Saturday, May 6, 2017

Raising Capital for a Startup: Convertible Debt

You have an idea, it's awesome and will change the world, something like a juicer or a toaster oven. Right now only you can see the potential, and you just need some funding to get started. You can use savings, but ultimately anything that's going to be amazing needs cash either to scale, or to get to market quicker - how do you raise that money? 

You can go to a bank for a loan, but they'll ask about sales, revenue, and profit, and seeing as you have none, they won't talk to you. So instead you go to an angel  (a rich individual or small group of rich individuals) or VC company, and offer them equity (shares) in your company in return for the money - but you still don't have anything, so how can they value your company to determine how much stock they should own? It's a large and expensive exercise to work that out (and you have no money to pay that with), at the end of which you may not think it's fair or viable for your needs.  

So with no revenue, product, idea of actual value, how can you reasonably raise money? A common way this is done is Convertible Debt. Convertible Debt is a hybrid between a loan (debt) and equity (shares) that tries to keep things simple in terms of the paperwork to get going, and puts off the tricky bit about valuation until later when there's more information to base that on.

Here's how Convertible Debt works - the company and investor agree on an investment amount, say $100,000, which the company will use to further the business/product. This is usually after a few rounds of meetings and presentations, where the founder has shown a basic pitch deck, presented a plan and a vision, and been vetted to some degree by the investor. Each Convertible Debt note can be different, I'm presenting a common version, but expect every one to have its own idiosyncrasies.

This money is given as a loan, same as with a bank loan, complete with an interest rate and repayment period - for example it might be at 3% interest, with a 2 year repayment timeframe. At the end of those two years the debt, along with interest (which has been accumulating all that time), is to be repaid in full. There are no debt payments made during that time, unlike a regular bank loan. 

That's pretty straightforward for a loan, but there's the equity part - if there is a "funding event" at some point in that 2 years (usually defined as a certain total amount of money raised) then the loan converts instead to equity (shares). Basically it starts as debt, then converts to equity, hence convertible debt.

How does the 'convertible' part happen? At some point a valuation of the company can be performed - but here the company has (say) 2 years of work behind it, perhaps a product prototype or early customers, and the VC firm putting in the Series A money (sometimes called "institutional money") has the capability and reputation to place that value on the company.

So, let's say that $100,000 of Convertible Debt was put into a company that a VC later values at $10,000,000 pre-money, puts in $2,000,000 for a $12,000,000 post valuation - that converts based on the pre-money valuation (usually, but not always) so those original investors get around 1% ($100k/$10m, ignoring interest) of the $12m company. They gained about 20% ($120k) on a pretty risky bet over 2 years, so it's a decent return but not earth shattering considering they basically made the company possible, were likely to lose everything, and the VC now has ~17%. 

This is a little unfair to the original investor, so this is why there is also a "discount" or "kicker" in the Convertible Debt agreement, where there is a discount on the price, often around 20%, so they get a bit more. With a 20% discount, they'd be getting 1.25% of the company ($100k/$8m) - now they've made a 50% return in value which is better, but still not that great, especially when that money isn't liquid and they still have the risk of future rounds of funding and it all going wrong. If the company happens to go stellar with that initial money, say a $100m valuation, then the investor gets an even smaller % of the company - that's a great deal for the founders and VCs!

Sophisticated investors in Convertible Debt often ask for a cap on the note (since it's debt, the term 'note' is often used for Convertible Debt). In the case above, they might have a note with a cap of $2m - in that case if the valuation goes over $2m at the Series A, the conversion of debt to equity is calculated at the cap - so it's ~5% ($100k/$2m) and now they've got a (paper) 500% gain, which will make them much happier. (Whether cap and discount both apply is down to the details of the note, sometimes it's just one of them).

So Convertible Debt has the benefits of keeping things simple in the legal papers (it can be done in a couple of pages), puts off the tricky aspect of valuing a company, and allows for the upside of equity in a growing company if things should take off. This is why Convertible Debt is a common financing vehicle early in a company, often in what's called the 'Seed Round'. 

What are typical terms? Usually these notes are for amounts in the $10k or $100k ranges (by definition it's a small company trying to prove things out, with a 'non-institutional investor'), but sometimes go into the millions. Interest rates are usually nominal, say 1 to 5%. The discount is also variable, but 15 to 30% is not uncommon. The term is a bit trickier, how long to make that? Well, you need to be actually able to do something with the money, and then with your new prototype or product go to a VC and the process of raising a Series A. Conventional wisdom tells you that if all goes great, a Series A raise takes 3 months, and it generally doesn't go well so assume it's 6 months. Basically, however long it's going to take you to get to something worthwhile, plus 6 months, is how long you want. For example, if you think it's going to be 9 months to a year to get to prototype, don't make your note term shorter than 18 months, and you probably want to give a little headroom in there for things going wrong. I've rarely seen a single year as a term, but I'm more a hardware person and those projects take longer, with the bulk in the 18 month to 2 year range - longer than that is rare as running a company for 3 years on convertible can be tough. Terms can also be conditional - that is they change with certain events - for example the discount may increase at certain points during the term of the note, starting say at 15% on a two year note and increasing by 2.5% each year. A founder may offer these terms to entice the investor to give a longer term, or the investor may want to encourage alacrity on the part of the company.

