High-Res Financing, High-Res Hangover: Low Resolution Thoughts on Convertible Notes and Priced Rounds

Mark Suster, a GP at GRP in SoCal and all-around good guy, wrote a very detailed post on the perils and unintended consequences of conventional convertible debt financing structures. His post struck a chord as he echoed (no pun intended) a lot of the views i have expressed to entrepreneurs over the years. His follow-on post, which was spawned by a vigorous discussion on twitter (twittercussion?) last Saturday among Fred Wilson, Dave McClure, Chris Dixon and Mark, was a great summary of the key elements that entrepreneurs and angel/seed investors both focus AND defocus on.

While I liked a lot of Mark's content, I was particularly tickled by the illustration on 'reconfigurable' liquidation preferences or, what I like to call the Jacobs Ladder* of Liquidation Preferences.

Unless I missed it, the one thing Mark didn't point out was the actual effect on the pre-money pricing of a post-convertible note round. He gave the example of a round that's priced at $12 pre, raising $3m and with a post of $15m. I will assume, for purposes of my adding color to this issue, that there was $1M of tiered conventional note financing in place (that is, multiple small infusions at different 'price points' with a cap + discount + interest). So the entrepreneur walking around the post-financing party circuit preening about his/her $12-pre/$15-post round that just closed completely misses the point that (s)he just got his/her engine block reworked. The new investor doesn't care (because (s)he got the targeted 20% ownership stake) but the entrepreneur+team got their ownership completely recast, probably to a point whereby the effective pre is closer to high single digits simply because of the high-res financing hangover.

High res financing, high res hangover. (my remix, Paul).

So here's our bottom line:

(1) Despite the oft-stated pros and cons, we are fine with convertible notes. It's important to understand that a lot of the c-note financings actually don't have a lead. Putting in the first $50K or $100K via a form of c-note doc that is just a copy and paste of what one found on the 'net (or blindly repeats your last deal) does not make you a lead. Lead-less (or party) rounds can be high-res value OR stress to entrepreneurs so we are sympathetic to the most optimal structures that can support the get-to-done objective.

We won't do the most recent variant (no cap, no interest, no discount) that we hear some excitable YCombinator companies may have floated (or gotten folks to invest off of). In addition, we have zero interest in investing in 'hot' deals and even lesser interest in acquiring startup logos for the sake of cocktail party chatter.

It's worth noting that in bankruptcy, secured debt always has greater priority than equity, whether common or preferred. Of course, most of these companies wont ever go through the process so that point is mostly moot.

If we do c-notes, we will have basic terms like a baseline multiplier on acquisitions prior to actual conversion, pro-rata floor rights in the next (priced) round, etc.

Occasionally, we hear of folks seeking MFI (most favored investor) rights whereby certain investors want the benefit of a full ratchet even in the absence of the priced round framework. We imagine that this is a function of the gamification of note financing and how 'celebrity' investors seek to leverage celebrity to get better pricing, often with no real exchange of value forthcoming.

We have used warrants (or a similar structure) to get a slightly discounted price in exchange for an early or 'anchor' commitment OR to lower the price but not impact the optics. Since we don’t really buy into social proof as a substitute for effective due diligence, once we decide we like the opportunity, we are good to go, subject to agreeing on terms.

It's worth noting that not all warrants are the same. A warrant convertible into preferred will enjoy a liquidation preference and thus is always 'worth' more than one convertible into common, particularly in a blah exit aka an acqui-hire. Note as well that if you do a priced round and you get a market price for the seed preferred with a common stock kicker (serving as the 'discount for optics'), depending on the exit, that discount may turn out to not amount to anything, meaning all the investor's returns were concentrated in the grossed up preferred price as a function of the exit multiplier.

(2) Priced seed rounds are great. They keep everyone on the same page and generally offer the same terms. Yes, issues like board seats, pro-rata thresholds, et al. will come up but nothing that can't be dealt with, particularly by an experienced lead investor who can set a price and terms and help syndicate aka corral/herd cats. The key dependency here is the need for an experienced lead. Yes, seed financings offer tons of opportunities for angels to help fund the next generation of high value companies but it's easy to take the process for granted, despite the fact that YC has made it 'easy' for their grads.

However, the priced round can become an issue if left open for too long and then existing investors become resentful because they accepted a different risk profile than later investors. This is a tough one to manage because it's the entrepreneur's responsibility to ensure his/her startup doesn’t run out of cash. In this case, I would suggest to the investors already on board to take up the rest of the round. If they choose not to, this creates a set of signaling issues that are outside of the scope of this post.

In closing, it's important to note that a lot of the current conversations around the topic of financing structures for seed-stage companies are almost exclusively US-focused. Our 'triangle offense' focus on leading/driving seed-stage tech investing activity in certain underserved markets (sub-Saharan Africa and SE Asia) will mean we will be doing a lot of entrepreneur and investor education in those ecosystems re: similar structures, albeit appropriately localized. If you are interested in this, look out for our EchoPlex™ learning sessions. We have run a few so far for entrepreneurs and women-in-tech in Lagos and looking forward to doing many more.

Life is a series of trades. Pause and think through your exchange framework. Then put on your big boy/girl pants and step into the arena.



*There’s a very interesting, albeit technical, paper by Chris Calabro on the 'Theory of Jacob's Ladder' @ http://bit.ly/QAjR4h