Wednesday 2 December 2015

Seeding with Convertible Notes - Watch for Thorns!


I've seen many startup and early stage companies present their idea and ask for funding in the form of convertible notes. This is a particularly common tactic in the US that has not quite found its way to Europe.

Far be it from me to say the emperor has no clothes, but.....guess what! The emperor looks likes scantily clad.

Mind you, that's not to say all convertible notes are bad.  They are not all bad.  All I'm saying here is that I have many more questions than answers.  Call me a frightened old toddy if you like.  But I have several concerns and that's among the reasons why to date Symfonie Angel Ventures has never bought a convertible note.

What's a Convertible Note ?

Those of you who are familiar with the structure can skip this part.  Those you who would like a bit of a primer - read on!

The convertible note is a way of the investor and the entrpreneur saying - "Valuing a startup or an early stage company is a thankless, almost irrelevant task. Rather than haggle over valuation and ownership stake, we'll agree to put that discussion on hold until there is a real business to talk about, which will be when we do a big financing called an A-Round."

So instead of selling equity the company issues a convertible bond.  The terms of the bond are something like the following:  

The bondholder gets a coupon of (for example), 8%.  Maybe this is paid in cash annually, maybe not. Maybe the interest will be paid in cash when the A-Round happens or when the note matures.  Maybe the interest will be paid in the form of shares down the road.  Every convertible note is different, no two are the same and the first question the noteholder should ask is - "when am I supposed to get my interest and how will it be paid."

The convertible note is a bond, so it has a stated maturity - say five years.  By then in theory the A-Round should have happened, supposedly, so its convenient to just assume maturity is not particularly relevant but just some notional fiction to be dealt with down the road.

So the second question the noteholder should ask is - how will this be repaid when maturity comes along?  Am I supposed to assume the business can re-finance the note?  Am I supposed to take it as a given there will be an A-Round and I will never see maturity?  What if the A-Round never happens at all?  What if the company can't repay?  What then?  Are we supposed to have a valuation discussion or am I supposed to assume the business will have failed?
Third element for the convertible note is the definition of an A-Round and what the note converts into.  Well, tough, to say!  Each note is a different animal, each has its own bells and whistles.  Typical I have seen is - "An A-Round is defined as being capital raising of at least $2,000,000.  When that happens the convertible note is converted into shares of the company at the same valuation as the the capital raising.  So for example, $2,000,000 is raised and the company sells shares with a valuation of $10,000,000.   The convertible note is $500,000 so therefore $500,000 converts essentially into a 5% ownership stake.

Often there is a bell on the convertible note called a "Cap."  The "Cap" is designed to ensure the convertible noteholder gets the benefit of the A-Round in the form of a reduced share price - say, for example 50% of the shareprice that is in A-Round.  So when the $10,000,000 valuation  A-Round comes along the convertible noteholder gets shares equivalent to a $5,000,00 valuation, so actually winds up with effectively a 10% stake, using the numbers above.  The bell is supposed to make the investor whistle away with the headline that there is a 50% discount to the A-Round.

The Devil is in the Details

For those of you who read the primer, you can see that I am just beginning to peel the onion on this topic.  For those of you who skipped the primer the bottom line is - this is a terribly thorny garden of roses so before you even consider walking in you'd best think not twice, but five times!

I went to business school at the University of Rochester.  I'm proud of that so I say that as often as I can.  To this day I marvel at the fact that the William E. Simon Graduate Schoold of Business accepted my application and moreover, that eventually, they gave me a merit scholarship. Priscilla Gumina was the admissions officer at the time.  She stayed there for many years after I left, so apparently my admission was not a disaster for Priscilla and certainly not for me!  Thanks again, Priscilla!

I had a professor at the Simone School by the name of Ron Schmidt.  This is where I get to pay tribute to him, which pleases me greatly.  He was undoubtedly among the best professors I had during my graduate and undergraduate training.

