What have I learnt?
Recently I’ve been spending most of my time making follow-on investments and helping businesses raise capital. This can be an exhaustive and very time consuming process for founders, and also particularly stressful when your business is running low on cash and it is taking a long time to win over new investors.
One particular company I am an investor in has taken almost 12 months to raise Series B capital. This process was extremely distracting for the CEO/founder and required the existing shareholders to bridge the business multiple times via the use of convertible debt. Fortunately we have an awesome VC shareholder who invested in the Series A round. They have really acted in the true spirit of partnership, which has made it significantly less painful for the Board to steer the company through periods of extremely tight cash-flow. The good news is the Series B round is now closed and the company is well funded, and in my opinion likely to become one of Australia’s next big startup success stories. It was a huge effort by the founder, his team and the Board to get this across the line. It has been a great learning experience for me. My involvement as a Director has allowed me to experience every form of financing – Seed, Angel, Series A and Series B, using priced equity for ordinary and preference shares, and also convertible notes.
Early Stage Financing in Australia
The most common form of investment (financing) in early stage ventures in Australia is via priced rounds – where in return for an investment you get shares in a company (equity). What a “priced round” means is that investment money has been “priced” i.e. the value of the company at which an Angel investor would buy shares has been set and actual shares in the company are issued. This is typically how Pollenizer has been raising Angel capital in the past.
Early Stage Financing in Silicon Valley
So how do the big US Super Angels invest in startups? Dave McClure does most investments on convertible notes capped at $5M (out of 70 investments only 3 have been uncapped). Ron Conway is happy to invest on an uncapped convertible note as he believes that a great company and a great team has the leverage to put their own terms on the table (e.g. his investment in Google at $75M was uncapped). It is worth noting that a capped convertible note can create a misalignment with early investors given they are not on the same page driving a higher valuation in next round. It is often the case that the cap sets the price for the next round…so need to be careful it is not set too low.
What is Convertible Debt?
Convertible debt is exactly that – debt which is convertible into equity at some later point in time (or is paid off). Typically this conversion is at a discount to the next equity round (to compensate the debt investors for their risk) and sometimes carry a cap on the equity price that the debt converts into. In the US startups commonly use convertible debt as it is easier (and therefore cheaper) to put in place. Preferred equity is often used by sophisticated Angel investors or VCs as it is stock that carries with it certain rights (preferences) in terms of how and when it gets paid back and a handful of other items that relate to the control of the underlying business.
Using “convertible debt” means investment money is not immediately priced. The purchase price for investors in this type of investment is set in the future when the company raises the next round of “priced” venture capital money. It is called “convertible” because it usually automatically converts to equity when you raise your next round of venture capital (qualified financing), say from a VC. It typically gets a discount to the price that the VC pays. The discount can be any % number, but typically in early stage venture this discount sits between 15-30%.
How are Convertible Notes used in Australia?
In Australia, convertible notes have typically been used as an instrument for a “bridge financing” – when an equity round is imminent, and likely to occur, but the company needs some money in between. In that case, it makes good sense to have a debt instrument, where the note holder converts into equity when the financing occurs. Since the financing would likely happen in short order, there is no need to have a valuation cap in the note. And if the financing doesn’t happen, the debt nature of the instrument ensures that the note holders would be first in line to get their money back — even if it is by virtue of a liquidation of the company’s assets. For taking the risk of the financing not happening the note holder receives a discount on the price of the round. In such a scenario, where the note is genuinely being used as bridge financing, a note makes perfect sense.
However, like in the US, some Australian Angel investors are slowly starting to see the use of convertible notes change. This is happening primarily because the legal fees associated with doing a priced/equity round have been so ridiculous, and the process extremely cumbersome and drawn out for young startups (yes, blame the lawyers). The convertible note is perceived by some as the easier, cheaper and faster option. Today, the convertible note is no longer just used in a bridge, but has also become a capital raising tool for Australian Angel rounds.
Convertible Debt verse Priced Rounds
Entrepreneurs like convertible debt for some obvious reasons. For starters, it can be much quicker to put together a convertible debt financing, so more of the capital being raised goes to the operations of the business, not to the lawyers (this clearly benefits both the entrepreneur and investors). Importantly for Pollenizer CEOs, it also defers an often difficult conversation (around how you value a company that is less than 9 months old).
In the most recent round of capital raising for Pollenizer portfolio companies it has become clear that convertible debt is clearly not for everyone. There are some key reasons why Australian Angel investors like priced rounds, these are:
• More clarity for investors around rights, more stability and less potential squabbling in the next round.
• Opportunity to get long term capital gains tax treatment if early exit.
• Price certainty instead of the lower of two different prices as with capped debt.
• In markets like Australia where sourcing early stage capital is difficult, investors can benefit from being the “only money on the table” and demand an aggressive valuation.
• Access to control rights (see below)
Here are some reasons why I am prepared to occasionally do the odd Angel investment via a convertible note rather than a priced round:
• If I believe it is a great market opportunity with a very strong founder and awesome team…and I just want in!
• If there is strong investment interest in the company.
• The note has a realistic price cap. As a note holder I will pay a lower price for these shares because I would have received a conversion discount for investing early.
• When my note converts, I will receive the same class of shares that the VCs buy in the equity round, which is almost always preference shares.
• I can spend less on legal advice due to less legal docs required for a convertible note (in my opinion most ventures will fail so the last thing I need to do as an investor is incur big legal costs on every early stage deal I do).
There are two kinds of rights that investors get when they put money in a company. The first are economic rights: basically that they make money when the investment is successful. The second are control rights: board seats, the ability to block financings and acquisitions, the ability to change management, etc. Convertible Notes give investors economics rights with basically zero control rights (legally it is just a loan with some special conversion provisions). Equity financings normally give investors explicit rights (most equity terms sheets specify board seats, specific blocking conditions, etc.) in addition to standard shareholder rights.
The one investor right that founders should keep in mind is the investor’s right to invest (or not). At the end of the day, if the investment terms do not suit the investor, then they will invest their money elsewhere. Therefore, rather than focusing on the best form of financing, a founder should focus on creating strong investment interest in their company. The lean startup process has taught us to use validated learnings and be more customer centric in building businesses. I think we should take the same approach with capital development by finding out what terms investors have used in the past and structure a deal together that makes sense for everyone. Most importantly, make sure the first investors can add value and offer you more than just their capital.
In the end I think Ron Conway has the right approach – a great company with a great team and strong traction should be able to set their own terms. These are the sorts of businesses we aim to produce at Pollenizer.
Evolution in the US to Convertible Equity
In the US we are now starting to see deals done using “convertible equity”. Here are some interesting blog posts that discuss the difference in using convertible debt verses convertible equity.
Adeo Ressi Introduces ‘Convertible Equity’, Convertible Debt Without Debt (Forbes.com article by J.J. Colao)
The Truth About Convertible Debt at Startups and The Hidden Terms You Didn’t Understand (post by Mark Suster, a 2x entrepreneur, now VC at GRP Partners)
Convertible Equity, A Better Alternative To Convertible Debt? (TechCrunch article by Leena Rao)
Convertible Equity – tipping the balance further in favor of founders (post by Silicon Valley lawyer Matt Bartus from Cooley LLP)