Yesterday brought us an executive order rolling back much of the (meager) progress we’ve made reducing the US’ reliance on carbon energy and the resulting impact on climate change.
The New York Times has a good editorial piece today on this and other moves this administration has made in its short tenure to protect the carbon energy industry.
I am of two minds on this. On one hand, I am pissed off, annoyed, irritated, upset, and dismayed that we have such a luddite in the White House that he can’t see what carbon energy has done, is doing, and will do to our planet. But on the other hand, I am well aware of the progress that wind and solar and other clean energy technologies have made in the last couple decades and I believe that market forces are on the side of our planet and against the carbon fuel industry and that these market forces are getting stronger every day.
Among other things, we will be doing our monthly match this weekend for a climate change focused non-profit and I hope you all will join us to raise money for climate change and stand up against these outrageous acts.
We are considering the following organizations:
Natural Resource Defense Counsel
Environmental Defense Fund
We may add others to this list. If you have any thoughts on these organizations or want to propose others, please do that in the comments.
The WSJ reported yesterday that Elon Musk is developing yet another company, this one based on neural lace technology, to create a brain computer interface.
Neural lace technology, as I understand it, involves implanting electrodes into the brain so that the brain can control machines directly without the need for an IO device like a mouse, keyboard, or voice interface.
I have no idea how advanced this technology is and whether it is ready for commercialization or if this is basically a research project masquerading as a startup.
But in some ways that doesn’t matter if you believe that at some point someone or some group of scientists and medical professionals will figure out how to directly connect our brain to machines without the need of an IO device.
There are so many times that I have thoughts that I don’t do anything with. They sit idle and maybe go nowhere. But if my brain passively passed those thoughts onto a machine for storage or some other action that could lead to a more productive train of thought that could be incredibly valuable. Or it could drive me insane.
I generally subscribe to the theory that all progress is good as long as we understand the negatives of the technology and we (society) engineer controls and the proper repoanes to it (nuclear weapons being an example).
But every time something as mind bending as the idea of connecting our brain to external processing, storage, and communication infrastructure comes before me I do have to pause and ask where this is all going.
At times like this it helps to have a belief system (progress is good). I am all for pushing the envelope of progress as long as we spend an equal amount of time and energy thinking through what might go wrong with things like this.
Hat tip to Niv Dror who read yesterday that I wasn’t sure how I was going to post today and encouraged me to write about this topic.
For the past few months, I’ve been living and posting from the west coast, as has become our routine during the winter months. Regular readers have likely noticed that new posts show up around 9am/10am ET instead of 6am/7am ET. This will be the last post from the west coast this winter as we are returning home to NYC this afternoon.
I am not entirely sure how I’m going to get a blog post in tomorrow morning as we arrive late and I’ve got an early breakfast, but I always seem to find a way. It certainly will have to be posted by 7:30am ET before I start my day. Maybe I will write it on the plane home this evening.
The winter out west routine works really well for me. It gets me away from the hustle and bustle of NYC and in a bit more reflective and relaxed mood. It’s not a vacation. I work ten hour days, but I start them at 5am and end them mid/late afternoon, in time for a bike ride or a late afternoon yoga class.
I am going to miss all of our friends and family in LA and the incredible weather, vegetation, sights, and smells. Here’s a photo I took from a sunset walk on the bluff with my friend Mark last week.
I will miss this place, but I’m also eager to get back to the big apple.
One of the most frustrating things about Board meetings is that it is difficult for founders and CEOs to get feedback on them.
I’ve seen some interesting approaches to addressing this problem lately.
Some companies are sending around post meeting feedback forms and asking all attendees to fill them out.
Some CEOs have asked their Board members to send emails to them summarizing their thoughts and take aways after the meeting.
I am a fan of anything that produces meaningful feedback for management from Board meetings.
My preference is to build the feedback function right into the meeting with a post meeting executive session between the CEO and directors where the feedback is delivered face to face in real time.
The big challenge with the post meeting executive session is that all Board meetings seem to run over on time and the end of the meeting is a time crunch.
So making time for the executive session is often challenging. But it is worth it in my view.