Professor Schmidt gave really hard exams!  They required essays for answers.  But in some ways they were easy.  You see, you got 50% credit if you just started your answer by saying "It depends."  The other 50% of the the credit you got by presenting a concise, well thought out answer that explained what it depends on and what the range of outcomes could be.

So - here's the question:  An entrpreneur wants to fund a startup.  An investor wants to invest in a startup. Is a convertible note a good choice for the investment structure?  

The answer is, of course, "It depends."  Now - onto the meat and potatoes.  There are at least five things every entrepreneur and every investor should think about before walking into this supposed garden of eden.  Here they are:

1. The interest rate - is that paid in cash or in kind.  If paid in cash when is it paid?  Annualy?  Monthly?  Quarterly?  At maturity?  Upon conversion into equity?   A cash coupon is nice!  If the company is successful finding other investors or the company starts generating some revenues, or if the company manages to hang around long enough - say really five years, at 8% I stand to get back 40% of my initial capital.  Forgetting the time value of money, there's something to be said about getting back some capital that was placed at serious risk. 

2. The maturity - What happens if the A-Round never happens?  Or what happens if the A-Round happens but not at a threshold valuation to trigger a conversion?  How will the company repay?  Will the company be able to refinance itself?  Or will the company be bankrupt?  What are the noteholder's rights as a creditor?  Is there any security at all is just a lottery ticket?

3. The business prospects - What has to happen for the company to have an A-Round?  What are the milestones and thresholds that need to occur?  What should the company look like in terms of revenue and profits?  Will the company still be loss making when the A-Round comes?  Will the A-Round be one on a long series of capital raisings needed to keep a company afloat while it looks to build moment and traction?  Some companies lose thousands, millions, even hundreds of millions and stay in business a long time and have multibillion dollar IPOS and make fortunes for the early investors.  That's the exception rather than the rule.

Startup City is littered with a pile of companies that received lots of investment only to go down in a ball of flames when there was no more capital to be found or the next great widget came along.

4. The Convertible Valuation - is it reasonable?  Can it be somehow economically and quantitatively justified?  Does the discount to valuation and the time until A-Round comes compensate for the risk?  Does an A-Round represent a real exit opportunity or is just another step to the exit?  When will the exit finally come and what can the return on exit potentially be?

5. Investor Rights - Does the investor owning the convertible have any rights in corporate governance?  What reports will the investor receive?  What say does the investor have in major corporate decisions?  How much more debt can the company take on?  What are the anti-dilution provisions?  Is the company obliged to set aside cash from capital raising, revenues or profits to repay the convertible? Can the entrprener and equity holders get dividends, bonuses and other cash out before repaying the convertible?

The Bottom Line According to Mike

Here's another tribute to Professor Schmidt.  Once he was lecturing about corporate structure and corporatae taxation.  To this day I remember him pounding his fist in the air and stressing the economic reality. I will paraprhase here, the quote might not be exact.

"You don't tax corporations, you tax people.  Someone owns the economic rights in a corporation.  Some derives economic benefits from the corporation.  When you tax the corporation you are taxing people!   Corporate taxation is one of the five greatest idiocies of the twentieth century."

I never asked Professor Schmidt what are the other four idiocies.  Suffice to say, that in my very humble opinion, Convertible Notes for Startups are a good candidate for one of the other four idiocies.  Hopefully they will not come to the shores of Europe anytime soon.  

Stay Tuned!!!

I laid out a fistful of problems.  I have a good friend and colleague named John Vax.   I had the pleasure of working with him for many years and he used to tell me that when he ran the Capital Markets desk at Commerzbank in Prague his staff would come and tell him about problems.  His reply was often (and again, I paraphrase):

"I know there are problems.  That's why I hired you.  I need the solutions, so tell me how you think we should solve the problems."

Having presented the problems with convertibles, the next blog I write will offer solutions.  Real, practical, honest to goodness solutions I will bring!  How's that for service?

Until then - remember - investing money is easy.  Investing takes no talent, takes no guts.  Investing successfully - well, that's a completely different story.

Want more information about my Angel Fund?  Click here!

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