Angels bring the ďhigh riskĒ capital to seed and startup companies and deserve consummate high rewards for their home runs. But, by employing convertible debt in seed and startup investments, angels substantially reduce their returns in highly successful ventures.
by: Bill Payne Angel Investor http://www.billpayne.com
Convertible debentures are debt instruments that convert into equity at triggering events. Angels and other early stage investors use convertible debt as a funding bridge until a subsequent, larger round of investment is closed, usually by venture capitalists (VCs). This bridge loan is converted to an equity investment under the same terms and conditions as the subsequent VC investment and at the same valuation, less a discount to compensate the angel bridge investors for added risk. The discount can vary from 5% to 30%, usually depending on the length of time between the closing of the angel bridge round and the closing of the subsequent VC round.
Convertible debt is inexpensive (minimal legal fees) and leaves the dreaded valuation negotiations to the VCs. When the target company has important assets (patents, capital assets, etc.), investing in an unsecured debt instrument could provide the investors with some downside protection, since distributions at a possible bankruptcy of the company would go first to debt holders before any distributions to shareholders.
The Internet bubble crushed many giddy angels and VCs who invested in seed, startup and early stage companies at outrageous valuations. Afterwards, many angels turned to using convertible debentures for seed/startup investments, as protection from down rounds, even when subsequent investors were not on the horizon. Unfortunately, using convertible debt in these circumstances can substantially reduce by 2-3X the ROI of angel investments, reducing a possible 20X return to 10X or even 7X.
Entrepreneurs and their advisors are eager to offer convertible debt to seed/startup investors. Postponing the valuation negotiation until a subsequent VC round preserves precious equity for the entrepreneurs. Furthermore, debt instruments are generally much less expensive to generate than are documents necessary to close equity rounds of investment, especially those requiring the establishment of a new preferred class of securities for the company. Noting that some attorneys offer reduced or deferred fees to entrepreneurs during startup, one could imagine attorney advisors also suggesting convertible debt for the first angel round.
But, convertible debt is seldom a good seed or startup investment for angels. How does convertible debt reduce the ROI of angel investments?
Entrepreneurs who need to raise multiple rounds of investment are asked by investors to raise enough money in each round to accomplish significant milestones, such as licensing of a critical piece of technology, completing a prototype, entering into an important partnership, entering beta testing, completion of FDA I testing, achieving first revenues, etc. Accomplishing these milestones reduces risk and increases the valuation of the enterprise.
Letís look at the valuation of a hypothetical company in the graphic below. The three stages of this company (A, B, & C) might be defined as follows:
A Ė a pre-revenue company with a prototype but without substantial orders
B Ė the same company after successful beta testing by the first customers
C Ė the same company after closing on additional partnerships that are substantially ramping sales
This is a plot of the valuation of a hypothetical new venture over time, say 2-3 years. Clearly the increase in valuation of the company is not linear, because of the achievement of specific milestones substantially reduces the technology and execution risk of the company. Demonstration that substantial revenues can be generated between points B and C would be expected to be accompanied by a large step up in the value of the company.
Angel investors typically invest at the seed/start up phase of enterprise development, on the timeline between points A and B. The company is typically pre-revenue but has accomplished some milestones and identified customers interested in testing the product.
Case I: Letís assume a VC discovers that an entrepreneur has an interesting product and is operating in a business vertical close to the sweet spot of the VCís portfolio companies. The VC is in due diligence but the entrepreneur is running out of cash. The entrepreneur approaches angel investors for funding and explains the VCs interest to the angels but makes it clear that the VCs investment is still several months into the future (but before Point B in the chart). In this case, it might make sense for the angels to accept convertible debt in exchange for their investment, knowing that it is likely, but not assured, that the VCs will negotiate a valuation and invest within a few months. Since the angels are assuming more risk than the VCs, all parties agree that a 20% discount off the valuation of the VC round would be fair for the angels who invest earlier. (The angels also assume the risk that the VCs will decide later not to invest.)
