CrunchBase recently published a including the different types of deal structures, priced (equity) and unpriced (convertible notes or SAFES). The post was a useful, if very high level, overview of the early-stage funding process. However, due to this simplicity, the article painted a naive picture of how unpriced rounds often work in practice. While notes and SAFES have become the norm in recent years, it doesn’t mean they should be, especially in underserved ecosystems like Texas, Pittsburgh, or Atlanta. new case study on early-stage funding In these metros, early-stage capital is scarce, thus increasing an investor’s negotiating leverage. Given that context, fundraising is often an extremely difficult hurdle to navigate for local entrepreneurs. Ultimately, unpriced rounds making up the majority of early-stage deals in emerging ecosystems can be shortsighted. Over the long term, it can limit a startup’s ability to raise future rounds and hinders the ecosystem as a whole by sometimes forcing great entrepreneurs to start companies in more favorable markets where investors are accustomed to optimizing for the company’s long term success. It’s easy to forget that, just 130 miles outside Chicago, is the University of Illinois’s main campus. “Remember, Marc Andreessen was building Mosaic at U of I, and Max Levchin,” probably best known as the founder of PayPal, “was down there too.” Carter relayed the story of how Levchin came to Chicago to raise money for his first startup, he was spooked by the terms put forth by the independent investors he spoke with. He probably left for the Valley because we [Chicago investors] couldn’t structure a deal,” — Jeffery Carter, Hyde Park Angels Convertable notes and SAFES only make the process more confusing by putting off the valuation and thus hiding the potential ownership (i.e possible dilution) at the time of conversion especially in cases where the startup has raised more than one note on varying terms. I believe some investors do like this opacity. Entrepreneurs are not the only ones put at risk by unpriced rounds of fundraising, the investor hasn’t actually put themselves on the cap table which leaves open the possibility of issues such as the renegotiation of their terms by the next lead investor. This puts the seed investor in the awkward position of getting the terms they believe they negotiated or being the “bad guy” who could potentially spoil the next round. The goal of any aspiring startup ecosystem should be collectively working to eliminate onerous term-sheets to better incentivize founder upside for the ENTIRE lifecycle of a company, not maximizing the “paper” upside of one investor for one round. This perspective enhances the goodwill between investors and entrepreneurs while encouraging both sides to continuously participate in the scaling of great companies. We achieve this by taking four simple steps: Legal fees used to be the main sticking point for doing an equity term-sheet but now the prices can be fairly comparable. As mentioned above, there remains little reason to delay valuation for sophisticated investors. Use priced seed rounds whenever possible. One of the best practices we’ve implemented is showing our entrepreneurs pro forma cap tables in the event of down rounds and the cap set in the term sheet. This allows us to highlight the various levels of dilution are possible for founders. Provide extreme clarity in the event the round must be a note or SAFE. We advise the startups with which we work to offer only one round of convertible notes with the same terms to all participants. As Fred Wilson has recently pointed out, $1–2M “feels about right” for the cap on the size of the raise. Obviously, this depends on the product being built and the anticipated runway. Simplify the terms. By doing this, we allow founders to do the research themselves and read the opinions from both sides to the table. Y-Combinator, Fred Wilson, Seth Levine, and many others have written extensively on this topic. We encourage founders to seek, and in many cases we provide, these resources. Provide a list of established VC resources and thoughts on notes. Anyone who has discussed venture investing with me knows I passionately dislike unpriced rounds though that doesn’t mean I won’t do them. The ultimate goal for us has, and will always be, to partner with the best possible companies. However, if we do participate in Notes or SAFES we work extremely diligently to make sure the terms are clear and founders thoroughly understand the pros and cons of the structure. Originally published at kevindstevens.com on September 13, 2017.

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Why Convertible Notes Hinder Growth In Underserved Ecosystems

Too Long; Didn't Read

Kevin Stevens

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Why Convertible Notes Hinder Growth In Underserved Ecosystems

Too Long; Didn't Read

Kevin Stevens

About Author

TOPICS

THIS ARTICLE WAS FEATURED IN...

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