Regardless of what technique you are using, if you are running Board meetings and not getting feedback on them, you are doing it wrong.
Jeff Raider founded/co-founded two “direct to consumer” businesses in the last ten years, Harry’s and Warby Parker. In this conversation with David and Andy, he lays out how he thinks about the ways that direct to consumer is changing the way brands and retailers do business.
I got this tweet today:
@fredwilson have you ever told the story of your profile pic?
— Jim Christie (@jamechristie) March 24, 2017
The answer is yes I have but it was eight years ago. I thought it would be fun to re-run that post.
Here is is:
I saw this tweet when I got up this morning:
hey @fredwilson – whats the story behind ur avatar?
While longtime readers know it, I figure many of you don’t. So here it goes.
Starting about four years ago, Howard Lindzon started commenting actively on this blog. He was funny, he was smart, and I enjoyed our banter in the comments.
One march vacation, our family made a short stop in Phoenix, where Howard used to live. He emailed me and offered my son and me two tickets to the Suns game. We took him up on that and that’s how we met for the first time.
It turned out Howard was hatching an idea for a web show for investors. Think Rocketboom meets Jim Cramer. I told him it was a good idea and encouraged him to do it. Howard would fire ideas at me and I would give him feedback on them.
Out of that came Wallstrip. Here’s a post I wrote a little over three years ago announcing the launch of Wallstrip.
One of the original ideas for the show that never really worked out was that there would be a dozen well known bloggers who would write short posts about each daily show. Howard asked me to do that and I agree to do it at least once a week.
So that’s how the avatar came to be. Howard asked his friend Jenny Ignaszewski to draw up avatars for all dozen of the stock bloggers using photos of them that were available on the web. The first time I saw my avatar was when Wallstrip launched and there it was along with Howard’s and a bunch of others.
From the minute I saw it, I liked it. It uses my favorite color (green) as the backdrop and the eye color (my eyes are sometimes blue and sometimes green and sometimes something else). It looks like me, but not too much.
So I began to use it a bit here and there around the web as I set up new profiles. But by no means was it the only profile picture I used. For corporate oriented services like LinkedIn, I’d use my Union Square Ventures headshot. For social nets like Facebook, I’d use a regular headshot. I used a photo of me taking a photo on Flickr for a long time.
But then I started to realize that the Wallstrip avatar was becoming my online identity. People would comment about it all the time. Around the time we sold Wallstrip, Howard asked Jenny to do a real painting of it which I now have in my office at Union Square Ventures. It’s a real conversation starter.
Sometime in early 2008, I just decided to go with it everywhere. It’s at the top of this blog and everywhere else I have an online identity. It’s my online brand now.
Like this blog, this was not planned. It just happened. That’s the way most of the important things in my life have come to be.
CARA is a research assistant for lawyers that offers a super simple proposition:
Securely upload a brief and discover useful case law
CARA uses Casetext’s wikipedia-like database of >10mm court cases and annotations and sophisticated natural language analysis and artificial intelligence to understand the brief and recommend related cases for a lawyer to analyze and possibly cite in their brief.
Lawyers seem to love CARA. According to Silicon Valley Business Journal:
“CARA is an invaluable, innovative research tool,” Quinn Emanuel partner David Eiseman said in a statement. “With CARA, we can upload a brief and within seconds receive additional case law suggestions and relevant information on how cases have been used in the past, all in a user-friendly interface.”
We think the legal business is ripe for AI-driven innovation. Much of legal research can and will be automated with tools like CARA.
If you are a lawyer and do a lot of legal research, check out CARA. Securely upload a brief here and check it out.
I’ve told bits and pieces of this story here on AVC over the years but I don’t think I’ve ever told the whole story. Y Combinator (YC) Demo Day has been going on over the past few days up in Silicon Valley and it prompted me to remember a demo day in Boston (where YC started) ten years ago:
— Fred Wilson (@fredwilson) March 22, 2017
It was the summer of 2007 and back then YC would do a summer session in Boston and a winter session in the Bay Area. Paul Graham eventually moved himself and YC to the Bay Area and the summers in Boston ended. I agree with my partner Andy that those early demo days in Boston were something special.
