Create Structure out of the Gate and You’ll Thank Yourself Later

Ari Newman is an entrepreneur, mentor, investor, and a friend. He works at Techstars where his responsibility is to ensure that the connections between alumni, mentors, and staff are as robust as they can be – helping entrepreneurs “do more faster” day in and day out.  His most recent company, Filtrbox, participated in the inaugural Techstars class (Techstars Boulder 2007) and was a win for all parties involved; Filtrbox was acquired in 2010 by Jive Software (NASDAQ: JIVE).

I’ve worked closely with Ari for a while and love his candor. He talks, from an entrepreneur’s perspective, with recent first hand experience. Following is his advice to early stage entrepreneurs for creating structure in their company.

Here’s the punchline: if you run your company as if you have closed a VC equity financing round even though you actually closed a convertible debt round, you’ll be in much better shape when it comes time to raise your Series A financing. Specifically, I am talking about putting a board in place, running formal board meetings, and making sure you have people at the table who act as  the voice of reason and sanity. One of the key benefits of doing this early on is that when it comes time to raise that next round, the people you’ll need the most help from are already involved and engaged.

Convertible debt financings have become an increasingly attractive approach for seed rounds because it delays the valuation discussion, costs less from a legal standpoint, and is an easier financial instrument to “keep raising more small amounts of money” on. There are two different cases, with shades of grey in between: (1) there are only a few investors or (2) it’s a “party” round, with $1M+ raised and  many investors. This second kind of seed financing can be a double-edged sword for the entrepreneur and company if not very carefully managed. This post is not about the economic implications of debt rounds versus priced rounds – there has already been plenty written about that including this great one from Mark Suster. Rather, this post is a call to action for entrepreneurs who have successfully raised a debt round and must now turn their idea into a serious business.

So why would you treat your debt investors (somewhat) like equity investors? This may seem counterintuitive, even even a pain in the ass. So, I’ll explain my reasoning through the story of ASC, a fictitious company that has a combination of characteristics I’ve seen across a number of early stage companies.

Acme SaaS Corp (ASC) was started by two entrepreneurs; they have a big vision and if they can execute on it, the business will be a clear home-run. One of them used to be a lead developer at [insert hot consumer tech company here].  They need to raise money before building anything substantial after determining that they needed a little dough to follow the Lean Startup methodology.

They decide to go out and raise money on a convertible note – several angel investors have signaled interest in participating in the note and they don’t feel ready to pitch VCs yet. Fundraising goes better than expected and they quickly find themselves with a $750k round consisting of several VCs and a bunch of angels. The investors, founders, and “community” are all super excited about ASC. They close on the $750k, hire a buddy or two, buy some Macs, and get to work.

ASC starts building product, but as they get into the thick of it, the team realizes executing on their vision is going to be extremely hard. Things start to get a little fuzzy in terms of priorities, but not to fret, the new office is coming along really well with all of the hiring! For the first the months, the team meets often and strategizes on what they want to build while some code gets written. Early customer development talks are going great which keeps the team really excited. Three months in, the burn is now at $70k/month.

Two more months go by and the team is continuing to iterate, but every two-week sprint results in some re-factoring and re-thinking. No updates, screen comps, or metrics have been publicly shared yet. It’s too early for that shit. Heads down on product, they say. Every now and then, investors are told things are going great and the founders are really excited about what they are doing. Soundbites from potential customers are encouraging. Eventually early product demos start happening but they’re rough and the product looks very alpha. At month six, one of the early hires leaves, a developer who turns out wasn’t a good fit. There is $350k left in the bank.

Seven months in, there is a beta product. It’s better than before, but not by miles. The people on the sales side don’t feel they can charge for it yet because who’s going to take out their wallet for something that isn’t perfect. A bunch of potential customers are kicking the tires on the product but it seems that every engaged beta customer needs something slightly different or feels as if the product is not ready to be truly used in production. “This is all a part of the normal product and customer development process,” the CEO tells the team. The burn is now at $90k/month as they had to hire a “customer delight” person to handle the beta process. The team thinks their investors still love them and that they are still a hot company. The first material update goes out to the investors, with lots of positive quotes from VPs at potential customers, and they all indicate future product acceptance if a bunch of other stuff gets in place. Investors are dismayed that there are no real customers yet. There is no discussion of burn, runway, and more financing yet. The team wants to make a little more progress first.

