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I started writing this post while working on my presentation for Enterprise Toronto‘s Small Business Forum 2010 on raising capital for high growth businesses. I’m by no means an expert at this topic, but there are a lot of basics that entrepreneurs and growth businesses can learn about both the type of capital and when to raise it. But Manu Kumar‘s (LinkedIn) must-read post (and the comments) about his Thoughts on Convertible Debt got me to thinking I would publish my list of resources. And Adeo Ressi‘s (@adeoressi) thoughts on Year of the Startup Default includes implications for entrepreneurs raising a lot of debt, because if Series A funding is more difficult to find than getting traditional bank loans or other sources of capital become more difficult with a large, even capped, debt load. There are a lot implications for entrepreneurs.
The starting point for my now almost 6 month old talk is the fantastic article by Bernard Lunn on Read-Write Web, The Capital-Raising Ladder, which defines the different types of capital that is available to startup companies and founders. The “ladder” concept is key in the article. Entrepreneurs generally have to start at the bottom of the ladder and work their way up each “rung”. Certain entrepreneurs can skip some of the rungs on the ladder particularly if they have had success in the past, i.e., it’s way easier for someone that has built a successful publicly traded company to raise angel or VC money than a student first out of school, but since much of this is a meritocracy it is easy for young entrepreneurs to demonstrate their ability to build successful companies and raise additional capital.
The implications of Manu Kumar’s post and Adeo Ressi’s are about the prevalence of startups raising convertible debt with angel investors because it is en vogue. Nivi (@venturehacks) has provided some of the best advice on founder fundraising at Venture Hacks and some good analysis of the impact and benefits of debt for entrepreneurs in his comments:
“Notes were good technology a few years ago but now there are better technologies like Series Seed that have many of the benefits of debt (speed, simplicity, less negotiation). And debt is pretty complicated when you really look at it. I’m guessing we’ll be back to equity in a couple years, for the better. But Series Seed and other equity docs need to be tested a bit more too.
2. You can work around this in two ways. The company can’t pay back the debt and it converts to equity at maturity. I always include these in debt agreements.” – Babak Nivi comment on Thoughts on Convertible Debt
The goal here is for entrepreneurs to have access to information to make informed decisions. I hadn’t thought about the impact that the potential debt load might have on Influitive’s ability to raise loans vs financing in the future.
I’m interested in the thoughts from Boris Wertz (@bwertz), Roger Chabra (@rogerchabra), Scott Pelton (@spelton), Chris Arsenault (@chrisarsenault), Mark MacLeod (@startupcfo), Craig Netterfield (@cnetterfield), Jordan Banks (@Jordan_Banks), Ben Yoskovitz (@byosko), John Philip Green (@johnphilipgreen) and others.
- What are the unique implications for Canadian founders in that are unique to the considerations for convertible debt?
- What are you thoughts on convertible debt notes as an investor?
Resources for Entrepreneurs
Here’s my short-list of resources around the mechanics of raising money and evaluating the documentation.
- Venture Hacks
- Brad Feld’s Term Sheet Series
- Term Sheet: Price
- Term Sheet: Liquidation Preference
- Term Sheet: Participating Preference
- Term Sheet: Board of Directors
- Term Sheet: Protective Provisions
- Term Sheet: Drag Along
- Term Sheet: Anti-Dilution
- Term Sheet: Pay-to-Play
- Term Sheet: Dividends
- Term Sheet: Redemption Rights
- Term Sheet: Conversion
- Term Sheet: Conditions Precedent to Financing
- Term Sheet: Vesting
- Term Sheet: Information and Registration Rights
- Term Sheet: Right of First Refusal
- Term Sheet: Voting Rights and Employee Pool
- Term Sheet: Restriction on Sales, Proprietary Inventions, and Co-Sale Agreement
- Term Sheet: Founder Activities
- Term Sheet: Initial Public Offering Shares Purchase
- Term Sheet: No Shop Agreement
- Term Sheet: Indemnification and Assignment
- Term Sheet: Compelled Sale Right
- Term Sheet: Contentious Issues and Lawyers
- The Challenge of The Ideal First Round Term Sheet
- Liquidation Preferences
- Venture Capital Deal Algebra
- Seed Series
- Financing Documents including Stock Purchase Agreement, Term Sheet, Investor Rights Agreement and Certificate of Incoporation
great aggregation here, David…thanks! will pass along this URL to some of our Hamilton based entrepeneurs, eh!