So a few days before demo day, Paul Graham emailed me and told me that a YC team wanted to launch its new product on AVC at demo day. He explained it was a new modern comment system that was better than the ones that came with WordPress and Typepad (which was where AVC was hosted back then). I was intrigued as I really hated the Typepad comment system. But I did not want to do any work to add a new comment system to AVC. Paul suggested I give him the login credentials to my blog CMS and he would give them to the founders. I agreed and over a few days, Daniel Ha and Jason Yan, the two founders of Disqus, put their comment system onto AVC. They left all of the old comments in Typepad and set up Disqus to power the comments on the new blog posts.
I showed up at Demo Day excited to see all of the companies (19 that day) present. When it came time for Disqus to present Daniel got up on stage, explained that the current comment systems were terrible, and that they had built a better one. Then he pointed the browser on the presentation computer to AVC, scrolled down to leave a comment, and there was Disqus running at the bottom of the post. He showed how easy it was to login, post a comment, and how it rendered nicely in line with the post. It was slick and I was impressed.
After the presentations, the investors would mingle with the founders. Paul and Jessica put out a super nice cheese and cured meat spread. I went up to Daniel and told him that I really liked his presentation. He thanked me and asked me if I would keep Disqus on AVC. I can’t remember if it was even called Disqus back then. But anyway, I told him that if he and Jason could build me one feature quickly, I would keep Disqus on AVC.
Here’s that feature request. The Typepad comment system would email me every time someone posted a comment on AVC. But I would have to go to AVC to reply. It was clunky and I hated it. So my feature request was “send me the comment notification emails with the ability to reply right in my email” (on my Blackberry at the time). Daniel said they would look into it.
I think Demo Day was on a Thursday. The following Monday, I got an email from Daniel saying that they had launched my requested feature over the weekend. So I tested the feature and it worked exactly as I had imagined it.
I had been making this feature request of Typepad for some time and they had not been able to get to it. I totally understand that a big company with a long roadmap is different than two founders with a brand new product. But the fact that Daniel and Jason had built it and shipped it over the weekend impressed me.
Disqus has been running on AVC ever since and I still love the product and the founders.
But I did not think about investing in Disqus at the time. I thought it was a utility that could be replaced by an even better comment system that would come along some day. In January of 2008, I caught up with Daniel in San Francisco and he explained that Disqus was running on tens of thousands of blogs and everyone who commented on the AVC blog with a Disqus profile could also comment on those blogs with the same profile. Then it dawned on me that Disqus was a network, not a utility. USV invested something like $300k in a seed round a month or so later and we have been investors in Disqus ever since.
To me, this is the quintessential YC story. Two “hackers” built something that the market needed over the course of a month or two during a summer in Boston (they were based in SF), demoed it to a bunch of investors, hooked one of them with the slick presentation, and eventually got the VC to invest in their company. But the part I love the most about this story is the feature request that they implemented over the weekend. That feature turned out to be highly viral because anyone who left a comment on any Disqus powered blog would get an email when anyone replied to their comment (and still do). That brought people back and the conversations flowed much better on Disqus powered blogs than on the incumbents’ comment systems. That is the power of listening to your customers. And the power of turning a customer into an investor.
My friend Howard Lindzon, who I met on this blog something like twelve years ago, runs an annual conference for fintech entrepreneurs and investors called Stocktoberfest.
Yesterday he hit me up on sms and told me they are doing Stocktoberfest East in NYC next week on March 29th and 30th. He asked me if I would do a chat with him. I told him that I’m not that interested in stocks but super interested in digital assets, cryptocurrencies, blockchain, etc. So we are going to do a 30min chat and I’m calling it Cryptoberfest.
Great news — my friend @fredwilson will be fireside chatting with me next week at Stocktoberfest is a session he is calling Cryptoberfest
— howardlindzon (@howardlindzon) March 21, 2017
My vision for this talk is a completely unprepared and unscripted talk between two old friends about all the amazing things happening in crypto land these days. It should be fun. If you want to attend, you can get a ticket here.
