Thoughts on Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist

Lately I’ve been reading this book called Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist by Brad Feld and Jason Mendelson.

I wanted to read this book because I felt like much of my knowledge about how the venture capital world works was pretty fractured, and this book came highly regarded.

I mean, I knew that companies raised capital in a sucession of series’, and before that they raised money from angel investors. Eventually, the company would grow big enough that it would go public through an initial public offering, which is the big liquidity event everyone is one day hoping for. I didn’t know how that all unfolded, though.

I also knew that there were different financial instruments through which companies could raise funding, like Convertible Debt, Preferred Equity, and SAFE agreements, but didn’t know which facilities were appropriate for which situations and which lifecycle stage of the company.

I also knew that companies would negotiate with VCs via a term sheet, and there were different levers that were pulled within that to strike a deal, but in hindsight, I didn’t know any of the terms.

I didn’t understand how any of the above tied together. I hope one day to start a company and go through the venture capital process, and felt as though this was a critical missing piece in my education.

Before I summarize the book to help me ingrain the information, a brief review:

This book is dense, especially for those without a corporate finance or accounting background. I didn’t feel like I had to look up any financial terms, but I also got a master’s degree in Accounting and work in finance. The book is full of some useful annecdotes/wisdom, especially in the latter half, but the first half is straight information. I had to reread some chapters multiple times. It reads like a textbook, which is refreshing for a business book. I rarely pick up business books anymore, since most are full of fluff and a lot of times you feel like you’re reading a 300 page advertisement for someone’s online course. But this one was jam-packed with great info. Overall, 8/10.

Notes:

Chapter 8: Convertible Debt

Convertible Debt, When and Why It’s Used

Convertible debt is typically used before a company has raised any financing. It is a way for investors to provide capital to a young company without setting a valuation. In essence, they are allowing the next group of investors to value the company for them. When the company raises their first true round, the convertible debt converts to preferred equity at a set discount rate. Investors also get a modest interest rate in exchange.

Company raises $500,000 in convertible debt in Y1 with a 20% discount to the next round. Six months later, a VC offers to lead a Series A round for $1M.

Total financing: $1.5M Series A Investors get $1M, or 1 million shares at $1/share. Convertible Debt Investors get $500,000 * $0.8/share or 500,000/0.8 = 625,000 shares.

Say post-money the company’s valuation is $2.5M ($1M pre-money). The investors own 50% of the company. The founders and employees own the other 50%.

Angels own 625/1625 * 50% = 19.2% of the company, but contributed 16.67% of the post-money valuation

VC’s own 1000/1625 * 50% = 30.7% of the company, but contributed 33.33% of the post-money valuation

Initial thoughts:

  1. It makes sense why a VC be concerned with whether or not there’s a convertible note that was part of the angel financing. It dilutes their ownership percentage. Angels are anti-diluted at the expense of the Series A investors.

  2. In some cases, a discount is nice, but it may have been better for angel investors to set a valuation at the time the convertible note was issued if the valuation in the Series A round is signifcantly higher.

Valuation Cap

On point 2, part of the convertible note deal could be a valuation cap. The valuation is basically the price investors pay. Valuation and price is a lever pulled during financing negotiations where investors want to buy low, but not low enough to not be able to motivate or attract the founders.

If the valuation cap is very high in the Series A round, then the Angels are paying a higher price, even if there’s a discount.

It’s helpful to think of this in terms of a hypothetical stock price where you don’t know the price today, but will know it 6 months from now where you can buy it at that price and a 20% discount, and all you know is that it will be higher. If you buy it today you forgoe that discount at the later point.

If the stock is worth $10 today, and it’s worth $50 6 month from now, then you can buy it at $40 share at that later point. You make the most profit by buying it today and having $40 in unrealized, or realized, profit. If you forgoe, you’re only up 25%, as opposed to being up 400%.

Note here this is a simplified example I’ve made where the discount does not play in to the cap. If, for example, the cap is $4M and there’s a 20% discount, then the true valuation cap is $4M * 1.2 = $5M. Once the discounted value goes above the cap, then the cap applies.

A valuation cap basically says I’ll take a 20% discount up to a valuation of X. If you get a valuation of >X, then my valuation is X.

Altering the above example, we can change the rules to say now that you can purchase that stock 6 months from now, but the most you’ll pay is $20 per share (no matter the actual fair market value). So, even though you’d still be better off buying at $10 and having a potential realization at $50. You can also buy at $20 if you forgoe and just wait the 6 months and make a $30 spread.

In a lot of cases, a valuation cap will limit the upside for the founders in Series A, since many VCs will focus on that valuation cap, and even if they were going to offer X, they will try to offer Y (less than X). There’s also the argument that the valuation in the Series A round is likely to be higher than what the Angels would have offered, as passage of time has led to a higher valaution (the startup has acquired more users, grown revenue, etc.)

To attract seed stage investors, consider a convertible debt deal with two additional features: a reasonable time horizon on an equity financing and a forced conversion if that horizon isn’t met, as well as a floor, not a ceiling, on the conversion valuation.

Feld, Brad,Mendelson, Jason. Venture Deals (Kindle Locations 2934-2936). Wiley. Kindle Edition.

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.

Feld, Brad,Mendelson, Jason. Venture Deals (Kindle Locations 2989-2992). Wiley. Kindle Edition.

Convertible Debt also comes with an interest rate, where the typically rate goes for about 5% and 12% with a mean of 8%.

Conversion Metrics

Several factors go into the conversion metrics.

Term is the amount of time a company must sell equity by. Typically capped at 1 year since that is the max maturity date VCs have agreed with their own investors that they are allowed to issue debt for.

Amount. Usually there’s a minimum amount the company must raise.

If the company cannot meet the convert metrics, then the debt remains outstanding. This is bad for the company since debt holders have more rights than shareholders like forced bankruptcy, etc. The debt can be converted to equity without new financing, via a vote. The voting rules here are important. Usually it’s just a majority, but in some cases it can be a super majority.

In the case that there’s a full acquisiton of the company before they’ve been able to raise Series A, etc. then usually the lenders just get paid back their principal plus interest. They don’t get any of the upside from the acquisition since they don’t actually own the company yet. In a stock deal, this can be tricky since the company needs to come up with the cash to pay back the debtholders.

Sometimes there is also a multiple on the principal, typically between 2-3x, but could be higher in later stage companies.

In other cases, there is a partial conversion in the case of a stock acquisition where the debtholders receive stock in the acquiring company at the original discount and a valuation subject to a cap.

Warrants

Warrants are an alternative to receiving a discount on the next round of financing. Usually in the case of later stage companies where a previous round has already been raised.

The amount of warrants that are issued to convertible debt investors is described via warrant coverage. If the warrant coverage is 20%, and the amount of the convertible note is $100,000, then, when the next round of financing occurs, the debtholders can purchase $20,000 of warrants at:

The most common case is price of the previous preferred. The upside for the warrant holders is the term length. If the term length is 5 years, and 5 years from now the company is worth much more, then the debt investors can purchase stock in the company at a much more attractive price.

Merger considerations with warrants are important. Typically, warrant holders have the right to exercise their warrants at a time right before the acquisition. This is usually a pain for everyone involved besides the warrant holders. The acquiring companies will sometimes offer stock in the acquirer to the warrant holders, and the target company will try to negotiate with the warrant holders to pay them off so they can get a deal done.

Last Notes

SAFE (Simple Agreement for Future Agreement) is an alternative to convertible notes, which is more founder friendly and less investor friendly (does not include an explicit pro rata right and no set maturity date) that was created by Y Combinator.