Full disclaimer … we like SOME convertible notes: Ours, and others that are properly structured. A good convertible note should offer an appropriate level of upside to early investors, while avoiding downstream complications that can occur when a company is priced too early. Our standard convertible note term sheet, and others we like, contain the upside features for note holders such as optional conversion provisions in the event of an early exit or at maturity, a valuation cap, and time based discounts. Specifically, we like to see the following in convertible notes:
1. Optional conversion into equity when the company is acquired before the note is converted. Ideally there is also an option for the note holder – us – to take a liquidation preference if the pre-negotiated equity valuation isn’t above a certain hurdle rate. At the end of day, we take far too much risk to merely have our note paid off with interest.
2. Optional conversion into pre-negotiated equity at the end of the term when the company is doing great but there has been no conversion event.
3. A valuation cap. This ensures our early, high risk money gets compensated commensurate with its value to the company.
4. A discount on conversion that increases over time, incenting teams to move as quickly as they can to get to the conversion event. We think that a company that does a conversion event in the first few months of the term of the note should be rewarded, and this is a good alignment of company and investor interests.
On convertible notes without these features, early investors may be taking risk disproportionate to upside potential. Delaying the pricing of equity gives the team time to create more value in the company before heavier control provisions are appropriate. While notes are technically debt instruments, philosophically we treat them as equity investments.
What about common stock? Popular with many incubator programs, common stock runs the risk of prematurely setting the company valuation. If priced too low, the company founders may have set a precedent that makes it hard to raise a larger future round. And if priced too high, it can create problems when pricing options for new employees, and if the price is really high it can set the stage for a future down round – or worst of all make a future capital raise nearly impossible because of a broken cap table. Common stock can also get buried under stacks of liquidation preferences – definitely risky for early investors.
And preferred stock? We like the new, lighter weight Series Seed or Series AA preferred structures that have emerged in the recent years, but only when raising a reasonable amount in the seed – say at least $250,000. These are much simpler than traditional Series A Preferred – lighter weight control provisions, fewer reps and warrants, and resultant lower legal fees.
But again, does it really make sense to value the company at such an early stage? Maybe, maybe not. Let’s look at our record.
In the 36 investments we did in PSF I, 8 were convertible notes led by other investors, 5 were priced preferred rounds led by others, and the rest were on our paper. In sum, about 2/3 of the time we have invested on our own paper; the remaining deals were done in a structure defined by someone else that we could live with. Bottom line, we don’t want to lose an investment in a good company just because of paper – as long as that paper is reasonable.
We use the following guidelines to help determine if an investment structure is “reasonable” or not, based on how much a company is raising at the time of the investment:
· $50,000 or less - either common stock or convertible notes (notes preferred, but common stock can make sense in select circumstances).
· $50,000 to ~$250,000 - definitely convertible notes.
· $250,000 to $500,000 - convertible notes or Series AA / Series Seed.
· $500,000 to ~$1,000,000 - Series AA / Series Seed usually makes the most sense.
· $1,000,000 and above - Series AA / Series Seed, or the traditional full-on Series A.
Because our initial investment is typically $25,000, we use convertible notes when we’re leading to optimize our risk/reward position for our investors while removing odd provisions that could cause issues with later stage investors.
Let us know your thoughts!
Angela and Jim