Despite the happy talk coming out of Washington and New York about the supposed economic recovery, the present economic and political order remains on course toward self-destruction. I’ve said it over and over again that the fundamental flaw is the compound interest that is built into the global debt-money regime. The fact that virtually all money is created by banks that “lend” it into circulation at interest causes debts to grow faster and faster with the passage of time. A quick glance at the timeline for public and private debt makes this obvious.
Prof. Richard Wolff, in the video below, does not mention this debt-growth imperative, but he does a good job of explaining how the governments and the central banks managed to temporarily forestall total collapse following the 2008 financial crisis, and why their actions are failing to solve the basic problem of slack demand.
We need to look beyond economic ideologies to find ways of defusing the debt bomb which grows bigger and more deadly with every passing day. A shift toward innovative, interest-free, approaches to the exchange of value and the financing of enterprise development provides the most promising route toward a soft landing. See The End of Money and the Future of Civilization.
From his newsletter this morning:
Indebted: Last week we noted that Wal-Mart subsidiary Jet.com had acquired ModCloth, an online retailer of vintage women’s apparel. No financial terms were disclosed, but this didn’t feel like a success for either ModCloth or the venture capitalists who had invested over $70 million into the business since its founding 15 years earlier. Here’s what happened, per sources familiar with the situation:
- In 2013 ModCloth went out in search of Series C funding, but the process was felled by a back-to-back pair of lousy quarters. So instead it accepted $20 million in unsecured bank debt.
- ModCloth effectively treated the debt like growth equity, rather than recognizing the time bomb it could become.
- When the debt first came due in April 2015, existing ModCloth investors pumped in new equity to, in part, kick repayment down the road for two years. This came amid four to five straight quarters of profitability, and just after the company brought in a former Urban Outfitters executive as CEO.
- Once the income statement returned to the red, ModCloth again tried raising equity ― but prospective investors cited the debt overhang as their reason for passing on a company whose unit economics were otherwise fundable. Insiders could have stepped up but didn’t.
- Jet.com heard of ModCloth’s debt coming due debt month, and pounced. We’ve been unable to learn the exact amount it paid, except that the amount left over for VCs after repaying the debt (and accounting for receivables) won’t be nearly enough to make them whole.
- 2 takeaways: (1) Debt is not inherently troublesome for startups, particularly if it’s supplementing equity as opposed to substituting for equity. But startups must recognize that not all cash is created equal. (2) ModCloth was founded in Pittsburgh, but later moved its HQ to San Francisco. It’s impossible to know if things would have worked out differently had the company remained in the Steel City, but some of its quirky retail culture did seem to get commingled with the “grow grow” tech etho
I have lived this story several times in my career and we are seeing this play out again in the market.
It is tempting to use debt instead of equity to finance a high growth company, particularly when you cannot get equity investors to value your company “fairly.” When a company has achieved “escape velocity” and is growing quickly, lenders look at it and say “there is enterprise/takeout value here and we are senior to the equity so the risk to us is pretty low.” And so they will underwrite a loan to the company even though the market hasn’t made up its mind on how to properly value the equity. So the temptation all around the table is to take the debt and kick the can down the road on the equity in the view that more time, more growth, more market validation will fix things.
This can work out well. Our portfolio company Foursquare is an example of where this did work out well. A debt deal in the middle of a business model pivot gave that company the time to re-engineer its business model and validate it. And time also allowed the company to come to terms with how the equity markets would value it and its new business model. Foursquare went on to raise another round of equity capital and refinance its debt and is in a great place now.
But, as the Modcloth story points out, debt can also work against you. If you can’t execute well post raising debt and get to another equity round or some other transaction (an attractive exit being the other obvious option), then you can have your debt called from under you and lose the control over the timing and terms of your exit. I lived through this story with a company I backed in 1999 and which was sold a few years ago in a transaction that was very good for the lenders and good for the management and very bad for the early equity investors.
Dan’s point that substituting debt for growth equity is a risky bet is spot on. That doesn’t mean it shouldn’t be done. But it should be done with care and with eyes wide open.
