West coast note vs East coast equity….aka Tupac vs Biggie

If you are an investor or startup looking to raise capital you are most likely in one camp or the other, but first a short reminder: If you are a startup looking to raise capital for the first time you should be more concerned about raising capital however you can with the right investors and operating your company at low costs then about only using equity or convertible notes for that raise.

Valuation

What a horrible word we all use in the early stage pre-revenue startup world. When I hear that word I gasp like a nun does after hearing a 6 year old say, “fuck you”. How to arrive at the almighty valuation at this stage is an age old debate much like our friends Tupac and Biggie have been through. Not surprisingly the valuation debate also holds a coast bias. East coasters tend to side with using equity to arrive at a valuation and West coasters tend to say a convertible note (and it’s hybrids) is a fair way to kick the can down the road and value the company at a later date. I’m more on the Biggie side of this argument and I’ll tell you why.

  1. Convertible notes and their hybrids are valuation events. Sorry Silicon Valley and accelerator world but you’re only fooling people with the, “this isn’t a valuation event”, rhetoric. If it’s not a valuation event then why doesn’t every startup come out with convertible note with a $50,000,000 valuation cap? That would be ridiculous right because they wouldn’t be able to raise in the future? So what happens when a seed stage startup comes out with a valuation cap of $6,000,000? First, they are assuming greatness within about 18 months because they really should be more like $1,000,000 or $2,000,000 if they are planning correctly. Second, startups using convertible raises are not valuing their early investor dollars fairly….(rough math) $600,000 raise on a $6,000,000 cap if it all works with a 20% discount means an investor coming in with the substantially important $100,000 investment would end up with roughly 2% in the firm and is squarely facing a non meaningful 2x on their money if post money valuation of the “professional round” was at $10,000,000. When you consider some advisers/consultants/board members get 0.25% to 0.50% in equity options (with cliffs) for no money in and only for 5–15 hours of work per month the $100,000 is getting screwed over ESPECIALLY if they are involved as much or more (which all day 1 investors should be). Three, later round investor dollars crush convertible note investors via dilution. Most of the time those investors don’t get the right to re-up their investment so not to face dilution. So if the $10,000,000 valuation above over time gets to $100,000,000 (2% = $2,000,000) then you are talking 20x ($2,000,000/$200,000) paper return? Nope. By then your day 1 investor, who so generously believed in you enough to cut a check and get you to that promised land, has seen his investments diluted to hell and their 20x is more like a 5–10x assuming they had no rights to buy in at later rounds which is often the case. Yes, I understand later round investors coming in with millions or even tens of millions have leverage and also deserve multiples if things work out, but why are day 1 investors getting slapped when they were possibly the most important investment you had? Remember there is no Series A without a Seed round.
  2. Convertible notes are cost effective and you don’t need to worry about registering with regulators? Cost shouldn’t be an issue because it’s a nominal amount when dealing with proper investors and many times they already have templates made that require minutes of changes only. Sure you can pick up a convertible note or SAFE agreement for free from your local coffee shop but once a proper stock purchase agreement is made so is it’s template and changes for a new investment cost a nominal amount if anything. Meanwhile registering with regulators is a headache for sure, you may have a couple other documents to file with the state but the actual costs of that is in the hundreds, perhaps sometimes just over $1000 (which by the way the investor is likely to cover and also remember equity investors typically invest more than if they did a convertible note so you’ll have a little extra cheese to cover this cost). Again, it’s not a big deal and I can say from experience once you take the day to complete that compliance you feel pretty damn good. And if you can’t figure it out ask your investor to help because they should have been through it before enough to make it relatively easy for you. If you still can’t figure it out you may have other business issues that are good for everyone to know about early on.
  3. Convertible notes are more straightforward and protect startups vs stock purchase agreements? Every contract, no matter if it’s an accelerator freebie or a stock agreement written by a 100 year old asshole law firm can be like the devil to you. Read them. If something is BS, doesn’t make sense, isn’t what you verbally discussed then say something. If you can’t get back to a comfort zone walk away because that investor isn’t for you.
  4. Convertible notes protect my equity and gives me a better chance to succeed and raise money later? Hmmmm. Bezos owns 12% of Amazon….I highly doubt he raised with convertible notes and seems to be doing pretty good. Gates? Don’t know but I am willing to bet it wasn’t convertible notes. Peter Thiel / Facebook 2004? Not sure again but willing to bet it wasn’t a convertible note. Yes, haters there are certainly cases of successful convertible note runs. My point is at the day 1 investor stage there has to be recognition of the importance of that investment and it’s only going to come with an equity valuation play. And don’t fret young startups…you will make your millions and millions if things work out.
  5. Convertible notes, SAFE’s and KISS’s can create false valuation events (if they are not properly valued) that attempt to lock in soaring unfounded values later on. To me they also create less incentive for investors to be actively involved with efforts to succeed, they typically set too high a cap which hinders future fund raising (side note: Do SAFE’s have a maturity date? That will be awkward.), they call for perfection and they can be littered with horrible terms for investors and the startups. Also wouldn’t investors invest more in equity rounds then debt rounds? They are more aligned for sure so I would think so.
  6. I’m a debt holder and get rights to assets if things go bad. So what? In the majority of cases what the hell assets are there going to be?
  7. If they don’t raise or meet their own terms for raising and notes don’t convert are they actually going to pay you back? Are you going to sue a startup with no money and no value in assets? No. No surprise in a situation like this and that doesn’t mean you would sue if you held equity.
  8. When a company is less than 2 years old, has no sales, no clients, no proof of concept an investment at that stage should simply be considered a partnership buy in. Yes that’s right….dodge the old valuation question again but in a new way here. If the investor truly is going to work alongside their check shouldn’t they be considered equity partners? Equity partner as in just like that kid from college you were about to give a 10% stake to just for joining? Please note this is acceptable only for certain check sizes. If you are investing less than $25,000 you should go with a convertible note or a hybrid.
  9. Convertible note investing is a game of ratcheting up the value at the expense of the new investors. Yes they set the price and the converts get a 20% discount to that money. That’s great but not so much for new investor and how would it have gone down if the first investors just took equity? How would that then look to the new investor? Think about your cap table….a messy investor table is not a good thing to have in the future. Is there such a thing as a messy active partner cap table? If there is a way to get around the messy cap table through a note then you are looking better.
  10. Unicorns today have created more FOMO then we have ever seen before and I think that directly effects the number of convertible deals being done. So many investors are getting into companies just for the logo or the chance to win the lottery that they gladly accept the quick and dirty convertibles. The more they invest in the better their chances of obtaining their ultimate goal, “I was an early investor in X”.

