Month: September 2011

Sep 29 2011

Convertible Debt – Other Terms

In today’s episode of our convertible debt series, we discussion a few other terms that come into play with a transaction.

Interest Rate: We believe interest rates on convertible debt should be as low as possible. This isn’t bank debt and the funders are being fairly compensated through the use of whatever type of discount has been negotiated. If you are an entrepreneur, check out what the Applicable Federal Rates (AFRs) are to see the lowest legally allowable interest rates are and bump them up just a little bit (for volatility) and suggest whatever that number is. Typically we see an interest rate between 7% and 10%.

Pro-Rata Rights: This term allows debt holders to participate pro-ratably in a future financing. Since many times the dollars amounts are low / lower in a convertible debt deal, investors may ask for “super pro-rata” rights. For instance, if an investor gave a company $500,000 in a convertible debt deal and the company later raises $7,000,000, the investor’s pro-rata investment rights wouldn’t allow them to purchase a large portion of the next round. Sometimes investors will ask for pro-rata rights that are a multiple of their investment. In this case the investor may ask for two to four times their amount. While pro-rata rights are pretty typical, if you have people asking for super pro-rata rights, or a specific portion of the next financing, you should be careful as this will likely limit your long term financing options.

Liquidation Preferences: Every now and then you’ll see a liquidation preference in a convertible debt deal. It works the same as it does in a preferred stock deal – the investors get their money back first, or a multiple of their money back first, before any proceeds are distributed to anyone else. This usually happens in the case when a company is struggling to raise capital and current investors offer a convertible debt (also called a bridge loan) deal to the company. Back in the good old days usury laws prevented such terms, but in most states this is not an issue and allow the investors to not only have the security of holding debt, but the upside of preferred stock should a liquidation event occur.

Other Terms: If you see other terms in a proposed deal outside of these, we’d guess that they are unique to your situation, as the ones we’ve discussed should cover the vast majority of debt transactions.

Sep 27 2011

Convertible Debt – Conversion In A Sale Of The Company

In today’s installment of our convertible debt series, we cover a specific case where the company is acquired before the debt converts into equity. There are a few different scenarios.

The lender gets its money back plus interest. If there is no specific language addressing this situation, this is what usually ends up happening. In this case, the convertible debt document doesn’t allow the debt to convert into anything, but at the same time mandates that upon a sale the debt must be paid off. So the lenders don’t see any of the upside on the acquisition. The potential bad news is that if the merger is an all stock deal, the company will need to find a way to find cash to pay back the loan or negotiate a way for the acquiring company to deal with the debt.

The lender gets its money back, plus interest plus a multiple of the original principle amount. In this case, the documents dictate that the company will pay back outstanding principle plus interest and then a multiple on the original investment. Usually we see 2-3x, but in later stage companies, this multiple can be even higher. Typical language follows.

Sale of the Company: If a Qualified Financing has not occurred and the Company elects to consummate a sale of the Company prior to the Maturity Date, then notwithstanding any provision of the Notes to the contrary (i) the Company will give the Investors at least five days prior written notice of the anticipated closing date of such sale of the Company and (ii) the Company will pay the holder of each Note an aggregate amount equal to _____ times the aggregate amount of principal and interest then outstanding under such Note in full satisfaction of the Company’s obligations under such Note.

Some sort of conversion does occur. In the case of an early-stage startup that hasn’t issued preferred stock yet, the debt converts into stock of the acquiring company (if it’s a stock deal) at a valuation subject to a cap. If it’s not a stock deal, then one normally sees one of the above scenarios.

With later stage companies, the investors usually structure the convertible notes to have the most flexibility. They either get a multiple payout on the debt, or get the equity upside based on the previous preferred round price. Note that if the acquisition price is low, the holders of the debt may usually opt out of conversion and demand cash payment on the notes.

While in many cases issuing convertible debt is often easier to deal with than issuing equity, the one situation where this often becomes complex is an acquisition while the debt is outstanding. Our strong advice is to address how the debt will be handled in an acquisition in the documents.

Sep 22 2011

Is A 180 Day Lockup Typical When A Company Goes Public?