If someone were to ask what the most successful startups of this decade are, the answer would likely be Snap (market cap $22bn). Uber and Airbnb might also be on the list although those companies were launched in the prior decade (2009 and 2008 respectively).
But what might be missed is the massive success of the decentralized startups, most notably Bitcoin (BTC) and Ethereum (ETH) this decade.
Look at these charts:
During this decade BTC has gone from essentially zero to about $1000/share which is a market cap of $16.3bn.
If anything, ETH is an even more impressive story. In less than two years (Ethereum was initially released in July 2015), it has gone from zero to a market cap of $3.4bn.
And anyone located anywhere in the world can invest in these decentralized startups and profit from them, unlike the traditional startups.
Obviously, there is no way to know where we go from here. Does ETH go to $100 or $5? Does BTC hard fork and cause the price to crash?
But of course the same is true of Snap, Uber, and Airbnb. Past performance is no guarantee of future success.
And it is also true that using traditional valuation methods (DCF, etc) on these decentralized startups is really hard. One of USV’s investors (LPs in the industry vernacular) asked me how to value a digital asset. It’s a great question and one we are working hard to understand. We don’t know the answer to it yet, to be honest.
But this much I know. There’s a new game in startup land. A new way to do things. And it is working for a lot of people who are playing that game right now.
Here it is:
We are on spring break with our son Josh this week in Utah and we caught most of the games yesterday. I am not a huge college basketball fan, I prefer the pro game, but there is something about march madness that is so great, particularly these first two weekends where the games come fast and furious.
So I thought we could have some fun sharing our brackets, or our picks, or whatever.
Here’s mine, sorry about the chickenscratch handwriting. I failed penmanship every grade in school for very good reasons.
I’ve got Villanova, Gonzaga, Kansas, and Kentucky going to the final four and Kentucky taking the trophy.
How about you?
I love it when companies quickly get into a market, start delivering a product or service, and then, over time iterate on their products and services to expand the market and their share of it. Contrast that with a company spending years getting something right before shipping their first product. I much prefer the ship quickly, get customers, and iterate and automate approach.
Our portfolio company Dronebase is very much using the iterate and automate playbook. As I posted about here a few months ago, they offered their first commercial drone flight in January 2015 and two years later they did their 10,000th drone flight. All during that time, they were automating much of the workflow for their customers, their pilots, and inside their operations.
Over the past ten days, they have shipped two things that demonstrate how highly automated the drone flight process has become.
On March 9th, Dronebase launched the “Enterprise API” with this blog post. I tweeted out the news:
“If you are a large company looking to get drone imagery for a lot of properties, what do you do?” https://t.co/R9yhnkAinN
— Fred Wilson (@fredwilson) March 9, 2017
And today, Dronebase is launching the Dronebase Pilot iOS app, which looks like this on a DJI drone:
The app can now connect to your drone to help you fly. Similar to how you use the DJI Go app, just dock your iPhone or iPad to your drone’s controller, open the app, and launch the drone. You’ll be able to see the 1st person point-of-view from the drone’s camera, shoot photos and videos, and control settings like camera angle.
Our goal, as an engineering team, is to keep drone pilots doing what they love – flying. The more we can streamline the busy work, the administrative stuff like classifying and uploading imagery, the better.
So with the API and the Pilot app, a mission can move from an enterprise customers’ application (like an insurance company’s adjusting workflow application) to a pilot’s phone without any human being touching that mission. And the imagery can flow back from the pilot’s phone back to the enterprise application in the same way.
That’s how you automate something after you’ve figured out what the market wants and how to deliver it. Instead of building all of this stuff before launching, Dronebase starting doing missions and listening to customers and pilots and then went out and built a crack engineering team under the leadership of Eli and started automating the process in the way the market wanted it.
The result will be a much larger available market for drone imagery, or as Dronebase calls it “Air Support For Every Business”. Because if you are a large enterprise with a need for hundreds or thousands of missions, you can programmatically issue (via the API) those missions from your existing workflow and applications and you can get these missions done for somewhere between $50 and $300 per mission. That’s the power of automation and scale at work. Which will massively expand the market for what enterprises can use drones for. Which will, in turn, mean orders of magnitude more flights for drone pilots to do. A win/win for everyone.
