subsequent round comes in, the earlier investors get a 10% price reduction off of the subsequent round of financing.
So it was a bridge note relatively common in many kinds of finance not just venture financing. So that was the origins of convertible debt.
Nick: Got it. In some time over the past few decades was it the speed at which Venture was evolving and the volume of transactions that were going on when this need was identified to bridge the gap? Or was there some sort of catalyst that created the opportunity for convertibles?
Bill: While convertibles have been used relatively consistently over time at some fraction of total deals; I think there were 2 triggering events that increased their popularity. The first was the internet bubble that burst in 2001.
Investors discovered that “maybe these companies weren’t worth this ridiculous $20 million pre-money valuation we were doing on a seed stage round. Maybe a good way to protect ourselves is not to price the round”. And let subsequent investors who, who they assumed would be more knowledgeable about valuation negotiate the valuation. And they would take a debt security and just let the VC’s price the round later.
That started in 2001 and there were some Angel Investors who felt that they were at more secure in having a debt position than an equity position.
The second trigger in my mind that really upped the ante and increased the volume of convertible debt was the explosion that we’ve had in the last 5 years in accelerators.
And Paul Graham and others who have started Y Combinators and the Techstars; remembering that they’re dealing with very early companies, very early stage companies that are very difficult to price said, “let’s just do ’em all as convertibles.
We’ve got, you know we’ve got 20 companies in this new class. Let’s just do them all as convertible debt and when they graduate form their accelerator and they raise their significant round off capital, we’ll just take a discount off of that round. And we use convertible debt to bridge the company to the exit from the accelerator.
Nick: Got it. So this segues nicely into the next thing I wanted to touch on. About 6 months ago there was a pretty healthy debate on Twitter with Dave McClure and I think Mark Shuster, Fred Wilson, Brad Feld; and it was on the merits of convertibles. There’s a pretty good debate on the benefits to using them and the drawbacks.
Can you first highlight the often sited positives of convertibles and why some investors prefer them?
Bill: Well I think you have to differentiate first of all the stage of the company. Companies that are going into accelerators, you know they are really pre-seed companies. They are so early; I mean we all read about the pivots that they do while they’re in accelerators, chartered to finding products that customers might want to buy.
Since these are pre-seed companies, they’re probably earlier than you will see Angels invest in most of them. So since they’re so early and since their product is so ill-defined; or their and their customers have not yet validated the product; in my mind convertible debt is an appropriate instrument for companies that are in or entering an accelerator simply because of their stage of development is so early.
So since you don’t know what the company will eventually become, what their product is, no customer validation; it’s really hard to price these deals. And it surely makes sense for accelerators to use convertible debt for these very, very early rounds.
Another advantage to convertible debt, especially in early stage deals is their simplicity; in that you can usually do a convertible debt in less expensively than you can do a preferred shares round or a common round.
So the lack of ability to price the round because you really don’t know what the company is about yet and the simplicity of simply offering a standard convertible debt to every deal that comes along to an accelerator is an advantage to accelerator managers and those investors who put money into these very early stage pre-seed deals.
Nick: Bill why in your estimation should Angels avoid using convertibles?
Bill: If there is; well let’s put it this way – if the cap which we described earlier is at a price that investors would fund the company today, then I have no problem with convertible debt. In other words if the cap is you know let’s say $2½ million, subsequent triggering the conversion is whatever the event is the funding with more than a million dollars or whatever that trigger might be, is at a price that I think is fair today than convertible debt that would be an appropriate instrument.
The problem is I’ve never seen a cap that’s lower than the median seed stage pricing of Angel deals in the US which is $2.5 million today. So since the caps are always higher, almost always higher, I’ve never seen one lower, than the pricing that we would apply to deals; it means that those who are funding seed-stage companies using convertible debt are paying too much money for them.
Nick: Interesting. Yeah I was talking with Jeffrey Carter of Hyde Park Angels the other day and I think it was off the record I don’t think we got this on recording. But he had mentioned to me that these convertible debt investors are often; it’s kind of a Catch22. It’s almost like they’re routing against the entrepreneur because they don’t want them to be raising at a really high subsequent valuation.
And the lower the valuation the better is for them because then they convert at a really low rate. But that’s counter-intuitive right, because you’re supposed to be betting on the jockeys that you think are gonna do really well and you want to help them do very well. So;
Bill: So if you think back to the drivers that I mentioned in 2001, investors were trying to protect themselves. And their position was well debt is ahead of equity when it comes to bankruptcy.
Nick: Right.
Bill: So let’s say the company’s got some patents or some other intellectual property or some valuable equipment. If the company goes out of business then we stand ahead of even the founders who have common shares.
