By Sanford Diday & Victoria Yampolsky, CFA - Initial Investment Structures are Critical Building Blocks - We all know time is money, but taking the wrong kind of money at the wrong time can be crippling. We think everyone needs to stop, take a deep breath, and think carefully about their role in the ecosystem. startup Business fundamentals rest at the core of our beliefs. We counsel lots of early stage companies and, as a rule, we challenge ourselves to remain critical of the status quo with hard analyses to make us better in all we do. For this piece, we focus on how choosing between convertible debentures and priced equity rounds can affect investor confidence, company growth, and founder dilution. , , and their principals have been consulting, advising, investing in, and working with startups and growth companies for over twenty years. Each new deal goes through a similar process, and we begin each with some basic truths in mind. Good fundamentals build good businesses. Do things the right way the first time, and you can avoid a lot of costs and headaches in the . JrPixels the Startup Station future The logic of executing well on fundamentals is nowhere more prevalent than in the financing process. In our experience, the importance of financing as part of company building is often lost on founders because they don’t have the necessary expertise to understand it well. Many founders think they don’t need it at such an early stage. That is a mistake. Because of the weight financing carries throughout the growth process, attempts to hack this process with quick, poorly structured deals may put your company at great risk. Nowhere do we see a need to sound the alarm more than with early funding rounds, specifically as it relates to the use of as a financing vehicle for pre-revenue companies. Historically, convertible debentures were not designed for pre-revenue companies. They were designed for revenue-generating companies to reduce their cost of debt while maintaining the tax benefits from interest payments. A call option on the company’s stock is a form of compensation to debt investors for the reduced coupon and is a way for them to participate in the upside when the company does well. convertible debentures (the convertible feature) Generally, we recommend all pre-revenue companies create a and do . We did this with great success with , , , and others within the last year. Unfortunately, we’ve seen an explosion of convertible notes in recent years, and we’re deeply concerned. pro forma financial model priced equity rounds Opkix InPerson Change My World Now Our rationale in support of crafting a financial proforma for priced equity rounds is rooted in firm business strategy. “ ?” We hear this — All. The. Time. Like with the rest of the MVP process, many entrepreneurs have trouble reducing the uncertainty in which they operate to a limited set of variables within a structured model. Their mistake is how they define the objective they aim to accomplish. Why create financial projections when it is all a guess The goal of financial projections is not to guess the future. That is not possible. Rather, the goal is to define the company’s business strategy for the next 2–5 years and create a mathematical representation of that strategy in the form of a financial model which may then be used as a core piece of your valuation argument and, of course, a natural guidepost for your priced equity rounds. - The Unsaid Pitfalls of Convertible Debt - The U.S. economy used to have a 66% failure rate for new businesses; now it’s ~ . It’s intellectually dishonest to suggest the reasons for this increase may be summarized in anything short of a doctoral thesis in Economics. Nonetheless, this fact tells us a lot about the state of the startup ecosystem and provides a clear reason why priced equity rounds present healthier options than convertible debentures for pre-revenue companies. Also, because startup investment risk has undeniably risen, investors have additional incentive to utilize complex financial instruments to their advantage. 90% We’re not saying convertible debentures are a bad instrument. Instead, we’re saying convertible notes are both misunderstood and frequently misused by startup founders and investors. You may have read some “industry experts” say things like, “convertible debentures are designed not to be paid, but convert to equity.” Let’s be clear, that both obfuscates the nature of convertible notes and is woefully incorrect. Let’s review the classic features of convertible debt. They were designed for revenue-generating companies with the intention of giving them access to lower-cost debt. They are a complex debt-equity instrument with compounding interest + maturity date + conditions on conversion + preferences + a lot more if you’re not careful (like , ‘lower of’ , and onerous ). Full Ratchets VWAPS OIDs The interest coupon is usually a cash payment to investors, made at regular intervals. While these payments may be deferred until the debt’s maturity, or converted to equity upon triggering events, these features are meant to be deal sweeteners not primary parts of the instrument. If the principal loan amount plus capitalized interest isn’t paid at regular intervals and doesn’t get converted, then the total amount (principal + capitalized interest) is due in full on the maturity date. A company must have a formal valuation prior to debt issuance to determine conversion terms. The inherent complexity of these instruments is far greater than the complexity of priced equity rounds. Specifically, this complexity may pose a grave threat to your company’s continued operations by creating cash flow pressures ( ) you may not be in the position to satisfy. They may also prevent your company from gaining future financing via a suddenly expanded capitalization table after a forced conversion. interest and principal payments We think it’s rational to say no one should enter into a contractual agreement they do not understand. After all, you could wind up with a fox guarding the hen house. Why would it make sense to load up a pre-revenue company with debt they cannot repay, which creates a ticking time bomb of a capitalization table with the potential to decrease founder ownership to de minimis levels? We certainly can’t think of a good reason. - Dubious Benefits of Convertible Debentures - . Perhaps, but as a result, you may give up a larger percentage of your company later at an unattractive price for a bit of saved time now. It’s faster . So, you’re saying you don’t want the right investors, but instead want fast money that may not be right for your company? Additionally, do you mean to say that understanding the correct corporate