Case II: Letís assume the entrepreneur and angels anticipate the need for raising more capital at some point in the future, but expect the entrepreneur to achieve substantial milestones with the cash invested by the angels. We might expect those achievements to move the company to or beyond point C on the chart above. If so, the angels should expect a 2X or more step up in valuation at the time the VCs invest. In this case, it is in the best interest of the angels to invest in a preferred security, rather than convertible debt. Establishing the preferred class of stock for the angels prior to the involvement of the VCs smoothes the road for the subsequent investment by the VCs. If the angels invest in a convertible debt instrument in Case II, the entrepreneur and angels cannot possibly establish a fair discount against the valuation of the subsequent round. [The author acknowledges that this simple model suggests that VCs might invest at valuations as low as $2 million, which is highly unlikely. Nonetheless, this example remains valid in explaining the thesis that convertible debt is a poor investment for angels.)
Letís establish some guidelines:
1. If and only if a subsequent investor (usually a VC) has a signed term sheet with the entrepreneur and has started due diligence, it may be appropriate for angels to invest using convertible debt (a bridge loan to the closing of a much larger round of funding by professional investors). In this case, the angels deserve a discount off the negotiated valuation between the entrepreneur and the VCs, probably 10% to 30%, depending on the time required to close the round.
2. If no subsequent rounds of investment are anticipated, angels may choose to invest in convertible debt but only with the conversion defined by a valuation acceptable to the angels at the time of the investment. In this case, angels may be reducing their risk somewhat in case of a negative exit. Debt holders will likely have the rights to take over assets (patents, etc.) in the case of a bankruptcy, ahead of shareholders.
3. If subsequent rounds of investment are anticipated, but no such investor has been identified, it is impossible to assess the time required to close a subsequent round. Even a poorly funded company, in such cases, can accomplish significant milestones that will raise the valuation of the company substantially. In this case, angels should never invest in convertible debt (unless the valuation at conversion is specified), even with a variable discount of the next round (say, 2% per month between the closing of the angel round and the subsequent round). Variable (or onerous) discounts usually result in the subsequent investor negotiating away a substantial piece of the discount. In this case, preferred shares are the most appropriate security for the investment.
One final comment against using convertible debt for angel rounds: Convertible debt creates misalignment between entrepreneurs and their angel bridge investors. Angels would prefer to see VCs invest at a lower valuation as the angels convert their bridge debt to equity (increasing the angelsí ownership fraction) while entrepreneurs seek VC investment at a higher valuation (maintaining more ownership for the entrepreneurs). Under these circumstances, angels may be less motivated to undertake activities that could increase valuation prior to the subsequent funding. Misalignment of entrepreneurs and investors is simply a bad practice.
For Entrepreneurs: Pursue smart money, that is, investors who can help you build a great enterprise. Smart money will likely want to invest in preferred shares in your company.
For Angels: Donít fall in love with entrepreneurs, their products or their technology. Look at the deal terms early. Walk away from non-negotiable deals in which convertible debt with no specified valuation set at the time of your investment, especially when no subsequent investor is on the scene.
For Attorneys Advising Startup Entrepreneurs: Understand that smart angels are going to walk away from most convertible debt deals. Help your clients structure deals that are best for both sides and will tee up the company for subsequent rounds of investment.
The author thanks friends George Lipper, editor of NASVFís NetNews and fellow angel investor, Robert C. Anderson, Esq, of Hale Lane Las Vegas for their comments on this work.
The author has made over 45 angel investments since 1980 and helped found four angel groups, the Aztec Venture Network (San Diego), the San Diego Tech Coast Angels, the Vegas Valley Angels and the Frontier Angel Fund (Whitefish, Montana). He has written the Definitive Guide to Raising Money from Angels, which is available at http://www.billpayne.com. He can be reached at firstname.lastname@example.org.