:-)
Jim
I introduced a founder to an investor group lately, and was disappointed that their conversation broke down even before it started.
This 1st time entrepreneur started the discussion by saying that he was looking only to do a convertible debt deal. The investor (representing his group) said that he was confident in pricing early stage startups and, besides, could only do equity deals. So that was it.
Given how few early stage investors there are in Canada, I don’t think entrepreneurs can afford to walk away if they don’t see they structure the like. Same is true for investors–there is always only so many good local deals, and its a shame to have good opportunities break down over these matters. Both parties should focus on how fast the business can build value, and then seek to find a suitable investment structure once everyone is excited to work together.
Hi John,
I agree. I am less concerned about the mechanism of investment (personally), I like convertible debt in certain situations but would not disregard a priced round on the investment vehicle alone – other issues like price/valuation might be a bigger sticking factor.
I wonder if that entrepreneur had specific issues that required the convertible debt vehicle.
I’ve done both convertible debt (on follow-on rounds) and venture debt. The classic reasons debt sucks still apply for all debt types, even convertible debt:
-it matures and can be called
-you have a life and death situation for your company when that happens. It really, really, really sucks when somebody has the power to kill you by calling your debt. You have to disclose this to people and it also sucks to disclose this to a big strategic partner. “Yes Guy at Verizon who wants to re-sell my product, I am sure Paul Graham won’t call his debt maturing in 8 months. Yes, we’ll still be around in 1 year, you want to do business with us. No I know that he hasn’t actually done something about the maturing debt yet.”
-you then have to negotiate with zero leverage. So the bondholder often says this “I won’t call your debt if you pay me interest”
-the one thing that sucks more than maturing debt for a young company is ongoing interest payments, slowly painfully bleeding $10k/month is very aggravating
-you have real issues with managing credit with suppliers, partners, retailers, etc who want to take financial risk and have some leverage/seniority in liquidation events
I am also extremely skeptical about any investment vehicle that has only been used in a “boom” times. I don’t think convertible debt has been well tested in busts. I have a feeling whenever we hit the next bad swing and “RIP Good Times” comes around again, there will be a lot of discussions about convertible debt. People forget that Angels & VCs hit cash crunches as well.
Standard term sheets have been around long enough now that they solve almost all the problems with doing equity, and give you the same advantages of convertible debt.
I have to admit I get really, really frustrated when I hear entrepreneurs tell me they are doing convertible notes so they don’t have a board and retain control. Who the f are you trying to invest that you don’t want them involved at the high-level of a business?
David, good on you for bringing this issue to the forefront again. Things are getting quite frothy on the funding side and it is worthwhile to explore the options within the context of the current environment.
This debate has been raging back and forth for a good time now. And we can all try and argue the pros and cons and one side or another. IMHO, John is correct, I think it is ultimately up to the entrepreneurs to layout a financing structure that they are most comfortable with. And for investors to find a way to work within that structure so that everyone achieves their goals. There are enough levers (price cap, participation rights thresholds etc.) that even investors who have traditionally only done equity deals can make a debenture deal work, and vice versa.
My advice to entrepreneurs would be to never let an investor force a structure on you that you are not comfortable with. That’s no way to start a partnership.
Great subject, worthy of a blog post respons, but in summary, i can at least answer the following:
We (as a VC firm) typical only do convertible debentures in portfolio companies, with the sole purpose of helping bridge to a certain financial milestone.
