Musings at Altitude

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Convertible Debt became popularized just after the Internet bubble burst in 2001. During that early investment “winter,” many early investors were “crammed down” by subsequent down rounds (if the entrepreneurs could get any follow-on capital at all). These new investors were funding these companies at a valuation far below the pricing that had been agreed to earlier, resulting in substantial dilution to earlier investors. In a defensive maneuver, some investors began using debt instruments that would later convert into equity when subsequent, often more sophisticated, investors were able to better determine and negotiate their enterprise value. The rationale was that the early risk would be compensated thru a discount percentage at conversion when that round’s valuation was set.

In this context is the reality of today’s early stage investing. This is where typically 5 out of 10 investments lose money, 4 are the “walking dead”, with no prospect of a return, and any only 1 has any meaningful return[i]. This drives the axiom that early-stage investors can only look at opportunities that would have the potential to have a 40% IRR or 2-4X return on their investment – and why they need a portfolio of 10 – 20 or more companies (more is better) to have a real chance of success.

While there are some advantages to using convertible debt for early stage investments, I now try to avoid them for many reasons. Here are some of my thought on why.

Reasons FOR convertible debt instruments:

• Simplicity & Speed & Low Expense. Convertible note financings are much simpler to conduct than equity. They can get done much more quickly and cheaply than priced financing rounds.  Early-stage investors want to get in quickly, get in without fuss or negotiation and don’t want their investment dollars going to legal fees.
• Defers Pricing Decision. It can often be very difficult, if not impossible, to value an early-stage startup. What EBITDA? A convertible note structure implicitly recognizes that a fair market price for equity is difficult to determine; it allows both the company and the investors to agree on something that is fair (a discount to a future price or a warrant coverage) without the end result (who wins) being entirely dependent on a finger-in-the-air valuation determination.  By the time a company’s priced Round “A”, it is often a bit easier to value the company and price the deal.
• Lack of Domain Expertise. While early-stage investors are often experts, they sometimes prefer to leverage the expertise of later-stage investors.  A convertible note structure allows the early-stage investors to benefit from the expertise of the A Round investors, setting the price for and negotiating the terms of preferred stock is a complicated and time-consuming process.  Convertible note financings allow investors to get in quickly, and sit back and let someone else do that work—and they can feel comfortable because they get a built-in discount or warrant coverage that the next round investor does not have.
• Safety. Convertible Notes are perceived as safer with protection from down rounds, at least by investors in the next round. (The only real protection from subsequent down rounds is negotiating the appropriate valuation at the time of your investment.)
• Preference. In the case of failure or early liquidation, debt holder investors are “ahead” of all shareholders. (But what is the value at that point anyway?)
• Cost. Legal costs for investing via a debt instrument are generally much lower than for an equity investment, particularly compared to a preferred equity round.

Reasons AGAINST convertible debt:

• Time Bomb. Convertible notes can be ticking time bombs: if the maturity date is reached, and there hasn’t been a Series A round (triggering the automatic conversion of the notes into shares of preferred stock), there is the potential for disaster.
• Lack of Alignment. Misalignment of equity with the entrepreneur. It is clearly in the investor’s best interest to eventually convert at a low valuation, while entrepreneurs wish to see conversion at a higher valuation.
• Debt vs Real Equity. Convertible Debt financing shows up as debt on the company’s Balance Sheet even though the investor most likely is investing with the intent to have it convert to equity.
• Lack of Security. Most of the early-stage convertible note financings that are done involve unsecured (usually also subordinated) convertible notes. These notes do not have a security interest and the investors do not have a right to seize the company’s assets, even if there was value with them.

“When angels make a lot of money from a deal, it’s not because they invested at a valuation of $1.5 million instead of $3 million. It’s because the company was really successful”. – Paul Graham, one of America’s premier angel investors and a founder of YCombinator

• Low Success Rate. Since early-stage investors lose money on 50% of deals and make 75% of their ROI on only 7% of them, this means that angel and early-stage investors can only afford to bet on potential home runs.
• Low Risk Premium. Downside protection at the expense of ROI just doesn’t make sense.  Convertible debt holders are lucky to enjoy a 25-30% discount off the valuation at a subsequent round.  But, in “home runs,” the valuation of the target company may have tripled in value with the angel’s money, before the subsequent investor is engaged, clearly not compensating the early investor for shouldering the most risk early in the company.
• Downside Focus. If investor’s focus is on protection from down rounds, it implies they are focused on their downside protection at the expense of enjoying returns on that tiny fraction of deals that, in fact, provide all their ROI.
• No Lead Investor. Many early-stage deals involve multiple investors with similarly sized investment amounts. No one really steps up and acts as a lead investor. When there’s a lead investor, current decisions (regarding terms of the deal) and future decisions (regarding stockholder voting or board voting points) are much easier to handle because there’s a lead investor who can suggest the interests of the preferred holders. But when there’s no clear major holder, it is easier to sit back than to make decisions by early-stage-investor-committee (something that can be time-consuming and, really, a painful and expensive process).

