
How to sell debt to investors - nivi
http://www.venturehacks.com/articles/attractive-debt
======
paul
I'm still not buying unless a valuation is attached (his option four). Here is
my reasoning:

Many startups are interested in using a convertible note for their early
funding. I've heard three reasons:

1\. It's less paperwork than preferred stock

2\. VCs would rather do a Series-A than a Series-B (one solution is to name
this first round "Series-Seed")

3\. It lets them avoid having to determine a valuation

The first two reasons seem fine to me, assuming that they are true. The third
reason is bad.

These convertible notes typically convert into preferred stock upon the next
major financing (presumably the Series-A led by some VC), usually at some
discount to what the VC pays (perhaps 20%). Sometimes there is a cap on this
conversion price. If that cap would be a reasonable pre-money valuation today,
then third reason doesn't really apply, since a valuation was in fact
determined.

However, if there is no cap on the conversion price, or that cap is very high,
then you are asking investors to give you money today, but not giving them the
upside between now and then next major funding (which probably won't occur for
another 6 - 12 months). During this 6-12 months you will build and hopefully
launch a product and begin to prove it's market potential, or not. That's a
lot of uncertainty.

Put another way, I'd rather wait 6-12 months to see what you build, how
successful it is, and how well your team executes, and then decide whether or
not to invest. And I'd gladly pay an extra 30%. However, if you need the money
today, then it needs to be at today's valuation, not next year's.

~~~
nivi
Hi Paul,

There are lots of benefits to doing debt in a seed round. We discuss them in
detail here: <http://www.venturehacks.com/articles/debt-benefits>

Here's a summary from the article: "Convertible debt is often the best
instrument for a seed round. You can close the debt cheaply and quickly and
then turn your focus back to your customers. That's good for the company and
its investors since speed is a major competitive advantage of a startup. If
you or your investors are veering away from convenience, low cost, and speed,
you are missing the point of seed stage debt!

"The seed stage is the worst possible time for the founders to negotiate an
equity financing. The company is nebulous, the founders are inexperienced, and
the company is starved for cash and time. The team should be testing
hypotheses about their business, not negotiating complicated term sheets."

See the article for details: <http://www.venturehacks.com/articles/debt-
benefits>

A cap doesn't determine a valuation. It just sets a cap. Setting a valuation
implies buying preferred stock, I assume you don't want to buy common stock in
the business. That means negotiating investor rights--that is a pain in the
ass. (I've never seen this but I suppose you could defer negotiating investor
rights and just say that the seed investors will get the same rights as the
eventual Series A investors. Anybody want to chime in?)

A cap can be closer to the founder's high minimum expectations and avoids a
long road show. A cap avoids setting a high valuation and then doing a down
round in the Series A. A cap avoids setting a low valuation and then being
unable to substantially increase the valuation if you do a Series A soon
afterward.

If you want more of a reward, we suggested increasing the discount. A 50%
discount guarantees you a 2x paper return on your money. A 40% discount
guarantees a 1.7x paper return. You can also have the discount increase over
time.

As always, our hacks are generalized and should be tailored to the specific
circumstances. And your deal is mainly determined by your leverage, nothing
else: e.g. every deal that closes is a "good deal".

~~~
paul
I agree with avoiding complicated negotiations, which is why I'm fine with
debt, but only if it is capped at a reasonable valuation.

Consider these two possible series-A investments:

\- Sequoia at a $5M pre

\- Some lame VC at a $15M pre

As a seed investor, I would probably prefer Sequoia (obviously the other
details matter, but on average), meaning that if they went with the lame VC I
would get double-hurt with uncapped debt (I get a smaller percentage of a
company that has a smaller chance of success).

