I frequently field questions from entrepreneurs and angel investors about Convertible Debt, and more recently about SAFEs (Simple Agreement for Future Equity). This is a topic that many have written about, so I thought it might help to do a quick post summarizing Vocap’s perspective and then provide some links to more thorough pieces written over the years.
If you are new to venture investing, these topics can seem confusing and complicated. Building a business is difficult enough. No one told you that you’d also need to take a minor in financial & legal engineering as well. If this is your situation, not to worry, as you can come up to speed on the basics quickly if you Google around.
I will share our perspective for starters. As early growth stage investors, Vocap typically leads Series A or Series B financing rounds. When we lead a round, we use a priced equity structure utilizing preferred equity. This is typical for institutional investors at our stage. We do use convertible debt in bridge rounds with existing portfolio companies, but we don’t typically initiate a new investment in a company using convertible debt. Here are a few quick bullets explaining our rationale on this:
- Ownership – with a new investment, we want to understand how much of a company we are buying and at what price. Convertible debt and SAFEs don’t answer these questions.
- Risk – we believe it’s in both the entrepreneurs’ and investors’ interest to establish a fair valuation for the company at its current stage. Convertible debt and SAFEs kick this can down the road. For reasons of speed and cost of funding, this can sound appealing, but it has some very real issues for both sides. From the investor’s perspective, why should they put capital at risk now only to see the use of this capital drive a higher price for their investment in the future? And for the entrepreneur, why should they be asked to (i) incur what can effectively be full ratchet anti-dilution (plus a discount) in a down round scenario or (ii) face potential increased liquidation preferences from the cap in an up round scenario? All of this to say nothing of the potential for a note cap to bias valuation on the next priced round. In the chart below, we’ve outline a few key risks for entrepreneurs to consider in both upside and downside scenarios, assuming a cap and discount structure.
If you’d like to understand this further, read Mark Suster’s post on the topic.
- Governance – given our operator-turned-investor backgrounds, we are typically ‘active’ investors that participate in a board role and seek to help entrepreneurs navigate choppy waters and grow their companies. If we are not in an active role, then we usually co-invest with another investor that will be playing an active role. Building a great company is very difficult, and having a strong Board in place to help management is important. Again, convertible notes and SAFEs kick this can down the road and do not deal with the issues of corporate governance. This may be fine for a friends and family round, but doesn’t fit at our stage.
Generally speaking, both entrepreneurs and investors should be wary of funding structures without valuations (non-priced rounds), particularly involving new parties. At the very least, it would serve you well to ensure you are aware of all of the risks.
As mentioned, there are quite a number of posts on this topic dating back to when convertible notes became a hot structure out on the West coast. Here are a few links you might find useful:
- Mark Suster’s posts on the topic from 2010, 2012
- YCombinator’s SAFE documents
- Jason Lemkin’s post on Convertible Debt vs. Equity on SaaSter
- Fred Wilson’s thoughts on convertible debt from 2011 and 2012