Convertible Note vs. Priced Preferred Round

Convertible Note vs. Priced Preferred Round

 

The form of an investment is an on-going issue for Angel Investors and Startup entrepreneurs.  This post describes the differences between a convertible note and a priced round, the benefits of each, and recommendations for investors, service providers, and entrepreneurs.

A priced round is easy to understand.  Each investor in that round is told the price per share, and is issued shares (generally preferred) at that price.  Legal fees for a priced round are usually in the range of $25,000 to $50,000.  So for a small round, the legal fees can be a significant portion of the round.  Also, many entrepreneurs and investors cannot agree on the valuation of the company to set the price.  I believe that this is the wrong reason to avoid a priced round, because it is indicative of a deeper problem and fundamental disagreement between the investor and the company.  Would you buy a car, where you didn’t know the price till you had driven it a year?

Many lawyers recommend that startups offer investors a convertible note, a form of loan that converts to equity when the next round is closed, usually with some form of discount.  It is both quicker and incurs lower legal fees than a priced round.  In general, these notes are used to “bridge” a company between two funding events, e.g. between a friend/family round and an institutional round.  There are several key parameters in these notes.  They are outlined below (with what I consider average values in Seattle today):

1)      What is the term of the note?  This can range from 3 months to 18 months.  In general, most of the deals I see have a term between 6-12 months, where 6 is more investor friendly and 12 is more entrepreneur friendly.

2)      What is the discount?  This discount can take two forms.  One is a plain discount, where the investor gets a price per share that is less than the next investors.  The second, is the issue of warrants, where the investor gets warrants issued as a discount (e.g. 1 warrant for every 4 shares = 25% discount).  This is to some degree related to the term – the longer the term, the higher the discount.  It is rather common for the discount to increase with the term (e.g. 20% for the first 6 months, then increasing by 5% per month for the next three months).  Currently, the discount is about 20-30%.

3)      What is the interest on the note?  In general this is either prime plus some percent or a fixed percent.  Lately, I have seen 8% annual.

4)      Is there an assumed value?  This takes two flavors in the docs.  First is what happens if the company doesn’t raise its round before the term of the note.  For example, if the company issued a 6 month note, but didn’t raise its round, at what price does the note convert?  Usually, investors will insist on a price that is prevailing for the company at the time the note was issued.  This is often the last round pricing.  For Seattle startups, without a final product or customers, that is typically in the $1.5M to 2.5M range, but there is great variability depending on lots of factors.  The second flavor of the value is what will happen if the company is acquired before raising the round.  For example, if the company takes in a convertible note for $1M, but then sells for $100M before the conversion?  Unless otherwise specified, the investor only gets their principal plus interest (in this case $1M plus 8%), while entrepreneur gets the other $99M.  As an investor, I like to be aligned with the entrepreneur, so would set an assumed value in this case, so that the investor has their choice of either the principal plus interest OR conversion at a fixed value (say $5M) in this case.

5)      Does the investor get any say in the terms of the round? When the company raises their round, it might be at terms that the investor would never have agreed to, but rarely has the right to do anything about it.

So, in conclusion, investors like priced rounds, and usually fight for them.  Entrepreneurs often benefit from convertible notes.  If the note is short term and has reasonable terms, it’s not a bad idea.  However, there has been a trend for longer notes (more than 6 months), at a time when the next financing round is not pending.  In essence, this is the company asking the investor to put up their money to build value in the company so that they will then pay a much higher price per share.  As an investor, not something I’m inclined to do.

Why the VC Model is Broken

Why the VC Investment Model is Broken

 

Before anyone worries about my title, Sequoia, Kleiner, and NEA will be fine.  Any of the very top Valley firms see hundreds of deals a month, only do a handful every year, and have all the capital they need to finance even the largest startup plans.  Since they are on sitting on a series of large funds, their management fees allow them not only to make sufficient money per partner, but also pay for any resources they need to both attract good deals, but also bring on board luminaries to help them understand where the market is going. 

