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Equity versus convertible debt: What’s best for entrepreneurs?

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). Continue reading →

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? Continue reading →

Join the Montreal squad for the 4 city hockey tournament at CIX on December 6th in Toronto

I’ve taken on the challenge to build a team to represent Montreal at the 4-city hockey tournament to be held on Monday, December 6th in Toronto as part of the CIX activities. Teams from Ottawa, Toronto and Waterloo are already confirmed. No one believes we can put a team together from Montreal that would be willing to go to Toronto for the tournament. Robert Montgomery, one of the organizers of the CIX basically laughed at me and suggested I should try out for the Toronto team.

For those of you who know me, I don’t want to just field a team, I want to win the whole thing. Now who’s with me?

I’m looking for players, coaches and sponsors. I would prefer to build a team with entrepreneurs, VCs, angels, and guys who work at startups and technology and gaming companies. Lawyers and bankers are ok if they’re really cool and cover the tech sector. I want to make jerseys and t-shirts, so sponsors will get their chance to shine. I’m also open for other sponsorship ideas. All the players will get a discount for the CIX show. There’s an entry fee for the team, but I’m looking for sponsors to take care of that. In addition to glory, the winning team gets $5K to donate to its local Children’s Hospital. Private networking event and free drinks and beer for all players after the tournament.

Details are likely to change, but this is what I know so far:

Date: December 6th, 2010

Where: Downtown Toronto

Team captains

Waterloo: Brydon Gillis, Brainpark Inc.
Toronto: Matt Leibovitz, BEST funds
Ottawa: James Smith, Labarge Weinstein
Montreal: Yours truly, Real Ventures

Format:
1 hr: games, 2x 20minutes running time periods

Proposed Schedule
Waterloo vs Montreal – 2PM
Toronto vs Ottawa – 3PM
Consolation – 4PM
Championship – 5PM

If you’re interested, please register here.

For updates, follow me on twitter.

Office hours at Montreal Startup Drinks – Angel Forum Edition on October 6th

I will be doing office hours wearing my Real Ventures (I can’t believe we still don’t have a real site up!) hat at the Montreal Startup Drinks event this Wednesday, October 6th, at 7:30PM at the Westin. I made a deal with my wife so I should be there pretty late. I want to meet every entrepreneur in the room, so make sure you look for me and bring your business card. It should be a good event. You can also email me at js@realventures.com in advance of the event with a synopsis of your project so we can have a more productive discussion.

For those of you who are not aware, Real Ventures is the upcoming second fund from the team behind Montreal Startup, the seed fund that provided startup funding to Beyond The Rack, Status.net, Whatsnexx, Recoset, iSentium, Oneeko, SocialGrapes, Vanilla Forums and mConcierge to name a few.