I’ve written a bit here about crypto tokens. How they can be a monetization model for new protocols. How they could be a new monetization model for online media. How they can be a business model for an online “commons.” And why USV invested in a hedge fund that will invest solely in these tokens.
I believe that these crypto-tokens are an important innovation in the world of technology. They allow for the financing and monetization of technology projects that rely on a network of contributors (of software engineers:open source, of contributors:online communities, of computers:p2p systems, etc) to deliver value to the market.
To date, we have mostly seen tokens used as financing vehicles. The last time I looked, over $300mm has been raised in “Initial Coin Offerings” (ICOs) to finance projects like the ones I referenced above. That number continues to rise as more tokens are sold to raise funds to develop these new businesses.
But the longer term implications of tokens have more to do with monetization than financing. And I think its a very elegant and powerful idea that the same “currency” can be used to both finance and monetize a network.
So with that preamble, I am excited that the first ever Token Summit will take place in NYC on May 24th and 25th. This event is being organized by AVC regular William Mougayar and Nick Tomaino, who runs The Control, which I blogged about a few months ago.
William blogged about Token Summit today and says this about the event:
We have identified the following themes that will be debated in a variety of formats, including on-stage interviews and panels.Token-based Business Models
How do tokens contribute to a business model? When do they make sense? How does an entrepreneur monetize? Where is the real value?Token Protocols and Platforms
What are the emerging token-based assets? Where/How are we going to trade them? What are the implications for fund managers?Distribution Mechanics
Lessons and best practices for pre, during and post initial cryptocurrency and token sales, including governance.Valuation Strategies
How do investors and users value tokens? How does a token transition from a speculative to utilitarian function?Legal Implications
Legal, regulatory and ethical practices for token creations.
I plan to attend this event and I encourage everyone working in or around this space to attend. It will be an interesting and lively discussion.
If you want to attend the event, you can register here.
There is no doubt that the healthcare system in the US could use some work. We spend way too much and the quality of the healthcare that many receive is not where it could or should be. We allocate too much of our healthcare spending in the last few months of a person’s life and not nearly enough on preventive care throughout our lives. We are not leveraging the power of technology enough to help treat diseases and other conditions early when the treatments are more effective. So I am all for modifications to our health care system that will allow for more innovation, more preventive and wellness care, and more engagement with the system.
What I am not for is a total and complete dismantling of the Affordable Care Act and a return to a time when many US citizens did not have a means to pay for the healthcare they need (ie insurance). The Congressional Budget Office predicts that the Republican plan that has been put forth will cause 15mm US citizens to lose their insurance in the near term and up to 24mm over the longer term (by 2026).
This would just take us back to the time when a large percentage of our population had no other option but to defer healthcare until they got really sick and then show up in hospital emergency rooms and stick the “system” (ie those with insurance) with the bill. This is not a good way to run our healthcare system. Sure it might enable the government to remove the mandate that everyone have insurance, which sticks in the craw of conservatives and libertarians, but the cost of doing so means less preventive care, less outpatient care, and more costly end of life care.
I believe citizens of the US should have healthcare insurance. If they can afford it, they should pay for it. If they can’t afford it, society should pay for it. But one way or another, everyone should have the ability to see a doctor regularly, get preventive care, find diseases early on and treat them, and not defer their medical needs until they become acute.
The Republican plan seems hastily drawn up, largely a political reaction to the Affordable Care Act, and a return to a time when the wealthy can afford healthcare and many others cannot. I would encourage the President, his team, and the Republican members of Congress to go back to the drawing board and come up with something that moves us forward, not takes us back.
I wrote this in July 2011, as a part of an MBA Mondays series on financing structures:
MBA Mondays are back after a one week hiatus. Today we are going to talk about convertible debt. Convertible debt can also be called convertible loans or convertible notes. For the purposes of this post, these three terms will be interchangeable.