Our business model is not built around loans, lending or any non-equity structure, its built around equity ownership and investing at specific stages where we feel we add a certain additional value beyond the cash, where we think that with our contacts in the industry we can help address the gaps and therefore provide the entrepreneurs with some support to help mitigate risk, thus create value. We want to help entrepreneurs build big businesses.
So asking for a convertible note, without us already being an equity owner in the Company, simply doesn’t fit our model. There are other firms that do high risk debt, subordinate debt, loans and credit margins.
You can go as fare as comparing a VC providing convertible debt to a startup the same way a Company approaches a customer with a new product, where the product is the equivalent to the funding and the client is the equivalent of the VC:
“What if I wanted to sell you a product, but couldn’t tell you the price yet, but I really want you to use my product and I want you to implement it into your operations. And once you do, a few months or even a year after, I come back to you and tell you the price that its worth (and for your support I give you a 20% discount on the price I just set). By the way, I’ll use your feedback over that time period to gather market intelligence in order to be able to fix the highest price possible for my product, and once I know what that price is, it get you to either accept it or give the product back!
So, do you think its a good deal? It’s a great product, want to start using my unpriced product now or wait until I price it?
This is great advice. And Roger I really love your personal commitment to put the control in the hands of the entrepreneur. It is refreshing (though lots of my other VC friends share a similar view). It’s great to hear you say it out loud.
I should note that I’m on talking about convertible debt for seed rounds, I think its the perfect tool for bridges, etc where the investor already has equity.
As Canadians, we all follow what’s happening in the Valley (in fact, I suppose that is true for all industry participants outside of the Valley). We have a portfolio company moving there now (Rewardli) and have met some other companies at the seed level. From the outside looking in, all I can say is that reality there does not match with reality here.
There, entrepreneurs are setting terms and have a plethora of choice when it comes to putting small (sub $1M) rounds together. I think they do debt because they can and because there is a perception that equity takes longer.
Entrepreneurs are raising many months of runway selling a small % of their company. That’s great for them, but I think a lot of these folks are getting spoiled at the seed level and may be in for a rude awakening when it comes to series A for 2 reasons: 1.) Terms and process are tougher; and 2.) the follow on ecosystem has not kept pace with the seed ecosystem and is not going to support all the companies getting seed funded. Expect casualties.
John correctly points out the reality here. We just don’t have enough investors for entrepreneurs to choose from. Also, sophisticated investors know how to price deals and are in the business of owning equity.
Entrepreneurs need to think about alignment. As an investor, I can say I’ll be way more engaged in a company I hold a meaningful amount of shares in than one where I don’t. Go for reasonable valuations and build a partnership vs. a motley collection of unengaged investors.
Finally, when it comes to the role of debt, remember that a business that is burning cash has no business having debt on its balance sheet without a big equity capital base to backstop it. And as a seed investor, seeing a lot of debt (that by the way, ranks ahead of me on liquidation) limits my downside protection on a deal leading me to either walk away or price that extra risk into it.
I’ve written about this in the past (although I didn’t take any absolute sides) – http://www.instigatorblog.com/convertible-debt-vs-equity/2010/09/01/.
I think people should think of it this way: “Right tool for the right job.” You don’t bring a toothpick to a street brawl. Or something like that.
Convertible debt seems to be ideal for bridge round type financings, when there’s an expectation that the value is going to increase substantially in a short time, and the entrepreneurs aren’t ready to commit to an early price. The investors know or expect that the conversion will be quick, so it’s not sitting there for years, which benefits no one. It’s essentially a loan and should be thought of in that way.
I can see Canadian entrepreneurs being concerned about pricing rounds because the price they’ll get is lower than in Silicon Valley. It’s just as simple as that. The market conditions here are different (they always will be) which keeps valuations lower. They’re lower in New York than Silicon Valley too so this isn’t unique to Montreal.