Most times both investor and company assume that it will be a clear situation of successful funding and conversion, or that the company has gone under, but if it's in limbo or limping along as often happens, things can be uncertain. What happens if things go wrong?

The most common way is for the term to expire and there to have been no funding event - the investor is due the loan back with interest, but no institutional investor agrees the company is worth funding, and we assume there is no money in the company to repay it. What happens then is the same as with any debt - debtor must come to an agreement with lender as to next steps, and this could be anything from bankruptcy to a renegotiation of the debt. With smaller amounts, both sides might just ignore it and pretend it didn't happen, with legal costs likely to outweight the investment amount, but the larger the amount the more an agreement needs to happen. Bankruptcy doesn't make sense, usually, as driving the company under ensures no chance of future success, and they are unlikely to have significant assets to liquidate to pay the investor back. It makes more sense for the two parties to come to an agreement, for example extending the term for another year while increasing the discount by 10%, and so it's usually recommended that if money isn't already in, start talking to your Convertible Debt note holders at least 3 months prior to term about what happens next.

Regardless, any institutional investor coming in for a Series A will want that paperwork cleared up before their money goes in, as they don't want a lawsuit or trouble later on.  This leads to some interesting situations where the Convertible Debt investor can start to demand beneficial terms from the company and hold up the Series A, or the company can demand the note holder give concessions like the discount rate or they won't go ahead (it's a "give me what I want or I shoot my company" tactic but I've seen it work). In those cases, it's down to bad blood between Convertible Debt investor and founder, and if it wasn't before it certainly is after.

One interesting permutation I've never seen play out is if a company does a convertible note between institutional rounds - for example between Series A and B when there was an original valuation and equity investors. It's odd, but it does happen, as LA Business Journal's Garrett Reim notes this is a route uBeam opted to follow when they took an (up to) $15m Convertible Debt round in July 2015 after a ~$10m Series A in summer 2014. This leads to a lot of possible weirdness that may or may not occur depending on how uBeam's fundraising for their Series B (which they must be deep into, now nearly 2 years from last fundraise) plays out.

First weirdness is that the Series A VC investors, who all get Preferred Stock that guarantees them paid out first from any money, are very unusually in the queue behind the convertible debt for being repaid, as debt always takes priority in any liquidation. This puts the lead investor in the position of desperately wanting a conversion from debt to Common Stock so they can take priority again.

Next is that the convertible round size was likely based on the then valuation of the company, with the expectation it would rise in the time between loan origination and maturity. If the situation arises where the Series B is a down round (lower valuation) than the Series A, or even similar, then the Convertible Debt investors will end up taking a huge % of the company even before the shares of the new Series B investor dilute the company further.

Lastly is that if the company had a valuation prior to the Convertible Debt investment, then there is the assumption that there is actually some value there, be it product, customers, IP like patents, or even remaining cash in the bank from the original Series A. A Convertible Debt investor at the note maturity may decide that liquidation is the best outcome for them, especially if they can get paid off first (perhaps they know the company has more cash in the bank than they are owed), and they do not think the company has much of a future. This can lead to an acrimonious situation as the investor plays 'hardball' with the company - that's not going to happen at the $100k level, but go past $1m and things are different. An element of that played out with Theranos when one of their investors, PFM, sued for their $96m investment back claiming fraud, when they know Theranos had $200m in the bank - basically taking the money before lawsuits and time removed the potential for any return.

Overall, Convertible Debt is a well understood way of raising money in the very early stages of a company, with simple terms and paperwork, but it can lead to some very difficult situations should it not convert at the end of the term.  There are other options and variations, such as SAFE, but in the interests of simplicity, I'm focusing just on that.

Update: Interesting Techcrunch article on the issues that SAFE and convertible note rounds can cause. Further reading on the matter - some key quotes that emphasize what I wrote above:

Why is this troubling? Because it has become more common for VC funds to pass on investing in deals altogether, solely because the waterfall of notes would consume too much equity. If outstanding notes prevent a new lead investor from meeting their fund’s required ownership targets without triggering a complete company recapitalization, a null set of equity distribution possibilities may arise.

In these cases, the only valuations that makes sense for a Series B lead investor force the dreaded “down round.”

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