Question: A company I used to work for has registered to IPO. Apparently I have to wait 180 days until after the company goes public to sell. Is this typical? When do investors get to sell? What happens when everyone gets to sell at that 180 day point? Does the stock usually tank? Or is there a provision to spread out the sales?

The answer is “yes, it’s standard.”  In fact, it is so typical that most financing documents of private companies lay out the restriction and get investor approval even in the earliest days of a company’s life.

There are exceptions, but when you see different provisions, it’s always driven by the investment bankers, not the company or investors.

As for what happens when the 180 day lockup comes off – it really depends on the company.  More times than not, the price goes down as investors and others speed to sell some / all of their stock to take risk off the table.  There are usually no provisions to spread out the selling.

Sep 22 2011

Convertible Debt – Conversion Mechanics

We continue our convertible debt series today with a discussion about conversion mechanics. This is a very important term, but usually one that everyone can be happy with at the end if they concentrate on it.

In general, debt holders have traditionally enjoyed superior control rights over companies with the ability to force nasty things like bankruptcy and involuntary liquidations. Therefore, having outstanding debt (that doesn’t convert) can be a bad thing if an entrepreneur ever gets “sideways” with one of the debt holders. While it’s not talked about that much, it happens often and we’ve seen it many times leaving the debt holder in a great position of leverage in negotiations.

Here is typical conversion language:

“In the event that Payor issues and sells shares of its Equity Securities to investors (the “Investors”) on or before [180] days from the date herewith (the “Maturity Date”) in an equity financing with total proceeds to the Payor of not less than $1,000,000 (excluding the conversion of the Notes or other debt) (a “Qualified Financing”), then the outstanding principal balance of this Note shall automatically convert in whole without any further action by the Holders into such Equity Securities at a conversion price equal to the price per share paid by the Investors purchasing the Equity Securities on the same terms and conditions as given to the Investors.”

Let’s take a look at what matters in this paragraph. Notice that in order for the note to convert automatically, all of the conditions must be met. If not, there is no automatic conversion.

Term: Here, the company must sell equity within six months (180 days) for the debt to automatically convert. Consider whether or not this is enough time. If we were entrepreneurs, we’d try to get this to be as long as possible. Many venture firms are not allowed (by their agreements with their investors) to issue debt that has a maturity date longer than a year, so don’t be surprised if one year is the maximum that you can negotiate if you are dealing with a VC investor.

Amount: In this case the company must raise $1,000,000 of new money, because the conversion of the outstanding debt is excluded, for the debt to convert. Again, its the entrepreneur’s decision on how much is a reasonable number, but think about how long you have (here 180 days) and how much you think you can reasonably raise in that time period.

So what happens if the company does not achieve the milestones to automatically convert the debt? The debt stays outstanding unless the debt holders agree to convert their holdings. This is when voting control comes into play. It is key to pay attention to the amendment provision in the notes.

“Any term of this Note may be amended or waived with the written consent of Payor and the Majority Holders. Upon the effectuation of such waiver or amendment in conformance with this Section 11, the Payor shall promptly give written notice thereof to the record Holders of the Notes who have not previously consented thereto in writing.”

While one will never see anything less than a majority of holders needing to consent to an amendment (and thus a different standard for conversion), make sure the standard doesn’t get too high. For instance, if you had two parties splitting $1,000,000 in debt with a 60 / 40 percentage split, you only need one party to consent if the majority rules, but both parties would need to consent if a super majority must approve. Little things like this can make a big difference if the 40% holder is the one you aren’t getting along with at the present moment.

Sep 20 2011

Convertible Debt – Valuation Caps

Today, in our series on convertible debt, we examine the conversion valuation cap.

The cap is an investor-favorable term that puts a ceiling on the conversion price of the debt. The valuation cap is typically only seen in seed rounds where the investors are concerned that the next round of financing will be at a price that is at a valuation that wouldn’t reward them appropriately for taking a risk by investing early in the seed round.

For example, an investor wants to invest $100,000 in a company  and thinks that the pre-money valuation of the company is somewhere in the $2 to $4 million dollar range. The entrepreneurs thinks their valuation should be higher. Either way, the investor and entrepreneurs agree to not deal with a valuation negotiation and consummate a convertible debt deal with a 20% discount to the next round.