For me in the end, the disadvantages of using convertible debt in angel/early-stage deals outweigh their advantages and in the end are simple:  At exit, investors typically don’t receive enough risk premium for their risk taken and further, risk misalignment with the actual success drivers of the company.

“Convertible Equity”, a Better Alternative?

Basically, “Convertible Equity” removes the repayment at maturity and interest provisions of Convertible Debt. Additionally, Convertible Equity is “equity” that may have a lower capital gains tax benefit for investors, since it is likely classified as “qualified small business stock”.

The SAFE (simple agreement for future equity), popularized by YCombinator,[ii] is one of the most popular convertible equity vehicles and is intended in most cases to replace convertible notes; addressing many of the problems with convertible notes while retaining their flexibility.

In addition to being simpler and clearer, the SAFE was designed to facilitate the alignment of investors and founders, remaining fair and balanced to both. Many top start-up investors were consulted and positively reviewed its development by YCombinator. The result was an open-sourced instrument that is a positive evolution of the convertible note. It is a simpler vehicle for the start-up community to accomplish the same goals and reinforce investor/entrepreneur alignment while removing or at least minimizing their impediments. The features that SAFE exhibits are reflected by YCombinator here:

Features of a SAFE:

Unlike a convertible note, a SAFE is not a debt instrument. Debt instruments have maturity dates, are typically subject to certain regulations, create the threat of insolvency, and can include security interests and sometimes subordination agreements, all of which can have unintended negative consequences for startups.

Because the money invested in a startup via a SAFE is not a loan, it will not accrue interest. This is particularly beneficial for startups, but also better embodies the intention of investors, who never meant to be lenders in the first place.

As a flexible, one-document security without numerous terms to negotiate, a safe should save startups and investors’ money in legal fees and reduce the time spent negotiating the terms of the investment. Startups and investors will usually only have to negotiate one item: the valuation cap. Because a SAFE has no expiration or maturity date, there should be no time or money spent dealing with extending maturity dates, revising interest rates or the like.

A SAFE still allows for high-resolution fundraising. Startups can close with investors as soon as both parties are ready, instead of trying to coordinate a single close with all investors simultaneously.

SAFEs allow founders to focus on building a company and enables them to consummate the right investment at the right time, thus benefiting both the company and its early stage investors.

It’s all about the Equity, not the Coupon.

As investors become more sophisticated they are willing to provide more balanced terms for investment. This enables founders to focus on developing the business rather than negotiating and monitoring compliance with complex legal terms. The SAFEs simplicity and flexibility afforded is a true win-win.

As more and more investors acknowledge that many of the protections negotiated in startup Convertible Debt are of little significance in the early stage scenario, it is no wonder that SAFEs are quickly become widely used in Silicon Valley and beyond.

Conclusion.

In this world, bolder investors who willing to take on early-stage investment risk will now get appropriately rewarded with lower prices while maintaining better alignment with the founders. Maybe just as importantly, in a hits-driven business, might be that they’ll be able to get into the deals they want. Whereas the “who else is investing?” type of investors will not only pay higher prices but may not be able to get into the best deals at all.

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[i] In terms of average returns, the largest and most widely-cited study was done in 2007 by Robert Wiltbank and Warren Boeker with funds from the Ewing Marion Kauffman Foundation.  That study looked at the returns of 3,097 investments by 538 angels and included data on 1,137 exits and closures.  The findings of that study were that the average return was 2.6 times the investment in 3.5 years or an IRR of 27%. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=102859

[ii] YCombinator Startup Documents https://www.ycombinator.com/documents/

The Welfare “Cliff Effect,” occurs when employees — usually women — receive a small wage increase. That small bump in pay might push them over a financial cliff if it means their income exceeds the limit for a program such as a child care subsidy. They could lose more in benefits than they gain from the raise, trapping many in a low-wage job or just completely leave the workforce.

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The West Michigan-based Talent 2025 organization has identified 3 barriers to helping those not in the workforce find a job specifically calling out this Cliff Effect (along with job and skills development).

It seems to me that we should start by updating our welfare policies with employment policies (as successfully done in Colorado and other states). We can start by removing the Cliff and replacing it with a gradual diminution until they reach a household survival budget threshold (currently at $22.94/hr). At the same time we need to provide a path for their skills development. The path to success and self-sufficiency for these people needs help. Now, if not sooner, is a good time to start.