A month later, another email update goes out to the investors – the team has decided to pivot based on feedback and they are super excited about the new direction and once they have the product updated to capture the new, bigger opportunity, it’s going be great. Oh, and the email says the founders will be in touch to discuss another round of funding since there are only 2 months of runway left.

Sound familiar? I could continue but the odds are that this story isn’t going to end well. The company flames out and the team gets aquihired. The investors get nothing.

While you may think ASC is an extreme case, it happens all the time. I’ve observed too many companies that have some or all of these elements in their story. I’m not saying, under any circumstance, that the debt round was the catalyst or sole reason for the company’s missteps but there are a number of times in this story where good company hygiene, good governance, and a properly utilized board would have helped to positively affect the outcome. Following are a few ways that a board would have helped out.

Easy Debt Round Lasting A Year – Even if the raise wasn’t that easy, the company was able to raise enough to buy a year or more of runway. In startup time, that feels like forever. It’s enough time to hang yourself if you are not careful. Had the company created a board and run it properly, they would have ratified a budget, reviewed compensation plans, and agreed on spending levels during early product development. The year would have been a full year, not just 7-9 months.

Real Product and Market Focus – This company lost 3-6 months of execution because they got lost building towards a high level vision. That high level vision was a beast to tackle, and being younger founders, they they didn’t realize they were in over their heads. With advisors or a board, the founders could have opened the kimono and asked for guidance. There are about a dozen corrective actions, best practices, or methodologies that could have been applied during this critical time. It’s up to the team to be able to execute them, but they had their heads in the clouds for too long and no one else at the table with them.

Don’t Pivot in a Vacuum – Had ASC properly used its board, advisors, and investors, it would have brought the pivot strategy to the table early on. A discussion around overall business viability, time to market, and capital impact would have ensued. A review of the cash position, burn rate, and execution plan would have revealed there was not enough cash on hand to nail the pivot while leaving 3-6 months of time in market before raising again. The plan would have to get way tighter, way faster. They didn’t keep the investors up-to-date, then pivoted without engaging or validating whether there was going to be follow-on support. They took a right turn into a brick wall. Investors do not own the company or its strategy. I often say “it’s your company” when I’m bluntly asked what direction a company should take, especially if I’m wearing my investor hat. While that is true, if you rely on outside capital to reach escape velocity, keep the cockpit talking to the engine room.

Use The Smart Money or Lose It – Almost every investor I know makes investments because they want the return, but they also believe they can be helpful to the company in some way. When teams don’t communicate and engage with their investors, the void is often filled with skepticism, doubt, and (often false) assumptions about the business or the team. You borrowed money (or sold a portion of your company) from these folks – they want you to be successful. Leverage them for the better of the company, whether that means using their wisdom or their rolodex. They also can create major signaling problems for your next round if you allow the radio-silence void to be filled with doubt and distrust. Who would blindly give ASC another big check after what occurred above?

Company Hygiene Matters – One of the responsibility of a Board of Directors is to regularly discuss financials, burn rate, and cash management. Had ASC created a board, the company would have potentially managed their cash more conservatively and had the wherewithal to initiate the shift of the company sooner, whether it be through M&A talks, raising more capital, or making the pivot earlier.

I bet that some of you reading this post are entrepreneurs who are in this situation. I beg of you, treat your debt holders like equity holders, and utilize their expertise to help further your business. One easy way to do so is to act as if they are board members. In the super hard, fuzzy, pivot-happy early days of a company, a little structure, accountability, and organizational discipline can be all the difference between running headlong into a brick wall or creating a meaningful, well-operated company.

Follow Ari on Twitter at @arinewman or ask him about the power of the Techstars network at [email protected]

  • I love these types of case studies, and I wished there were more like that.

    I would add there’s another subtlety there, which is when the startup has advisors, but they don’t have joint meetings. Instead, the founder takes salami advice from each advisor and gets blind sighted that way. I’m seeing this trap with a couple of companies I’m interacting with, where I know there are other advisors there, but the CEO is insulating them from each other. That’s bad.

