Investing in an early tech company seed round costs our fund an average of $40 K to $50 K. As a result, making a $100,000 investment simply does not make sense for most VC funds. Angel investors fill the much needed “gap” in pre-Seed startup financing
Convertible notes allow angel investors to minimize their legal expenses and to defer valuation negotiations until a subsequent round of financing. This allows the startup flexibility for the timeline to develop metrics which can be used to determine a fair pre-money valuation in subsequent rounds of funding.
Here is seven things you need to know is about convertible notes.
1) Uncapped Convertible Notes. Usually means that the valuation for the note conversion will be the same as the Series A valuation.
2) Capped Convertible Notes. The note conversion caps the valuation during the Series A conversion. For example, if the term sheet has a $6 million conversion cap, even if the Series A valuation jumps up to $20 million the note will convert at a $6 million valuation. The convertible note seemed ideal to defer the valuation question till the company has metrics to determined valuations, but with caps the valuation question remains in play.
3) Conversion Rate Discounts. For example, the note holder gets a discount (ie a 15%) of or when the note converts.
4) Aggregate Proceeds. Usually required by the VC to convert all convertible debt to equity in this round. VCs usually want this so that no debt is senior to their investment.
5) A common mistake made by founders is to raise too much convertible debt without understanding precisely how much dilution that occurs when the note converts to equity. This is easy to do because of the rolling nature of convertible notes versus a “one time event” of a Seed or Series A financing. In addition, many founders forget to calculate the dilution that will occur from the convertible debt conversion to equity and how it also diluted the option pool.
6) Convertible debt is usually simpler and less costly than Seed and Series A rounds. Nevertheless, it’s still most likely considered a “security” as defined by the SEC. So be sure to always have an experienced attorney draft these documents. This is not something you want to “do-it-yourself.”
7) The VC Valuation on the term sheet is post money. Post money equals the VC investment plus the amount of the VC investment. Convertible notes are usually included in the money valuation.
For example, the term sheet post money valuation is $20 million and the VC invests $5 million for 25% equity. Let’s say that $3 million in convertible debts after caps and convertible note discounts are factored in. Here is where the cap and conversion rate discounts can have a major impact on founder dilution. Also, the employee option pool is agreed to be $2 million. Keep in mind that typically convertible notes and employee option pools dilute only the founders and not the VCs. Assuming no other variables, the founders in my example might be getting a much lower percentage of equity than they were expecting. Founders must know that the devil is in the details.
It seems a little unfair that founders may only get 1-2 experiences in term sheet negotiations whereas the VC has a wealth of experience. From a VC perspective, we’re looking to mitigate our risk through preferred shares.
If I invest $1 million into your company for 25% equity, what happens if the company exits for $2 million? Without liquidation preferences, I’d only get back $500,000 back (25% of the equity). With 1x liquidation preferences, I get my $1 million back.
Liquidation preference allows the VC investor who owns preferred shares to be paid “in full” prior to any of the common share investors (founders and employees) getting paid off. With a 2x liquidation preference, the VC gets the first $2 million and the common shareholders get $0.
I came from a real estate hedge fund background and we focused primarily on hard money lending. Higher levels of liquidation preference reminds me of a hard money loan. With a 2x liquidation preference, I have something like “the collateral of a house.” If we fire sale the startup for $2 million, I can still double my money.
It’s important to note that liquidation preferences typically apply to M&A exits or bankruptcy proceedings, but not to IPO exits. On most term sheets, the preferred shares convert to common shares in the event of an IPO.
Here are some tips on a few things to check on your term sheet.
Review your term sheet to double check that your conversion from preferred shares to common shares is on a 1-to-1 basis.
It’s uncommon to have participating liquidation preferences, which means that the VC preferred shareholder still owns a part of the company even after getting paid-out their liquidation preferences. This is like eating your cake and having it too. The typical term sheet has non-participating liquidation preference which means that the investor has to choose between exercising their liquidation preference or converting their preferred shares to common shares.
Seniority of liquidation preferences. It’s common for later round investments to have seniority in liquidation preferences over earlier rounds. You’ll want to understand exactly how the waterfall of payouts is constructed. Seniority alternatively could be Pari Passu.
