Paul Graham, founder of Y-Combinator, sent out a tweet on Friday saying: “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”
It’s an interesting data point on Y-Combinator companies, but is this truly a macro trend? Have convertible notes really won? And if so is that good for start-ups? Good for investors?
I think the answer to these questions are that 1) it’s not at all clear that this trend is as definitive as Graham suggests; 2) it’s a mixed bag for entrepreneurs (more positive in the short run, potentially negative in the long term); and 3) it’s clearly not a positive trend for early-stage investors.
First a quick terminology recap (skip this paragraph if you’re already familiar with convertible debt vs. preferred equity). The most common forms of investment in early stage business are convertible debt and preferred equity. 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 carries warrants (same rational) or a cap on the equity price that the debt converts into. Historically convertible debt has been easier (and therefore cheaper) to put in place. Preferred equity is stock which 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.
Also, before I jump into this let me state that I have the view that, like many things involving start-ups, there’s a balance between what’s good for investors and good for entrepreneurs (there’s a symbiotic relationship between the two). I believe in cutting fair deals with entrepreneurs and don’t at all subscribe to the belief that an investor should try to obtain harsh control or preference terms (almost all of our investments at Foundry have a 1-times preference multiple and are non-participating; see this post by my partners Jason and Brad for more details on what these terms mean if you’re unfamiliar with them). Paul himself said in a March 2009 article: “When you hear people talking about a successful angel investor, they’re not saying "He got a 4x liquidation preference." They’re saying "He invested in Google." And I believe that’s true, although as you’ll see below, I also believe there also has to be reasonable compensation for the risk that early stage investors are taking. We should all be so lucky as to find the next Google, but one’s investment strategy needs to be geared to finding the next Mint or del.icio.us.
Has Convertible Debt Won?
I asked this question to a number of angel investors (all with institutional angel funds or running Y-Combinator like programs) and the results were mixed. Interestingly there seems to be a real split between the coasts. While all of this year’s Y-Combinator investments have apparently been structured as convertible debt, that’s not the case with other programs. While some are clearly seeing a heavier weighting to convertible debt than to equity, one east coast based program I talked to told me that fully 100% of their companies who had received funding had done so in the form of equity. Of the super-angels I talked to, several reported that “all” or “almost all” of their initial investments were currently being structured as convertible debt with one (again, east coast-based) exception who reported only 5-10% of their deals were structured as debt. It’s hard to say where in the country the line shifts from equity to debt, but it’s clearly a much stronger trend out west than on the east coast (at least the northeast which was where the firms/programs that I spoke to on that side of the country are located). To be clear, any west coast trend by definition is trend, given the skew of investing to that geography (and by far the majority of the so-called super-angel investors are west coast based).
The trend that Paul is pointing out appears to be taking place, but is less than definitive (and much less so than I expected).
Now on to by far the more important question – Is this trend a good one for entrepreneurs and investors?
Traditionally convertible debt is used for initial funding rounds that are smaller in size, where the financing isn’t substantial enough to cover the greater legal costs of a more traditional seed equity round, where the investor base lacks a “lead” to price and negotiate terms, or where the financing size is such that all parties agree that not enough money is being raised to put a stake in the ground around pricing. As I noted above the conversion terms typically contain a discount to the next financing round and – according to the super-angels I talked with – also almost always contain a cap on the price at which the equity can convert at later. Both these terms are designed to bound the risk that the convertible debt investors are taking in not pricing the round – they’re investing in an debt-like instrument with equity like risks.
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 it also puts off the valuation question to a later date and tends to shift at least some risk from entrepreneur to investor (I’ll talk about why this is in the next paragraph below). Interestingly however, with the increasing number of seed financings we’ve also seen a decrease in the complexity and cost of equity seed financings such that they more resemble in time and cost convertible debt structures (both Y-Combinator and TechStars have model seed docs up for those wishing to further streamline the process). As a result I believe some of the perceived difference in time and cost are disappearing and less relevant to the debt vs. equity debate.
It’s the question of terms that’s key to the investor side of the equation and where I believe the convertible debt trend starts to fall down. In the investor’s best case scenario, the convert terms reflect the current market value of the business (specifically, the cap appropriately prices the equity value of the business at the time of the debt investment). However the investor hasn’t actually purchased equity and has opened themselves up to an easier renegotiation of their terms by a later investor (who, almost by definition, wields more power at that time than the original angels, assuming the company actually needs to raise capital). More likely, however, the convert cap reflects a premium to the current fair market value of the business. One super-angel I talked to told me that while a year ago these caps “approximated what I’d pay in equity” that they’re now “33% higher than what I’d normally agree to pay now.”
I have no doubt that the convertible debt structure has the effect of raising prices for early stage investing. Within some reasonable range this isn’t a huge problem – early stage valuation ranges move up and down with the markets – but in larger increments (which we’re seeing now) and viewed in the light of angel investing economics, these changes in early stage valuation may be problematic.
Traditional venture investors average up their cost basis in a company and “protect” their ownership over time by investing in subsequent rounds. Often, angel investors don’t participate in future rounds (or if they do, they do so at a much less meaningful percentage of the round) meaning that their initial buy-in forms the basis for the majority of the shares they ultimately own in a company. Ironically, the trend of companies raising less capital actually enhances the importance of the initial round buy-in (both because that initial buy-in becomes less diluted meaning the first round price was that much more important and because even if an angel wants to buy up more in later rounds they’ll have less of a chance to do so; I also believe that along with the trend of companies raising less capital we’re also seeing earlier and somewhat smaller average exits – also enhancing the value of initial round buy-ins as fewer investors are truly swinging for the proverbial fence). I’m a big fan of the rise of the so-called super angels – I think they’ve been great for the overall entrepreneurial ecosystem and I’d like to see them continue to thrive.
So how is this trend bad for entrepreneurs?
Clearly in the short run this trend is positive for entrepreneurs because it has the effect of both deferring an often difficult conversation (around valuation) and ultimately increasing early stage company values and as a result decreasing entrepreneur dilution (by the way it’s also good for Y-Combinator, TechStars and other similar programs since the shares the program gets of each company act as founder shares in this financing equation). And I have no doubt that there will be many entrepreneurs who benefit from this trend. But it’s not clear to me that it’s sustainable (just as it wasn’t a decade ago). Ultimately investors need to be compensated for the risk they take in making their investments. With capital being relatively fluid (and the angel markets being finicky) as companies run into trouble, as valuation caps begin to be disrespected, as overall return profiles decrease because of higher early stage prices, money will flow out of the asset class. And ultimately this doesn’t benefit entrepreneurs either.
If you’re a long time reader of this blog you’ll know that I don’t like superlatives and I don’t like sweeping generalizations. I don’t think convertible debt is bad and I don’t believe as famous angel investor David Rose has said that “Smart Money’ doesn’t invest in convertible debts. Period.” Different situations call for different capital and financing structures. That said, a broad market trend towards convertible debt has implications that I think are bad for the overall early stage investment ecosystem.
I look forward to a healthy discussion in the comments below!
Quick disclosure note, I’m a personal investor in TechStars and from that end actually benefit (at least short term) from this trend. As an angel investor I’ve participated (this was prior to raising the Foundry Group fun) in convertible debt structures, including several very positive outcomes. I’m also an investor in several angel funds that are in the middle of this market. Foundry itself rarely (which is to say never to date) structures a first round as convertible debt.