I agree with you that that’s counter-intuitive. I’m a world class gambler when it comes to Angel Investments. I’m looking for 20 and 30x return on investment. And just like everybody else in this field 50% of my deals give me zero so why bet on the downside. I’m going to look for the upside every time and the best way to maximize my upside is to invest at a low valuation in the first round I invest in.
Nick: Got it. There are scenarios when it may be appropriate for Angels to use convertible debt. You talked about some of those but can you touch on those again and illustrate what those scenarios would be when you think it in fact is appropriate?
Bill: Well I would say there are 2 primary scenarios. We did mention them earlier so I won’t elaborate too much.
The first is when a subsequent investor has already been identified and the company needs runway to get to the closing of the subsequent round; or the round by the subsequent investor. So the company needs a couple hundred thousand dollars to get to a 5 million or a $10 million close. That’s a traditional bridge round.
The second situation which I think favors convertible debt is when you’re betting on a pre-seed deal. As is the case in accelerators when you’re really not sure where the company’s going; you would have great difficulty negotiating a price. You’re very, very early and therefore you’re going to depend upon the subsequent investors to price the round
Incidentally if you think about investing in pre-seed or even idea-stage companies in some cases you might; this would probably be an insult to them; but you might consider accelerator somewhat like friends and family rounds.
In other words they’re investing before there’s been any market validation. Of course accelerators bring much more to the party than friends and family investors. But they’re both investing at a very early stage before there’s any market validation on the product.
So those would be the two situations – Too early to be able to validate the market and so therefore a pre-seed deal and then bridge to a much larger round.
Nick: You know, I came across an opportunity recently. It was an industrial opportunity. The founder had invested a significant amount of his own money in developing this physical, large asset that had value. He had previous investors and he had traction. He was selling a service in this case. He used this large industrial hardware product as a service. And he was focused on raising $3 million to $4 million, and he proposed doing a convertible note as a bridge to this round. Now, I really liked his product. I thought it was very disruptive, but I had concerns about his ability in our environment to raise that large round. Is that a scenario where the convertible note might have been appropriate because, being a debt holder, you would be senior to the equity holders and in the case that he was not able to raise the subsequent round and ran out of cash then the asset would be transferred to the debt holders?
Bill: I think it’s feasible that that can happen. You said the company was trying to raise $3 million or $4 million, and that was a little red flag for me. If you look at all of the investors – let’s just take the US as an example – angels typically, let’s say, throw a half a million dollars at a deal and they may do that in several rounds of investments. The median venture capital round is between $7 million and $8 million, and frankly there aren’t very many VC rounds that are done at $4 million or less. There may be individual VC cheques, but together, two or three of those cheques are getting you up to 5, 6, 7, 8, 10 million dollars. So the number of investors there are in the US that write $3 million cheques is actually pretty small. So the first thing that’s important for the investor here and the entrepreneur is to understand capital sources in the US, and there are very few in sources to come up with $2 million to $4 million in cash. And I would be skeptical of trying to raise that amount of money for any company. And where they’re located is also a key issue. If you’re located in Silicon Valley or one of the other, you know, Boston or Austin or Seattle or LA, if that’s feasible, if you’re located in [00:13:30.01] or Kansas City or Billings, Montana or [00:13:35.09], I will tell you, that size round is really, really tough to raise. So I’ll also… another red flag that went off. I don’t invest in service companies, and most investors don’t. There are very few service companies that scale, meaning can get to, you know, 20, 30, 50 million dollars in revenues and justify a really high exit price. When you’ve got a piece of equipment like you’re speaking of, it may make a difference. But if you think about, let’s say a legal firm or an accounting firm or an HR firm, all your assets walk out the door at 5 o’clock at night, and they may couple together and decide to start a competitor tomorrow. So service companies are not a popular business vertical for most investors. In your case, since that big piece of equipment was required to provide this service, then I’d be considering how many highly trained people were necessary to support that business and where are we going to find them.
Nick: Interesting. Yeah, part of the feedback I had was to move away from the service model, because it seemed like a bad fit for what they were trying to do.
Bill: Yeah.
Nick: But back onto the topic, what happens if an angel invest via a convertible? The startup is very successful and profitable and never does another fundraising round or never has a qualifying event. Is it possible that one will never have the opportunity to convert?
Bill: Well, it’s possible that if the entrepreneur exits and there were no triggers and no time limits, the entrepreneur simply pays back the investor with the stipulated interest rate. But many convertible debt instruments have a time limit involved. In other words, the entrepreneur’s got three years, let’s say, to raise the triggering event. If the triggering event does not happen, then there are provisions in many such notes for default, which means the lender then owns the company. So it simply depends upon the level of sophistication of the security itself.