Partnership Buy-In

The idea of a partnership buy-in is something I think about quite a bit. Assuming they are like me, early seed stage investors are partners with a check. They work for the entrepreneur, they utilize their resources, network, experiences, etc until the day comes, like it does for many founders, to step aside and let someone else step in. When I say work for I mean they work for the startup company like an employee, on a daily basis, like they are a true partner. Just because they didn’t know the entrepreneur growing up, they didn’t work with them at their last shop, doesn’t mean the investor can’t be that person. The precarious situation about valuing the company is still present but I think it’s been played down with this approach as it should. Think about it like this…When you are starting up a company and talking to friends and colleagues about joining you do you say to them, “the split will be 60/40 because the company is worth $1,000,000” or do you say, “we would split it 60/40 because that’s what you’re worth to me and I need you to do this with me”? To me this is it. This is how you “value” a day 1 investment. You don’t need caps, you don’t need conversions or extensions, a pivot still works, etc and the most important thing is you are truly aligned.

I will end with this message from Biggie to convertible note lovers…….. “Biggie Smalls is the illest. Your style is played out, like Arnold wondered, ‘What you talkin’ bout Willis?’”

My views are my own drawn on investment experience. Grammar and punctuation mistakes are also my own. If you need more to consider I’ve included links covering topic from one of my favorite VC bloggers Mark Suster.