Convertible debt is when a company borrows money from an investor or a group of investors and the intention of both the investors and the company is to convert the debt to equity at some later date. Typically the way the debt will be converted into equity is specified at the time the loan is made. Sometimes there is compensation in the form of a discount or a warrant. Other times there is not. Sometimes there is a cap on the valuation at which the debt will convert. Other times there is not.
There are a number of reasons why the investors and/or the company would prefer to issue debt instead of equity and convert the debt to equity at a later date. For the company, the reasons are clearer. If the company believes its equity will be worth more at a later date, then it will dilute less by issuing debt and converting it later. It is also true that the transaction costs, mostly legal fees, are usually less when issuing debt vs equity.
For investors, the preference for debt vs equity is less clear. Sometimes investors are so eager to get the opportunity to invest in a company that they will put their money into a convertible note and let the next round investors set the price. They believe that if they insisted on setting a price now, the company would simply not take their money. Sometimes investors believe that the compensation, in the form of a warrant or a discount, is sufficiently valuable that it offsets the value of taking debt vs equity. Finally, debt is senior to equity in a liquidation so there is some additional security in taking a debt position in a company vs an equity position. For early stage startups, however, this is not particularly valuable. If a startup fails, there is often little or no liquidation value.
Friends and family rounds, which we discussed earlier in this series, are often done via convertible debt. It makes sense that friends and family would not want to enter into a hardball negotiation with a founder and would prefer to let the price discussion happen when professional investors enter the equation.
The typical forms of compensation for making a convertible loan are warrants or a discount.
Warrants are another form of an option. They are very similar to options. In the typical convertible note, the Warrant will be an option for whatever security is sold in the next round. The Warrant is most often expressed in terms of “warrant coverage percentage.” For example “20% warrant coverage” means you take the size of the convertible note, say $1mm, multiply it by 20%, which gets you to $200,000, and the Warrant will be for $200,000 of additional securities in the next round. Just to complete this example, let’s say the next round is for $4mm. Then the total size of the next round will be $5.2mm ($4mm of new money plus $1mm of the convertible note plus a Warrant for another $200k). The total cost of the convertible loan is $1.2mm of dilution at the next round price for $1mm of cash.
A discount is simpler to understand but often more complicated to execute. A discount will also be expressed in terms of a percentage. The most common discounts are 20% and 25%. The discount is the amount of reduction in price the convertible loan holders will get when they convert in the next round. Let’s use the same example as before and use a 20% discount. The company raised $4mm of new cash and the convertible loan holders will get $1.25mm of equity in the round for converting their $1mm loan ($1mm divided by .8 equals $1.25mm). Said another way $1mm is a 20% discount to $1.25mm.
Convertible notes also typically have some cap on the valuation they can convert at. That cap is anywhere from the current valuation (not very common) to a multiple of the current valuation. Recently we are starting to see uncapped convertible notes. These notes have no cap on the valuation they can convert at.
Startups typically think about raising capital via convertible debt early on in the life of a startup. They want to move fast, keep transaction costs low, and they are often dealing with a syndicate of angel investors and it is easier to get the round done with a convertible note than a seed or series A round. While these are all good reasons to consider convertible debt, I am not a big fan of it at this stage in a company’s life. I believe it is good practice to set the value of the equity early on and start the process of increasing it round after round after round. I also do not like to purchase or own convertible debt myself. I want to know how much of a company I’ve purchased and I do not like taking equity risk and getting debt returns.
However, later on in a company’s life convertible debt can make a lot of sense. A few years ago, we had a portfolio company that was planning on an exit in a year to two years and needed one last round of financing to get there. They went out and talked to VCs and figured out how much dilution they would take for a $7mm to $10mm raise. Then they went to Silicon Valley Bank and talked to the venture debt group. In the end, they raised something like $7.5mm of venture debt, issued SVB some Warrants as compensation for making the loan, and built the company for another year, sold it and did much better in the end because they avoided the dilution of the last round. This is an example of where convertible debt is really useful in the financing plan of a startup.
