Busting the myths about convertible debt financings
A lot has been written about the benefits and disadvantages of equity and convertible debt financings for founders and investors in recent months. Paul Graham of Y combinator seems to believe that all startups should raise convertible notes. Seth Levine from the Foundry Group implies in his post “Has Convertible Debt Won?” that convertible debt is generally good for entrepreneurs and bad for investors. I also like Mark Suster ‘s post and Fred Wilson’s thoughts on convertible debt. I believe that equity is the investment vehicle that gives startups the best chance to succeed. In addition, it is the only funding mechanism that ensures the interest of founders and investors are aligned, which I argue is the single most important trait of successful startups.
A lot has been written about the proclaimed advantages of convertible debt financings over equity. I want to use this post to bust some of the myths and highlight some of disadvantages of convertible debt for both founders and investors, and talk about the benefits of equity financings. For more information on no cap convertible debts, check out my other post about the Alphonso Labs – Pulse financing.
Busting the myths
Convertible debt financings are cheaper than equity.
In our seed fund Montreal Startup, we have completed the vast majority of our seed equity financings for less than $10K. In fact, I believe we can easily get to $5K per transaction for our next fund with the use of standard docs. At this level, convertible debts don’t offer any cost advantages. Besides, clarifying the share terms and finalizing an initial shareholders agreement between seed investors and founders right at the beginning with more founder friendly terms is likely to improve the quality of those terms at the series A or B levels as a precedent has already been set. This approach should also reduce the closing costs of the next round as the terms will already have been negotiated. Finally, an equity investment doesn’t accumulate interest, thus reducing the long-term costs of the transaction (10% interest on a $500K investment is $50K per year).
Convertible debt financings are easier to close and close faster.
Some people argue that pushing out the discussion around valuation and the terms of the shareholders agreement to the next round makes it easier for entrepreneurs and investors to get a deal done fast. That’s probably true for convertible debt with no cap, but I would argue that other terms like interest rates, discount on the next round, and conversion scenarios in the event of an acquisition are also terms that can take time to negotiate. For convertible debt with a cap, that argument doesn’t hold water. You still have to negotiate a cap. Caps are problematic for entrepreneurs and investors. Investors are likely to want the cap to be close to the valuation they would expect in an equity round. Founders will want to see a price closer to the valuation they expect at the next round. Assuming both sides can agree, this cap sets a precedent for the next round investors who may use it to negotiate their price if the deal isn’t super competitive.
My biggest issue here lies with the assumption that closing a deal fast is a good thing for founders. In my opinion it’s the complete opposite, unless the entrepreneur has known the investors for a long time and has done business with them in the past. As an entrepreneur, as mentioned above, it is vital to know who your investors are and make sure the interests are aligned. Closing fast is unlikely to let you achieve that. The same can be said for the investors, although they have much less to lose than the entrepreneur in this scenario. Once an investor makes the decision to invest in a company, the want to secure their position as fast as possible. Once an investor is in, you can’t easily get rid of him. As an entrepreneur, do you really want an investor with whom you can’t negotiate a fair deal in a couple of weeks? I don’t think so. The negotiation of an equity investment is an important step in the building of a strong founder-investor relationship, and the sooner it comes, the better. You’ll learn a lot from each other during the process.
Convertible debt financings provide less dilution for founders.
This one is tricky as it really depends on how well the company does with the seed money and who the seed investors are. A small fraction of companies hit it out of the park with their seed money and hit every milestone they planned for and more. For those companies, the next round is likely to be done at a higher valuation than the proposed cap, but it’s not guaranteed. I lot goes into getting a series A done (existing investors, size of opportunity, location, timing, market, competitive landscape, macroeconomic issues, etc.). If the company does really well but fails to prove its business beyond a reasonable doubt, like most companies end up doing, chances are the series A round will be hard to raise and the valuation won’t hit the cap. There is no downside protection for founders in convertible debt financings. That’s a big problem. In addition, your interests as a founder are not aligned with your investors as they are likely to at best be apathetic about the valuation since their debt instrument converts at a discount. Since investors holding convertible debt benefit from a lower valuation, some may even use the situation as an opportunity to get a better deal.
In the event the company misses its milestones, the entrepreneur is screwed, regardless of whether there is a cap or not. The entrepreneur has no leverage with its investors. If everyone starts on the same side as partners, as they do with an equity investment, these tough situations are much easier to deal with. A company with a convertible debt hanging over it is much harder to fund than a company with a clean cap table. So unless the company is in the top 10% and everything goes according to plan, convertible debts are bad for entrepreneurs.
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.
Advantages of equity financings
Alignment of interest
Equity financings provide for the best alignment of interest between founders and investors, which is key to the success of a startup. Once the deal closes, entrepreneurs and investors stand side-by-side, both holding equity in the company and ready to take on the rest of the world. If the valuation of the company increases, both investors and entrepreneurs benefit. If the going get’s tough, investors are closer to the entrepreneurs than they would if they were holding debt and more likely to be supportive. When the next round comes around, investors will team up with the entrepreneurs to get the best possible deal from the best possible investor. The same holds true for early acquisition offers. As an entrepreneur, you are much more likely to get the support of your investors in such a scenario if they are holding equity and getting a good return in the transaction.
Getting to know your investors
To complete a seed equity round, entrepreneurs have to push their prospective investors early, agree on terms and conditions (including valuation!) and agree to get diluted, but they’ll learn a great deal about themselves and their prospective investors in the process. Negotiating an equity financing is an important learning experience for any founder. Entrepreneurs should spend as much time with their prospective investors as they would recruiting a partner or senior executive to their company. Time is not the enemy. Making a mistake about an investor could make the next few years of an entrepreneur’s life miserable. If you’re a founder, spend the time, get to know your investors and get a deal done.
Companies that raise equity have clean balance sheets with no debt and positive equity. In addition, equity doesn’t come with any monthly interest expenses that either have to be paid on a regular basis or accumulate over time.
Equity financings provide flexibility
Regardless of whether the company is hitting it out of the park, is just doing well, or is having a hard time, as discussed above, a seed equity round provides more flexibility to the entrepreneur and the company, especially if it raised money from an angel or seed fund. No valuation expectations linked to a preset cap for the next round. Full baking from existing investors to get the best possible deal. No requirement for a specific investor to take the majority of the next round. Enough room to attract external investors. Clean balance sheet. Ability to accept early acquisition offers without having to deal with debt conversions. With a negotiated shareholder’s agreement in hand, both seed investors and founders can team up to put pressure on new investors to abide by the rules set in the seed round.
It is true that equity seed rounds create dilution for founders. That being said, equity provides more clarity as to what the future holds than a convertible debt round. Building successful companies from scratch is difficult. Removing complexity and improving clarity early is a good thing. You never know what the future holds.
I like to think that I have a pretty good moral and fairness compass. With that in mind, I believe it’s fair for an investor who works his butt off and does his best helping the entrepreneurs he works with to benefit from that work when the company does well. Equity is the best way for entrepreneurs to compensate their investors for their contribution. It keeps them motivated. Guys like Jeff Clavier of SoftTech VC, Dave McClure of 500hats, Brad Feld of Foundry Group, Ron Conway of SV Angels, Josh Kopelman of First Round Capital, Reid Hoffman of Greylock, and Fred Wilson of Union Square Ventures, to name a few, work like mad to help the companies they invest in succeed. Although some of them will do convertible debentures, I’m convinced they all prefer equity. It just makes sense. Founders and investors, hand-in-hand, working together to change the world.
I’m sure I missed a few important points but you get my drift. I’m a big fan of seed equity rounds.