I’ve also been involved with Hollywood feature film funding. Liquidation preferences for a VC remind me a lot of the film waterfall. Typically, the P&A (Print and Advertising.. the cost to market the movie) gains seniority in liquidation preferences. The seniority may not even be equal amongst the P&A investors. Something like 40% to 50% of the P&A goes to media buy spends (like tv commercials). If I were investing in a film, I would want to be like Disney or Fox and own the media buy company. I’d want the profits from the media buy, merchandising and distribution fees to exceed whatever money I have invested in the movie.
If you’re a start-up founder, you’ll want to master the financial structure of your term sheets. Don’t end up like the average movie producer who made more than $100 million in box office sales but ended up making nothing after all the liquidation preferences were paid out.
As you probably can imagine, I get asked this question a lot. So let me take you behind-the-scenes on how I evaluate which companies to fund.
Venture capitalist usually set up limited partnership funds and file a Reg D form with the SEC. Typically, they raise capital from limited partners.
But here’s two major problem facing a new VC fund. Until you have a track record, you have no track record. Without a track record, why would any limited partner want to invest in you. In addition, with a limited track record, you’re asking limited partners to park their money with you for 10-years while investing in high risk startups.
The challenge is that only 10% of the VC funds end up getting 90% of the limited partner funding. Why is that? Because for a limited partner like an endowment to park money for 10-years, they want to earn internal rates of return between 70% and 90%. So they prefer to invest in the top 10% of VCs.
So what happens to the other 90% of VC funds that are not in the top 10% of returns? Well, they die. In fact, the average VC fund only gets a return of 18% to 20% IRR. It’s called “One fund (for 10-years) and done.”
I look for companies with the potential for 100x returns. If I invest a $1 million, I’d like your business to have the potential to get back $100 million in 5-7 years. A single “hit” with a 100x return can set-up a VC fund for life. For example, Accel Partners made over 1,000x funding Facebook’s seed round. Just one investment caltipulted Accel into the top 10% of VCs for life.
I’ve been pitched by over 1,000 companies this year. Only 3 companies seem to have the potential to fit my investing criteria.
What do other VCs look for? The VCs that are likely to be “one and done” tend to settle for 10x on a series A for companies with proven traction and 20x on a seed round. But VC general partners will likely not last beyond 10-years if they don’t hit a 100x company in their portfolio.
I’ve been pitched by some super promising companies but the problem was that the founders wanted something like 20% equity for $20 million. For a company with no revenue! Without getting into the details of pre-money versus post-money (which I’ll discuss in a future post), we’re in the vacinity of a $100 million valuation. To get a potential 100x return, the valuation would have to jump to $10 billion.
Even if successful, how many companies reach a $10 billion market capitalization?
So now that I’ve discussed the math problem for VCs, you’ll understand why VCs look at the market size as their #1 investment criteria. It’s not a secret that successful VC investments are 70% market and moat, 20% founders, and 10% product. However, the types of companies that realize 100x returns are likely to be in markets whose future size is presently unknowable. As a result, I believe that metrics like TAM (total addressable market) can be deceptive. In my opinion, VCs are simply taking wildly imaginative guesses when it comes to market size. Peter Thiel articulates another complicated factor in guessing. Thiel says, “Build a monopoly in a small market and expand into adjacent markets.” So a company may start in a small market but end up in a bigger total market.
Thiel also calls out the elephant in the room. What does every VC seek but will never admit in public? Hint… it starts with “mono” and ends with “poly.” 🤫 The greatest tragedy for a VC is to guess the right market but fund the wrong company. Silicon Valley is a winner-take-all world. Sustainable differentiation (aka “Economic Moats” as termed by Warren Buffet) is absolutely required to become the winner-take-all. Interestingly, Warren Buffett doesn’t like to use the evil “M” word either.
Finally, I’ve been around the tech scene in Seattle for sixteen years but now “snow bird” (well without the snow) between Las Vegas and San Francisco. I’ve often wondered why the Bay Area companies have dominated the 100x exits. Unlike most Bay Area VCs that only invest within a 20-mile radius from their Palo Alto office, I travel around the US and talk to companies everywhere.
So I’ve been able to compare the difference between founders from a variety of states. My observation is that the Bay Area has one thing that other areas don’t have… technical product managers who have experience in “100x Exit” companies.
Don’t get me wrong. I’ve met with experienced technical product managers (who do for example 5-Day Design Sprints) in other states but they just don’t have experience in companies that have had a “100x Exit.”