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Are convertible debt with no cap deals good for entrepreneurs: the Alphonso Labs – Pulse financing

I wanted to address the convertible debt deal with no cap that was recently done for Alphonso Labs by Redpoint Ventures, Greycroft Partners, Mayfield Fund, Lightspeed Venture Partners and an unnamed fund from the perspective of the entrepreneur and the company. I don’t want to get into Angelgate and angel-VC relationships for now. In this financing, 5 investors invested $200K each in a convertible note with no cap. Most of the press about this transaction describes it as a great deal for the founders and the company. I’d like to argue the opposite. For the five VCs investing in Alphonso, maybe except for Greycroft which has a smaller fund, $200K doesn’t even qualify as noise. It doesn’t show up on the radar. They could write this off tomorrow and no one would notice. They are obviously making the investment to buy an option for the next round. As a founder, you want investors who become an extension of your team and sit on the same side as you. I’m not sure how having 5 investors with nothing to loose and an option to buy shares in your company in the future helps in any way. That being said, I don’t have all the details so the comments below are not necessarily specific to this transaction but to a hypothetical transaction similar to it. For more information about the subject of convertible notes, you can check my other post on the subject “Equity versus convertible debt: What’s best for entrepreneurs?” Now let’s look at the different possible scenarios:

1- Company hits all their milestones and more: In this scenario, the five investors want to reinvest and do more than their prorata. I’m sure they all have rights of first refusal on the next round. Who sets the valuation? Who negotiates the terms? Who takes the board seat(s)? For most of these funds, their model is to deploy a minimum of $10M per investment and return 10X that. That’s 5 X $10M X 10 = $500M. These economics only work if the company sells for over $1B. How many of those have we had since the collapse of the Internet bubble? How can the entrepreneur accommodate all them? In this scenario which should be all positive, the entrepreneur is likely to have to manage a situation with five unhappy investor who cannot deploy as much capital as they want into the deal. In addition, the company will not be able to raise outside capital as the 5 investors are likely to take everything that’s available. If there’s no outside capital, the valuation discussion is likely to be strenuous at best. In this scenario, had the company raised a seed equity round with angels, it would be in a position to run an auction for its next round and pick the right investment partner to help the company achieve its vision. Not sure this is the situation a founder wants to be in if he’s hitting it out of the park. Shouldn’t he be building the company instead?

2- Company is doing well but misses some of their milestones: In this scenario, you’re likely to have some investors who want in and other who aren’t sure, although the herd mentality may get them all to rally behind the ones who want in, especially if the additional capital commitment is minimal (less than $2M per investor). Many of the points above apply here as well. Valuation and terms and conditions discussions are likely to be difficult. No one’s getting what they want. The valuation of this round is likely to kill any positive impact coming from the no cap nature of the initial debenture.

3- Company is doing average to bad: In this scenario, the founders are screwed and the company is not fundable. The 5 VCs are unlikely to invest and as such, the company is likely to be unable to raise an outside round. With the herd mentality in the VC world, who would invest in a company where the 5 VCs already in it have decided to pass? In addition, in the event the entrepreneur convinces someone to invest, the company is stuck with a debenture on the balance sheet that will need to convert, likely at a lower valuation than the seed round valuation had it be equity instead of debt. Not a good situation.

4- Company gets an attractive acquisition offer: I’m guessing that there is wording in the agreement to cover this scenario, giving investors conversion rights of some sort. On the one side, you may have an entrepreneur who would welcome the opportunity to put $20M in his pocket. On the other, you have 5 VCs who each need to return a minimum of $20M for this investment to be worthwhile for them. I can’t see how this situation can end well. Somebody is going to get hurt in the process.

In summary, I don’t think it makes sense for entrepreneurs or companies to put so much pressure on themselves so early to potentially reduce the effective dilution of a seed round. If the company is a runaway success, the reduced dilution won’t have a material impact on the entrepreneur’s standard of living. If anything goes wrong, that deal is likely to make his/her life miserable for the duration. As an entrepreneur, keep things simple. Negotiate a deal with your prospective investors and bring them in a an equity partner and make sure the interests are aligned.


#1 Equity versus convertible debt: What’s best for entrepreneurs? — JS Cournoyer on 10.12.10 at 2:02 pm

[…] Are convertible debt with no cap deals good for entrepreneurs: the Alphonso Labs – Pulse finan… → […]

#2 Michael Whitehouse on 10.12.10 at 3:33 pm

This is an excellent treatment of a complex subject matter. Should be a must read for founders … it could certainly spare some young entrepreneurs many headaches and much frustration.

Really well done.

#3 Alexis Smirnov on 10.13.10 at 12:17 am

Thanks for the analysis, JS.

The fact that there’s no cap on the convertible note seems immaterial to the outcomes here. In order words, the issue here isn’t so much the structure (convertible debt, no cap) – it’s the make-up of the angel round.

#4 JS on 10.13.10 at 12:42 am

Thanks Michael, greatly appreciated

#5 JS on 10.13.10 at 12:45 am

Alexis, in essence you are right. The article was not meant to compare the benefits of convertible notes with no cap in relation to convertible notes with caps. As an entrepreneur, no cap is usually better. I just believe that equity is a better option. Check out the other post for a more detailed discussion on that.

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