In contrast, the small and medium size firms (and anyone on less than fund 4) have a very different situation, particularly if they are not in Silicon Valley or Boston.  Let me illustrate this with an example.  Let’s say Fund X has $200M under management, has 5 partners, and plans to have their money allow for four years of investment.  Then each partner invests about $40M during the life of the fund or about $10M each year.  Considering that each partner does on the average about 1 deal per year, which means that each deal must be about $10M invested and reserved into each company.  Very few of the small or mid-tier VCs work alone, so that means that 2 or 3 VCs per deal – all with the same model.  Therefore, the plan is that each startup take in at least $25-30M in invested capital.

So given this reality, what must this company’s exit look like to get a venture return of 5-20x? Let’s use an example – an early-stage startup called Putrats.   Assuming that the VCs own 50% of the company, with the Putrats option pool being about 30% and the founders and seed investors having only 20%, then the value of the company must be about $50M to break even.  (Of course, things like liquidity preferences change that.  And could make a $50M acquisition valueless for the employees and founders!  More on that in another blog.)

For Putrats to qualify for an A round with a $10M pre money valuation, it must be an advanced startup, with product, revenue, and customers.  (You could quibble and say that’s not really a startup, but then you would be making my point!)  It is for this reason, that most VCs are no longer doing the same kind of seed and early stage investing that VCs of the last generation did.

So how does this work for the VCs?  This model will work if the IPO market is robust, but it is not and I don’t believe it will come back any time soon.  Most companies get their liquidity from acquisition.  (I used to be in the corporate acquisition business at Microsoft.)  While a very few exceptional acquisitions will occur at $250M, most will be in the $20-50M range.  The VCs that control the board and the preferred equity won’t accept a $50M buyout.  Instead they will continue to pump more capital into the company to grow bigger, eliminating all but a few acquirers.  This further dilutes the founders and seed investors.

So why do VCs do this?  And why to Limited Partners continue to invest?  The answer is a great paper story.  Let me explain. 

Let’s assume that Putrats’ first financing was done at a $10M pre-money and raised $8M, with each of 2 VCs taking $4M, or a post money valuation of $18M.  In the second round, they were joined by another VC who puts in $10M and the 2 previous ones each put in their pro rata of $6M.  In this example the post money valuation would be almost $50M and the VCs would now own 60% of the company.  This is fairly typical example. 

So why does this appear good to investors?  The first VCs in the deal get a write up on their $4M, since the value of the company has increased from $18M to $50M.  On paper, their original $4M investment is now worth over $8M.  Since the second round is usually within 18 months of the first, this looks like a fabulous return!

But at a $50M post money valuation, Putrats would need to be worth well more than $100M in acquisition value to get the same return on the new money, so the investment syndicate (now in firm control of the company) will reject any acquisition offer that is less than that.  It is a vicious spiral for the entrepreneur, who finds that their share of the company shrinking and exit options fewer.

This will catch up with the VCs sooner or later.  Management fees are 2-3% per year.  So for FundX, that is 2.5% of $200M or $5M per year.  Assuming that the active investment period allowed by the LPs is 5 years, and then the management fee decreases by half, then the total fees for a 10 year fund is $37.5M.  That means that FundX only invests $200M – $37.5M = $162.5M.  In order to break even (make a positive return), FundX needs to make 23% just to dig itself out of the hole. 

So why isn’t this obvious? – the J curve.  Historically, every VC fund loses money in first few years and then makes it up later; this is called the J curve.  Because the average time from investment to liquidity is about 7 years for a startup (except during the bubble years of the late 90s when the time to liquidity was very short), the only real metric that can be used to value the portfolio is the post-money valuation of the latest round!  So, on paper the VC return looks good for many years past when the result is set in stone. 

So… unless market conditions go back to very highly valued companies, one can expect lots of fallout.  I expect that VC will fall out of favor.  There will be consolidation, and dislocation ahead.