structure for the needs of your business such that it supports good corporate governance and the further success of your company doesn’t matter? It allows me to jam investors in quickly and provides more flexibility with regard to whether I’m an LLC or an Inc . You’re right; it is more expensive. However, doing this work provides a more thorough view of your business model combined with a solid financial model so you can have realistic valuation discussions with potential investors. Doing this work will enable you to lay out concrete near-term goals for your company as well as a salient strategy to hit those targets. You will also be able to evaluate which human, infrastructure, and financial resources are required to launch and scale. Further, you’ll identify when you can expect to see revenue, break-even, and enjoy profits. What’s more, this analysis will organically determine critical company milestones which guide the timing of financing. Doing an early priced equity round is more expensive because it requires me to do more financial and legal work . Sure, but again, the cost savings are not enough to make up for the potential loss of equity and control of the business. It reduces transaction costs You see where we’re going with this? Long-term thinking is always a beneficial exercise, and long-term planning usually wins the day. - Fundamentals Matter - Here’s the deal: in companies is about aligning the economic interests of the company with those of investors. Priced equity rounds on pre-revenue companies support this basic tenet; convertible debentures, generally, do not. Likewise, it follows that it’s best to value pre-revenue companies using their own business and financial fundamentals rather than an arbitrary valuation (or valuation cap) taken from a so-called comparable that qualifies as such only by virtue of it being in the same industry. That is especially true when those “comparables” have different business models, products, and growth strategy, and therefore have nothing to do with the company being valued. investing Founder marginalization is potentiated with convertible notes because the deal terms don’t include the right to invest in future rounds ( as well as a set of information rights that spell out the rights and conveyances of all parties. Both features are typical of seed equity instruments, and when absent, may increase the likelihood of a host of problems, including 1.) Confusion about the precise nature and meaning of the verbiage outlining the legal rights conveyed by the convertible debenture agreement, 2.) An expanding investor pool at later financing rounds that may not agree with the legal language, and 3.) A litany of capitalization table issues that distribute decision-making power between increasing numbers of entities. Do you want a one-time investor?) When convertible notes are misused, and conversion is set as a primary feature, there is a misalignment of incentives between investors and founders; not to mention pricing confusion in the marketplace. This applies especially to debentures without caps and discounts. It goes without saying that founders want to move quickly to hit milestones and get to the next round at a maximum valuation they can justify. However, the debt holder has an economic incentive to get a lower price for the first priced equity round, so she is in a better position upon conversion or sale . Such misalignment tends not to exist with priced equity investments because each investor agrees to buy X shares for Y price, which is much cleaner and allows all parties to know what they own and when. Clarity is always good. (remember, the debt is tied to the equity, so as the price goes down, investor share count goes up) As if all that wasn’t enough, convertible debentures remove founders from the immediate responsibility of carefully managing the capitalization table, which can be deadly. Mastering the math of how investments affect the capitalization table is essential for anyone growing a company and a categorical imperative if you’re raising money. We presume no one wants to drop the ball with such a critical piece of business. To be fair, there is at least one reason to use a convertible debenture in a pre-revenue company, and that’s as a bridge loan to an appropriately valued predetermined equity financing round. In this case, when structured properly, they make sense because they remove conflicts of interest between insiders. Is it possible to structure convertible debt to have the same properties as a priced equity round? Yes. But, if you are going to do that, why not use the instrument you are trying to emulate, which is easier to understand and structure? If your company is pre-revenue just do priced equity rounds. Don’t believe the hype. They’re not that hard to execute, and over the long-term, they better align the interests of founders and investors and help evaluate how successfully you are executing your strategy. There is no better tool for evincing clear proof points that will define and drive the need for a higher valuation. - Conclusion - Fundamentals First! Make it your motto. Do your research, build your business strategy, create your financial model to reflect your company’s execution plan, and then make sure your company’s financial model and business model make sense. Ask yourself if you would invest in your company. Is the business case compelling enough? Is there enough long-term potential? How confident are you that you can hit your valuation benchmarks with all the strategic initiatives you intend to put in place? After you complete these steps, you can create a meaningful business plan deck, executive summary, corporate profile, and a product outline for presentation to investors. Do this well, and you radically increase your chances of finding the right investors that serve the growth needs of your company. Along the way, you’ll glean a much more thorough sense of how your business is geared and what levers you may pull to execute your company’s go-to-market strategy. As a result, you will be much more likely to succeed because you’ll be prepared for changes that will invariably come your way after launch. Don’t forget, . strategic planning and execution are everything Cheers and good luck! . Originally published at JrPixels

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Most Pre-Revenue Deals Should be Priced Equity Rounds, Not Convertible Debentures

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Sanford Diday

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Most Pre-Revenue Deals Should be Priced Equity Rounds, Not Convertible Debentures

Too Long; Didn't Read

Sanford Diday

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