If you want to take a shot at a crazy valuation and/or great terms on convertible debt, you should move to the Valley and give it a shot. Doesn’t mean you’ll get it, but at least you’ll experience the fishbowl.
At the end of the day, I would bet that in most cases the ownership stake of founders ends up being around the same whether they originally received convertible debt or equity financing. If in the end you’re going to end up with X% or +/-5% of X anyway, I’d lean towards pricing it and getting it over with. What really impacts ownership stake is the overall success of the company, which isn’t determined by how you took financing in the first place.
Great post and discussion, David – without being too repetitive, here are a few thoughts:
– Prefer equity over convertible loan but open to the later if it makes sense for everybody involved
– Would never participate in a convertible loan without a cap
Having said all that, I am getting increasingly concerned that greed has taken over a lot of the fund raising discussions (especially in the Valley). Many entrepreneurs only seem to be optimizing for valuations but not for the quality of their investors. Building a start-up is a tough, long haul and the best strategy to come out on top after 7 or 8 years is to have smart, experienced and committed investors on your side. Value is mostly created by the exit price, not necessarily by saving 2-3 % in equity along the way by optimizing for valuations. If you keep this in mind, the whole convertible note vs. equity discussion becomes a bit artificial.
Hi David,
For the types of early stage deals I am interested in, I am a fan of convertible debt usually with some sort of price cap. Basically, I like that it postpones the prolonged and sometimes awkward discussions around valuation (although can provide an early boost to the future valuation if the round is handled properly), reduces legal fees, gives me some economic rights but doesn’t mess w/ the control that founders deserve and keeps everything really simple and quick at a stage where time and business focus are paramount.
Jordan
David great conversation. I line up with Boris – money is neither good or evil and the same goes for structure. It is all about who your partner is. Find an investor who loves your idea and can add REAL value to making it happen. Getting tied up in knots about structure is not what it is about. Convertibles are fine from a VC perspective and often takes away some of the crazy discussions about valuation when it just isn’t possible to know.
I disagree with Ben about location/value dynamic a little. The border is getting erased and this is a good thing. Quality entrepreneurs are finding quality investors with some acceleration. Look at the round Kik completed with Fred Wilson. Everyone in Canada will say the valuation was crazy, but folks down here said that of Facebook @ $100M pre and Twitter @ $30M, GroupOn @ $60M, Zynga $100, and on it goes. They are now all trading for $Bs….
The reality is we are at the junction in time where, with relatively little capital, massive global businesses are being created. If Canadian entrepreneurs have a big vision and show exponential user engagement, capital that shares their vision will come. I spoke with three founders in Canada this morning who all just closed big $ rounds in the last 2 months.
Radiant6 will not be the biggest company that Canada has in this cycle. The MoLoSo is a massive tail wind.
Chris “build a $1B company” Albinson
Very good article and it will help me immediately as our MVP is near completion and ready to go. I understand that convertible debt can be a good tool instead of equity. I’m getting better traction from equity when i include our Eligible business corporation status (30% BC provincial tax credit), possible RRSP involvement and possible 750k lifetime capital gains exemption. In some cases a person is only risking 27% of their investment.
For convertible debt does anyone know if its converted into equity can a EBC credit be claimed? Assuming i stick with BC investors.
A couple of points in the cap table will not make a big difference in the end outcome.
A million more or a million less in pre money valuation will not make a big difference.
Whether the instrument is equity vs convertible debt (with a reasonable cap) will not make a big difference.
As Canadians, I think we need to spend less time debating these issues and more time building great companies.
Thanks George,
Sometimes I find it useful to put myself in the shoes of the investors to better understand their arguments for an against different funding mechanisms. My goal for entrepreneurs wasn’t to get into a detailed breakdown of the advantages or disadvantages of different financial vehicles, but to get our funders to share their thoughts to help educate and inform entrepreneurs about how the funding sources treat this.
Agreed, for entrepreneurs we need to focus on building great companies.
Congrats on 500Startups. Keep on killing it.