Nine months pass and the company is doing well. The entrepreneurs are happy and the investor is happy. The company goes to raise a round of financing in the form of preferred stock. They receive a term sheet at $20 million pre-money valuation. In this case, the discount of 20% would result in the investor having an effective valuation of $16 million for his investment nine months ago.

One on hand the investor is happy for the entrepreneurs but is shocked by the relatively high valuation for his investment. He realized he made a bad decision by not pricing the deal initially as anything below $16 million would have been better for him. Of course, this is nowhere near the $2 to $4 million the investor was contemplating the company was worth at the time he made his convertible debt investment.

The valuation cap addresses this situation. By agreeing on a cap, the entrepreneur and investor can still defer the price discussion, but set a ceiling at which point the conversion price “caps”.

In our previous example, let’s assume that the entrepreneurs and investor agree on a $4 million cap. Since the deal has a 20% discount, any valuation up to $5 million will result in the investor getting a discount of 20%. Once the “discounted value” goes above the cap, then the cap will apply. So, in the case of the $20 million pre-money valuation, the investor will get shares at an effective price of $4 million.

In some cases, caps can impact the valuation of the next round. Some VCs will look at the cap and view it as a price ceiling to the next round price, assuming that it was the high point negotiated between the seed investors and the entrepreneurs. To mitigate this, entrepreneurs should never disclose the seed round terms until a price has been agreed to with a new VC investor.

Clearly, entrepreneurs would prefer not to have valuation caps. However, many seed investors recognize that an uncapped note has the potential to create a big risk / return disparity especially in frothy markets for early stage deals. We believe that – over the long term – caps create more alignment between entrepreneurs and seed investors as long as the price cap is thoughtfully negotiated based on the stage of the company.

Sep 15 2011

Convertible Debt – The Discount

As we start our convertible debt series, we’ll focus on the discount. Remember that a convertible debt deal doesn’t purchase equity in your company. Instead, it’s simply a loan that has the ability to convert to equity based on some future financing event (we’ll tackle the conversion mechanics in a later post.)

Until recently, we had never seen a convertible debt deal that didn’t convert at a discount to the next financing round. Given some of the excited market conditions at the seed stage, we’ve heard of convertible deals with no discount, but view this as irregular and not sustainable over the long term.

The idea behind the discount is that investors should get, or require, more upside than just the interest rate associated with the debt for the risk that they are taking by investing early. These investors aren’t banks – they are planning to own equity in the company, but are simply deferring the price discussion to the next financing.

So how does the discount work? There are two approaches – the “discounted price to the next round” or “warrants.” We are only going to focus on the discounted price to the next round approach, as it’s much simpler and better oriented for a seed round investment. We’ll cover warrants in a later post in the series.

For the discounted price to the next round, you might see something like this in the legal documents:

“This Note shall automatically convert in whole without any further action by the Holders into such Equity Securities at a conversion price equal to eighty percent (80%) of the price per share paid by the Investors purchasing the Equity Securities on the same terms and conditions as given to the Investors.”

This means that if your next round investors are paying $1.00 per share, then the note will convert into the same shares at a 20% discount, or $0.80 per share. For example, if you have a $100,000 convertible note, it’ll purchase 125,000 shares ($100,000 / $0.80) whereas the new equity investor will get 100,000 shares for his investment of $100,000 ($100,000 / $1.00).

The range of discounts we typically see is 10-30% with 20% being the most common. While occasionally you’ll see a discount that increases over time (e.g. 10% if the round closes in 90 days, 20% if it takes longer), we generally recommend entrepreneurs (and investors) keep this simple – it is the seed round, after all.

Sep 13 2011

Convertible Debt Series

We’ve been overwhelmed by the support for our book Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist. As part of the experience of releasing the book, we’ve gotten the chance to interact with many new people interested in the venture capital and angel financing process.

The most often requested additional topic that we don’t cover extensively in our book is the use convertible debt in early stage – especially seed stage – financings. While we generally don’t use convertible debt at Foundry Group, we’ve had plenty of experiences with it over the years and strong opinions about what entrepreneurs should pay attention to when consummating a convertible debt transaction.