My guess is we will see the use of convertible debt, particularly with no compensation and no cap on valuation, wane as the current financing gold rush fizzles out. It will remain an important but less common form of early stage startup financing and will be particularly valuable in things like friends and family rounds where all parties want to defer the price negotiation. But I expect that we will see it used more commonly as companies grow and develop more sophisticated financing needs. It is a good structure when the compensation for making the loan is fair and balanced and when the debt vs equity tradeoff is useful for both the borrower and lender.
Angel/seed rounds used to be done via priced equity securities, either common or preferred. Then, starting about ten years ago, we started to see convertible debt being used in the angel and seed rounds. By 2010 this was the norm and Paul Graham tweeted this in Aug 2010:
Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.
— Paul Graham (@paulg) August 28, 2010
Which led me to write this blog post here on AVC. I was not a fan of convertible notes then and I am not a fan of them now. USV has done a number of convertible and SAFE notes since then. I would guess that we have done a dozen or more of them in seed and angel rounds we have participated in. We are not opposed to convertible and SAFE notes and will not let the form of security the founder wants to use get between us and investing in a company that we like.
But I continue to think that convertible and SAFE notes are not in the best interests of the founder(s).
Here is why:
- They defer the issue of valuation and, more importantly, dilution, until a later date. I think dilution is way too important of an issue to defer, for even a second.
- They obfuscate the amount of dilution the founder(s) is taking. I think many investors actually like this. I do not. I believe a founding team should know exactly how much of the company they own at every second of the journey. Notes hide this from them, particularly the less sophisticated founders.
- They can build up, like a house of cards, on top of each other and then come crashing down on the founder(s) at some point when a priced round actually happens. This is the worst thing about notes and doing more than one is almost always a problem in the making.
- They put the founder in the difficult position of promising an amount of ownership to an angel/seed investor that they cannot actually deliver down the round when the notes convert. I cannot tell you how many angry pissed off angel investors I have had to talk off the ledge when we are leading a priced round and they see the cap table and they own a LOT less than they thought they did. And they blame the founder(s) or us for it and it is honestly not anyone’s fault other than the harebrained structure (notes) they used to finance their company.
The Series A focused VC firms that often lead the first priced rounds get to see this nightmare fold out all the time. The company has been around for a few years and has financed itself along the way with all sorts of various notes at various caps (or no cap) and finally the whole fucking mess is resolved and nobody owns anywhere near as much as they had thought. Sometimes we get blamed for leading such a dilutive round, but I don’t care so much about that, I care about the fact that we are allowing these young companies to finance themselves in a way that allows such a thing to happen.
Here are some suggestions for the entire angel/seed sector (founders, angel investors, seed investors, lawyers):
- Do priced equity rounds instead of notes. As I wrote seven years ago, the cost of doing a simple seed equity deal has come way down. It can easily be done for less than $5k in a few days and we do that quite often.
- The first convertible or SAFE note issued in a company should have a cap on the total amount of notes than can be issued. A number like $1mm or max $2mm sounds right to me.
- Don’t do multiple rounds of notes with multiple caps. It always ends badly for everyone, including the founder.
- Founders should insist that their lawyers publish, to them and the angel/seed investors, a “pro-forma” cap table at the closing of the note that shows how much of the company each of them would own if the note converted immediately at different prices. This “pro-forma” cap table should be updated each and every time another note is isssued. Most importantly, we cannot and should not continue to allow founders to issue notes to investors and not understand how much dilution they are taking on each time they do it. This is WRONG.
Honestly, I wish the whole scourge of notes would go away and we could go back to the way things were done for the first twenty years I was in the venture capital business. I think it would be a better thing for everyone. But if we can’t put the genie back in the bottle, we can at least bottle it up a bit better. Because it is causing a lot of problems for everyone.
The Gotham Gal‘s first angel investment, back in 2007, was Curbed, a network of three lifestyle blogs; Curbed, Eater, and Racked, all of which have become “must reads” in their categories (respectively real estate, food/dining, and shopping/commerce). Of the three, the Gotham Gal has always had a sweet spot for Eater and in this podcast, she talks to Amanda Kludt who has been at Eater from the very early days and now is the managing editor of the entire site. It’s a great conversation about what is happening in online media, the food business, and more.