Nick: And do you often find that an exit will be considered a qualifying event in a convertible?
Bill: No, I would say… It would never be a qualifying event. I mean, there will be liquidation provisions, but you’re not looking to get your money back. You’re looking to convert to equity and sharing in the upside with the entrepreneur. So that would surely not be a desirable triggering event. It may be a trigger just to make sure that the investor gets their money back, but surely would not be a desired exit.
Nick: If we assume that the situation is appropriate for a convertible, and an investor is negotiating the provisions of the note, what are they key terms and the key elements of that note that you would suggest to the investor that they make sure to include and/or pay particular attention to?
Bill: Well, in my case, the terms that one might pick to be critical may preclude other terms. For me, the cap needs to be what today’s valuation is, and that’s going to be $2 million to $3 million in most cases. If the cap is appropriate at today’s valuation, then there would be no discount. What we often see in the cases of a discount is that the discount increases over time, so there may be a minimum discount, let’s say – pick a number – 10%, and every quarter thereafter, the discount goes up by 3% – 5% such that in two years you might be looking at a 30% discount. I have often seen convertible debt where the discount was also capped. In other words, the discount could never be more than 30%. That, of course, would not be an investor-friendly term, but of course, you could also imagine that at 5% per quarter in X number of years, the investor owns the company, because they got a, you know, 100% discount. They buy all the stock they want at zero.
Nick: Right.
Bill: So, there are some triggering issues, but they’re primarily around the cap, the total discount, and the timing. When does the convertible debt terminate such that there is the default? What period of time does the entrepreneur have to raise additional money? And what’s the size of the triggering round? Could it be $10 000 or must it be $5 million?
Nick: This may be a topic for another show, but I’ve also seen some timing implications on convertible notes before the round is closed, where the founders will set up three different term sets for the convertible depending on when you get your money in. So if you get your money in this month, you get a 30% discount. If you get your money in next month, the discount goes down to 20%. And if you wait till the very end of the fundraise, your discount might go down even further. So, it’s interesting…
Bill: Well, that’s not an uncommon offering in this light. Entrepreneurs often need to motivate early money in, and I’ll give you an example on the equity side. But let’s say that the entrepreneur is offering 10% of the company for $250 000, but is planning on an early close. So at the end of, let’s say, 90 days from now, they’re planning on closing as long as they have at least $100 000 that’s in committed investment. And at that closing, if it’s $100 000 or $150 000 or the whole $250 000 they’re looking for, there will be a tenure of 15% warrant coverage which means that the investors have the right at some later date to buy more stock up to 15% of the number of shares that they buy through the equity offering at the same price as this round. And people who come in after that don’t get that warrant coverage. It would amount to essentially the same thing.
Nick: Got it.
Bill: It’s a motivation to be an early investor.
Nick: Yup. Yeah, it’s often tough, I think, for founders to get the first investor to jump in. It’s the riskiest capital often. So…
Bill: So true. One of the things that precludes that, however, is there is often a term that investors include which says that all money is escrowed until the full round is committed. So the entrepreneur must continue to raise money until they get the full half million dollars, let’s say. And any cheques that come in are put in an escrow until such time as the whole half million is raised, or maybe $300 000 of the half million is raised. And that sort-of reduces the risk to some degree for the first $50 000 cheque that comes in.
Nick: Yeah, you know, we only have so much time today, but I’d like to get more of your thoughts on that. So I was shocked when I began angel investing, that every investment was not escrowed. And maybe that’s just region specific. Maybe that’s where I’m at in Chicago. But pulling other angels in the area and other angel groups, it just seems like it’s something that used to be done, and it’s no longer as common. Can you speak to when escrow is used and has it changed over time?
Bill: I’ve not known it to change over time, and I have usually participated in rounds that defined an early close or precluded an early close. So I believe for most sophisticated angels, that defining closing of early closing or, in this case, the cashing of cheques is a very important part of any term sheet. I don’t think we investors generally on that first round of investment want to see our $25 000 cheque cashed and spent only to discover later that the entrepreneur was only able to raise $75 000, and they needed $250 000 to have a chance of getting anywhere. So I think that’s a really, really important aspect of term sheets, be they for convertible debt or for equity.
Nick: Yeah, I couldn’t agree with you more. Give them some money now, and you’re also just extending the runway to raise instead of build the company, so…
Bill: Yup, that’s right.
Nick: Alright. Bill, do you have any other recommended resources on the topic of convertible notes?
Bill: There has been so much information written on convertible debt that I think anybody who simply googles convertible debt will find more information than they can bargain for. I know I have written four blogs on this subject, basically speaking against convertible debt unless the conditions that we discussed earlier were met – that being if it be a very early stage company or a bridge to another round.
