Who Is Really Benefitting From Financing Deals?

Published in the San Diego Union-Tribune, July 27, 2015

Let’s talk about money.

And to get started, let’s explore a quote from Kevin O’Leary, my favorite “Shark Tank” investor. “I think of money as soldiers. I send them out to war each day, and I want them to take prisoners and come home, so there is more of them.”

On the other side of the battlefield is the entrepreneur. And the first salvo in wartime engagement is financing. Kevin has money, he is going to give it you and the discussion is basically how much and in what form.

And now we come to one of the most common forms of financing — the convertible debt note — and the question: Is this good for you or is it good for Mr. O’Leary?

First, what is a convertible note? It is a loan made to the entrepreneur. The key feature of the deal is that it converts into equity upon the occurrence of a future financing in an agreed upon amount. Another key feature is that there is usually a discount for the current investor (often 20 percent to 25 percent) when the next financing occurs (if ever), and so while the second investor (usually a venture firm) pays $1 per share, for example, the convertible note investor gets to buy his stock for 80 cents.

Note to all lawyers reading this: Do not get cute and give me the 23 nuances and tricky provisions associated with the structure. The big idea here is whether convertible financing is good for O’Leary or good for the entrepreneur.

The premise for the entrepreneur is this: Why argue about the valuation of my company today, because that is too hard to figure out. Just give me some dough, and you will get a “better” deal when some future dummy (venture investor) “sets the price of the next round.” The premise here is that a “professional investor” should pick the price, not friends, family and fools.

Let me quote Asheesh Advani, “determining how to value a startup is notoriously arbitrary and entrepreneurs tend to overvalue their new businesses.” So, my personal point of view is obvious — just don’t overvalue your new business.

In my opinion, convertible debt is a dumb deal for the investor, and it is wonderful for the entrepreneur. He borrows some money — which may never be paid back (unless the company survives), there is no personal guarantee and often the note is not even secured by the assets (intellectual property and desks).

In other words, in exchange for not arguing about the valuation, the investor gets the opportunity to take all the risk. Sign me up for that one.

Let me explain about risk. Let’s pretend that in fact, the company makes it and gets venture financing and a promising valuation. You, the investor, get a modest discount into ownership in the new round — but in fact, it was your money that allowed the company to make it to that point. In other words, to quote Emily’s List — “early money is like yeast” — and should be valued as such.

Twenty years ago, convertible notes were used very seldom. The entrepreneur and the investor arm-wrestled and agreed upon a price at that point in time. Interests were aligned. In the current world of financing, the entrepreneur (ostensibly) is king and does not want to “give away too much” by pricing the round. Unless the note has a very low or very modest “cap” — effectively a ceiling on the pre-money price of the new round — the investor is not being properly compensated for his risk. A cap functions as the worst price you the investor will be valued at.

Without a cap, why would I lend money to a company and then agree to a purchase price later based on its success? The more successful the company, the more I will finally pay for my equity share. That is nuts. You wouldn’t do that in the stock market, so why do it in startup-ville?

We will revisit this topic again from time to time. But like O’Leary, my soldiers are well trained and expensive and I do not want them gunned down needlessly.

Rule No. 410

Be respectful of money — especially when it is not your own.

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