This series won’t be a discussion about the pros and cons about raising a traditional preferred equity round versus a convertible debt round. Plenty of discussion about this can already be found on the web about this. For a primer, take a look at articles by Jason Mendelson, our partner Seth Levine, and our friends Mark Suster and Fred Wilson.

This series will be about the terms that matter and how to best approach thinking about how them, much like we did in our Term Sheet series which went on to inspire the book Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist.

We’ll be publishing posts on Tuesday and Thursday for the next few weeks so as not to compete with Fred Wilson’s awesome MBA Mondays series and Brad’s “just getting started” Finance Fridays series.

We hope you like the new series and as always, please comment freely, tell us what you think, and help us clarify stuff we don’t explain well.

Sep 8 2011

Do You Need To Be A Corporation To Raise VC Funding?

Question: Does one need to switch an LLC to a corporation to raise VC funding? Would you recommend starting out as a corporation pre-money or as an LLC?

The short answer is yes, you have to be a corporation to raise VC funding

VCs will want you to be a C-Corp for a few specific reasons. The main advantage of an LLC over a C-Corp is that the taxes are not flow through.  In other words, your company’s tax situation will not hit the bottom line of the VC.  As VCs are generally structured to be flow through tax entities, if your company was a LLC, your tax situation would flow through the VC and directly to their investors.  This is not a good place to be and VC investors demand that we only invest in C-corps to stop this problem.

And you should be happy, because if this wasn’t the case you’d get nagging phone calls every year from every investor in a VC fund looking for that tax documents.  🙂

The second issue is issuing stock to employees.  Since stock options are the chief motivator of employees at a startup, you need have a stock option plan.  In a LLC, there is no concept of stock ownership.  It’s about “unit” ownership and it’s nearly impossible to mimic a standard stock option plan in the world of “units.”

Before raising money, you should feel free to start off as a LLC.  In the “old days” (ten years ago, it was time consuming and costly to convert from a LLC to a C-corp, but these days it’s much much easier.

Sep 7 2011

What Should You Do When An Investor Asks You For A Business Plan?

Dan Shapiro has an excellent post up titled What to do when an investor asks you for your business plan. In it he addresses something we missed in Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist.

In the section where we discuss business plans, we say:

“We haven’t read a business plan in over 20 years. Sure, we still get plenty of them, but it is not something we care about as we invest in areas we know well, and as a result we much prefer demos and live interactions…. However, realize that some VCs care a lot about seeing a business plan, regardless of the current view by many people that a business plan is an obsolete document.”

We go on to say:

“Regardless, you will occasionally be asked for a business plan. Be prepared for this and know how you plan to respond, along with what you will provide, if and when this comes up.”

As Dan rightly points out, we don’t tell you what to do. He does:

“Whenever an investor asks you for your business plan, send them the same damn packet you send to everyone else. In our case, that was a 3-page “executive summary” and a dozen slides giving an overview of the business with some screenshots of the product (it was mobile, and 2006, so there wasn’t any easy way to send them a demo). Don’t apologize and don’t mention the business plan.”

Dan – we completely agree. Well said – thanks for adding the paragraph we clearly left out.

Sep 2 2011

Suster: The Problem with Collecting Logos at Startups

Mark Suster (GRP) nails it with his post The Problem with Collecting Logos at Startups. He explains the problem with the following subtopics:

  1. Leaderless rounds
  2. Not enough skin in the game
  3. Nobody’s head on the chopping block
  4. Fights over follow ons
  5. Information leaks

He also answers the question “is there any good case for taking a large number of VCs into your deal?” and lists the “top 5 excuses for taking many investors in a round.”

Mark’s punch line is priceless:

“You don’t need logos. Logos are for insecure people. Just like they were in high school when the cool kids had to wear the right logos on their shirts, shorts and handbags. Show strength & conviction. Make the tough decisions and choose the investors with whom you feel the closest fit. Make sure they own enough to be motivated to work with you in good times & bad.” 

Bingo. Go read the post.