Nick: Right.
Bill: So there’s just a whole bunch of information out there. All of the super angels that you’ve mentioned earlier have written on the subject. I think the important thing for the reader is to put yourself in the shoes of the writer, and if it’s Paul Graham for example, remember he’s sort-of talking about, you know, earlier stage deals than most angels would invest in. So it may make more sense in his case than in somebody who only invests in, you know, in a little bit later stage deals. There’s another document, another form of a convertible debt, and unfortunately it’s a skip… it’s a… I’m having a senior moment. I can’t come up with the name. But it’s a convertible debt-like instrument that is in fact not debt. It’s a promise to buy equity. It’s simply an instrument that says, “At the time of a subsequent round you can buy equity, but there’s no interest rate and no cap involved.” Paul Graham, he’s been advocating this for Y Combinator for eighteen months or so, and I’m sorry, but I can’t…
Nick: Is it a safe, by chance?
Bill: Yeah, that’s it. It’s a safe document. That’s right.
Nick: Got it. Okay, we’re going to have to do another episodes on safes. Transitioning a little bit, if we could cover any topic in venture investing, what topic do you think should be addressed on the podcast and who would you like to hear speak about it?
Bill: Well, there are so many that it’s really tough to come up with a specific subject. Let me just talk a little bit about due diligence. If we hear of investors who spend really miniscule amounts of time on due diligence before writing a cheque, you know, they sit down with the entrepreneur and talk for a couple of hours and they’re sort-of ready to write a cheque. And we… especially the super angels sort-of speak against the typical angel because it takes the typical angel a long time to complete their due diligence and, you know, negotiate the term sheet. Now I think the primary reason for this is, most angel groups consist of fifty or sixty members, and they’re investing in all kinds of different business verticals. Super angels probably are investing in the narrowest possible definition of a business vertical, and therefore they already understand that business vertical really, really well. So the amount of due diligence required is low. I would like to hear an angel leader such as Ian Sobieski from the Band of Angels or John Huston form the Ohio TechAngel Fund talk about how their group does due diligence and compare that to a few of the super angels who invest very narrowly and therefore already understand the space really, really well and don’t need to spend nearly as much time on due diligence. That would be one topic that comes to mind.
Nick: For someone who’s new to startup investing, what advice would you give to them, Bill?
Bill: I would advise them, number one, join an angel group. And number two, jump on a due diligence team as soon as possible. There’s no better way to understand how angels do deals and what kind of background information they gather before writing a cheque than jumping on a due diligence team. And don’t assume that simply because you’re on the due diligence team you’re then obligated to write a cheque. It’s a good idea to, but if you’re not comfortable, don’t write that cheque till you’re ready. And the second piece of advice is, I’ve seen angels get very enthusiastic and start writing a cheque a month and so 24 months later, they’re out of capital, they can’t do any follow-on investing, and they haven’t got any of their companies that are anywhere near close to exit. So I would encourage a new angel to write a couple of cheques a year, build up a portfolio of 10, 12, 15, 20 companies over a period of time such that by the time you’re writing your fifteenth cheque for a new company, you’ve got a nice little exit coming along which could allow you then to invest other people’s money in the future – that is, the proceeds from your earlier investment.
Nick: Right. Great. Well, before we wrap up, can you tell us more about what you’re up to these days and what the best way is for listeners to connect with you?
Bill: Well, I spend a lot of time sharing my experience as an angel investor. I’ve done that by leading workshops and seminars in most of the western part of the US and Canada as well as eight or ten other countries. I really enjoy – it’s sort-of a third career – sharing my experience as an angel investor. I still write a few cheques, although much, much less so since it takes ten years to enjoy a good exit, and I’m already in my 70s. There has to come a time when you must realize that you’re putting a load on your heirs by writing a cheque today if you’re not going to be around at exit. So that’s an important consideration. I still spend a lot of time mentoring angel investors and entrepreneurs on raising capital, probably more entrepreneurs than angels, but I do both. And I’d like to take the summers off as much as possible and do a little fishing in Montana.
Nick: Sounds like a great place to spend your summer. So best way for listeners to connect, is that by reaching you on your blog at billpayne.com?
Bill: Or just send me an email at bill@billpayne.com. That’s fine.
Nick: That will wrap up our discussion on convertible notes. I can’t wait to have Bill back again to shed some light on one of the many topics he’s written about. If you want to learn about angel investing, I can’t urge you enough to go to the blog at billpayne.com, although my disclaimer is that every time I jump on there to learn something, it seems like I blink and it’s eight hours later. So be ready…
Bill: Well, thank you very much. Thanks for having me today.
Nick: Thanks so much, Bill. Appreciate it.
