Over the past few days there have been 2 important blog posts on convertible debt. The first was Mark Suster’s post titled “One Simple Paragraph Every Entrepreneur Should Add to Their Convertible Notes” and the second was Brad Feld’s post titled “The Pre-Money vs. Post-Money Confusion with Convertible Notes“.
Mark’s post warned of the often unintentional punishment that founders inflict on themselves when doing a convertible debt deal that contains a valuation cap. The punishment comes in the form of “unjust” liquidation preference that the note holders end up with when they convert at a valuation cap that is way lower than the valuation of the actual round. Quick explanation: a note with a valuation cap provides that upon a subsequent conversion of the note to equity resulting from a subsequent equity round (let’s say a Series A round), the note holder either converts at a price equal to (i) a stated discount to the Series A price OR (ii) a price determined using the valuation cap. For example, if the valuation cap was $3mm and the Series A round pre-money valuation was $10mm, then it would be likely that the note holders conversion price would be determined using the valuation cap (so $3mm/# of shares outstanding fully diluted pre-money = conversion price). Bottom line: the note holder chooses whichever option gives a lower price for conversion.
The “unjust” liquidation preference comes in when the valuation cap price applies (it also applies a bit with a discount that is large). In the example above, let’s just pick easy numbers and say the Series A price is $1.00 per share (calculated by taking $10mm premoney valuation/10mm shares outstanding fully diluted = $1.00). Appling the valuation cap of $3mm, the conversion price would be $3mm/10mm shares outstanding fully diluted = $.30. So the note holders convert their principal and accrued interest at $.30 a share and buy a lot of Series A!!! Each share of Series A will have a liquidation preference of $1.00 (assuming 1X preference, which is normal). So, the note holders pay $.30 a share yet get $1.00 per share liquidation preference. WOW!! Therein lies the “unjust” liquidation preference of $.70 a share!! It is like unjust enrichment. You can read Mark’s post on how to solve this problem.
Brad’s post talks about how convertible debt factors into the premoney valuation……or NOT. My view on this is clear: the purchasing power of the convertible debt (which in simplest terms equals (i) the number of shares purchased by the convertible debt AFTER applying discounts or valuation caps, multiplied by (ii) the full price of the shares paid by new purchasers) needs to be subtracted from the negotiated premoney valuation. If it is not subtracted then the new equity purchasers are not getting what they bargained for. I wrote a detailed post on this issue called “Building Convertible Debt Into the Premoney Valuation” back in early 2013. If you want a good explanation, check out this previous post.
Due diligence never has a good connotation. For companies raising money and management teams words like painful, slow, tedious, and torture come to mind. Pick your adjective. For investors, words like tedious, eye opening, boring and critical come to mind. Due diligence is critical to help VCs derisk our investments a bit.
I recently read a fabulous (now that is a word you never associate with due diligence!) article on the process. It was published by Lisa Suennen (I do not know Lisa) on PE Hub and is here. Lisa’s post includes a slide deck that explains her vision of due diligence as a 12 step program; this is clearly relevant as due diligence will drive anyone to the bottle! The slide deck is here.
The wonderful thing about Lisa’s presentation is that she asks questions throughout her entire deck. And they are the right questions. Preparing for due diligence using this presentation as a guide will greatly reduce the pain of going through the due diligence process. For companies raising funds and management teams, I suggest getting your ducks in a row in advance – create a separate folder in your investor file sharing system (dropbox or otherwise) for each category and then populate each folder with relevant materials and write-ups.
I hope this helps you survive due diligence! Have a great weekend.
Tough for me not to jump on the bandwagon when I see an article on the benefits of launching a startup in a small city.
Here is a most recent example from Inc. I agree with all 8 items listed, and I think Ithaca has 7 of the 8. Ithaca has centers of excellence (primarily at Cornell and now also at Coltivare; we have REV; we have good business locations to rent (with more being built); we have a really smart available workforce due primarily to Cornell, Ithaca College and TC3; companies clearly make a big splash when they are successful or exit; we have a very well connected startup community thanks to many events and eship-oriented groups; and Ithaca does allow for plenty of “focus” time. In my view, however, we could use more executive talent (so, all you seasoned execs, feel free to move here!).
In addition, one item not listed explicitly that I think should be on any list is that small cities are fabulous places to live and raise families. Easier, cheaper, “kids camp for everything”, great outdoor attractions, no traffic, 5 minute commutes, etc.
In short, Ithaca rocks for startups (and do many other small cities, but I am a little biased!).
I thought it might be interesting to pose a question and see who gets the right answer. The facts leading up to the question are a little complex, but I think the question is an easy one.
1. Company AB is an existing operating company that is doing well. Company XY is also an existing operating company that is doing well. Both AB and XY have venture investors. AB and XY are in the same industry “Z”, but have complementary product offerings.
2. Private equity firm LM wants to do a roll up of AB and XY to form a larger company with a broader range of product offerings in industry Z.
3. The plan is for private equity firm LM to make an offer to buy company XY. The structure of the offer is not irrelevant, but assume it would be a stock purchase. LM’s offer would be made through company AB, so that it feels like LM/AB are making the offer together with the end game being that AB’s management team would run the combined AB/XY company.
4. To finance the offer, private equity firm LM would first make an equity cash investment in AB. Then AB would use a big chunk of the investment cash to buy company XY. Company XY’s stockholders would thus be cashed out (and hopefully happy). At the end of the day, Company AB would own Company XY (they would likely do a legal merger) and the shareholders of Company AB, which now includes the private equity firm LM due to its equity investment in AB, own the combined companies.
5. Let’s assume that private equity firm LM invested $22 million in company AB in step 4 above. Let’s assume that $19 million of that is used to buy company XY (so $3 million of fresh cash is left in the combined company to fuel ongoing operations).
Question: as an existing investor in company AB what is the #1 most important fact not disclosed above that I need to know to figure out whether or not I am in favor of this proposed deal?
Leave your answers in the comments.
I just came across a super series of easy to understand videos on startup boards of directors. Brad Feld (Foundry Group) teamed up with the Kauffman Founders School and created about 35 minutes of content arranged in 7 relatively short video segments. Brad wrote about this today is his own blog.
It is worth viewing for anyone that has a board of directors or is considering forming one (for those in the very very very early stages). The videos are here on the Kauffman Founders School site. In fact, the site contains links to video series on a number of relevant startup topics (finance, leadership, selling, marketing, etc.). Easy viewing.
It is over 40 degrees and sunny here in Ithaca today. I saw some students in shorts!