Posted by: hdemott | August 31, 2010

Convertible Notes or Equity? Who Cares! The Debate Misses The Point

Over the last 24 hours I’ve read no less than 5 VC luminaries discuss the finer points of Convertible Notes versus  Convertible Preferred Equity.

Fred Wilson is here

Chris Dixon is here

Brad Burnham is here

Seth Levine is here

Mark Suster is here

My answer to the debate is:

WHO CARES!

The debate misses the essential points.

All of these articles rehash the finer points of the deal structures and the pros and cons of each – but to sum it up – convertible notes (particularly the ones with no caps) are for either unsophisticated investors or professional investors who are desperate to be in a specific seed stage deal. Otherwise, traditional preferred structures are the way to go – as they give you the equity rights you demand for taking equity risk and properly price the deal (why else is a fiduciary giving you money for – to abdicate this duty?)

Okay, so what is the real point behind all of these conversations?

The point is that the VC market has moved from having too much money chasing too few deals in the early to late stages – to having too much money chasing deals at the seed stage.

The outcome of this is that valuations are rising – and terms (thus the debate between convertibles and preferred) for professional investors are getting worse.

For a real VC, not an angel or super angel with $20M to invest, particularly a VC with a “name brand” this is a particularly dangerous position to be in. With enough $ chasing early stage deals – and convertible debt getting more popular, VC’s will be forced into a choice of  putting money into structures that are not particularly favorable for them or trying to convince founders to change the structure to an equity position.

The great thing about being a “name brand” investor is that you can get in early, and then get a ride on the valuation as your involvement helps push up valuation to the next round. If the company is really doing well, there are still a host of late round investors who are willing to buy secondary shares – so you could end up in a position to sell a small minority of your shares and get all of your capital back – while continuing to keep all of the upside.

If you agree to a convertible structure – particularly one without a cap – you are working against yourself. A “name brand” VC will push up the next rounds price – and thus they will own less of the company without a cap – and if they are going to have a cap – then they are setting the economics – so why not just go to equity anyway – it is what they are doing.

The flip side of the coin is not really examined either.

For founders, convertibles without a cap are fine – and Brad Burnham explains this in some detail – so I won’t rehash it – but they too are missing the bigger picture in all of this debate.

When doing a seed financing, you partners are really all that matters – outside an obviously mispriced valuation (Chris Dixon makes this point well). So when founders demand convertible notes with or without caps because of legal fees or because they feel it is going to give them an extra 2% ownership in the company – it is a rookie mistake – shortsighted and ultimately potentially destructive.

You don’t create value on a seed stage deal – but you can set up a situation that makes it more difficult to fund later.

There has been a ton written about the negative signaling effects of a “name” VC who doesn’t follow on – but not much written about why this happens. Lost in this structuring debate is an important point for founders which is the following:

1. Pick your financial partners not by what price they are offering you or what structure they are proposing – but based on what they can do for you beyond handing you the check. 1 second after that wire has hit – their money is no different than anybody elses – and you are now stuck with them. Is that a situation you want?

2. Forgetting domain expertise or a VC’s ability to get you in doors with partners or buyers – ask yourself whether your new partners are people who you are willing to spend a day a month with – and speak regularly to – and talk and e-mail even more frequently. Because you will.

Just an uninformed opinion, but if you are going to take money from a “name brand” VC – do it in a way that makes the greatest use of their brand name – so it in the form of a simple preferred doc – and get busy building value by executing on your plan. However, only take money from anyone, brand name or not, if you feel strongly that you have some personal chemistry with and who offers you more than a check.

My guess is that when “brand name” investors beg off after an initial seed round they do it for one of two reasons: 1. either the team and company is not performing well, in which case the signal is real and future investors are potentially smart to stay away, or 2. the investment was just money, and there was never any real personal involvement between the founders and the investor and never was going to be. Of course it could be both – but you usually don’t see people walk away if things are going well and everyone is getting along and working together toward a common goal.

P.S. While trolling around I just ran across a piece that makes this point perfectly. David Pakman of Venrock has a great post up. Read it here

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Responses

  1. Agreed – but one of the things that has happened – positively – in the past few years is that seed terms have become commoditized. That’s good. Taken to its extreme however, hasnt the seed investor been commoditized? Why does it matter who invests – if you execute the company will do well, if you dont, it won’t. Isnt this the logical outcome?

  2. I think companies that execute will become successful regardless of the investor base – but companies that execute and have more “brand name” investors may just succeed a little quicker. If you don’t execute – nothing is going to save you. I do believe there is a middle ground, where you have built a great team and the product is doing okay – a more well known investor base may be able to help you hire the next great person to push the company over the edge – or make the right intro at a larger company who could acquire the company in question.

    And yes I completely agree that commoditized terms are a good for everyone involved except the lawyers. If I remember correctly, you’ve kicked your addiction to that particular drug – so you know better than most what a good thing standard forms are.


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