    If you have picked the right advisors, you will benefit from the synergy of their collective advice.

    • great point

    • I think collective is the norm William, not the exception. In every case I’m involved with the founder has brought the advisors together.

      But–the point is not that really to me. Advisors and BOD members are different in what they do. If you want oversight not advice, even informally you need to create that structure even if it is not legally required.

  • I have no idea why ANY entrepreneur would EVER take a convertible debt investment. If they fail they still have to pay the money back. If they succeed, the investor gets an equity stake, probably way too much. Most of the risk is on the entrepreneur. If you’re an investor, for God’s sake, have some balls. Either give em a loan and take the chance they’ll fail and not pay it back or just take an equity stake and share the risk (and potential rewards of course).

    BTW, Brad, luv’d your piece in the WSJ last week!

    • How likely is it that an entrepreneur of a failed startup pays back convertible debt investment? Does the debt belong to the company, or the founder?

      • My personal take on this is that most savvy early-stage investors go in eyes-open in terms of convertible debt. The debt belongs to the company (or at least it should). I’ve seen situations where the team shuts down operations when they know its not going to work and they return remaining capital to the investors, and I’ve seen shutdowns when the cash is all gone. The debt holders sometimes just write it off and move on, and sometimes get involved and try to create some kind of return on remaining assets.

        • Absolutely my experience. If there wasn’t that protection, you could easily just have advisors on one hand and a business loan on the other.

      • You’re missing the point, which is that convertible debt is slanted towards protecting the investor rather than sending a message to the entrepreneur/company that you are walking down the path together.

        • Makes sense, thanks.

        • ?
          The dept is issued against the LLC or the S Corp. They by definition create a wall between the corp and the individual.

          That’s what I’ve done previously or are you saying something else?

          • I’m not sure why everyone is focused on whether the debt is issued to the company or the individual. Its typically the company of course.

            What I’m getting at is that this type of financing aids the investor at the expense of the company compared to other financing types. Things aren’t much different than pure debt except if the debt converts to stock, probably because of a successful liquidation event. The investor has a higher return than in the case of pure debt because they receive the equity AND has been making interest off the debt prior to the liquidation event. Debt financing for high-risk entrepreneurial activities tends to carry non-trivial interest rates so this to me slants this financing structure towards the investor. Thus my statement, either do pure debt or pure equity.

          • Actually, most convertible debt will convert on the next financing as long as it is an equity round. This is the main reason early stage companies use convertible debt. In the downside case, where the company fails, it doesn’t matter in either case.

            I’m not sure what you consider a non-trivial interest rate. Most convertible debt is between 8% and 12%, which is a pretty low cost of capital for a high risk company. And – this debt is almost never “current pay” – rather it just gets added on to the amount being converted into equity in the next round.

            In my experience, convertible debt is a proxy for an equity investment and is very different than “debt”. And – most early stage companies can’t raise classical debt in any event.

  • I absolutely love the message you are communicating, but I’m not sure that you need a formal board of directors (yet) to avoid these mistakes. Obviously every situation is different, but in this case ASC simply needed some strong mentors who could help them with a lot of the typical startup mistakes. I know you were just giving one example, but it seems to me that the biggest problem is they kept their heads down and never came up for air. This problem could have happened even if they had a board.

    • Scott – agree that it could have happened even with a board, but I’d submit that if the company had been using the board well and was fully engaged that a few of the key mis-steps would have been caught earlier or potentially avoided.

      • Ari – totally agree. I think we’re now saying the same thing. It just doesn’t have to be a “board” per-se… just some oversight and willingness to be open to feedback. The reason I brought it up is your example may be typical for you, but what I see are $50-250K seed rounds, so for those, a formal board seems like overkill to me – you need 1 or 2 very motivated and experienced mentors – you don’t have enough money to do much more than an MVP and some initial metrics – whereas your example is a company that’s a bit more mature (or who have leading characters that can raise more cash on their name/reputation) and the risk of losing that larger chunk is higher.

        I loved your overall concept, so I’ll stop complaining now LOL.

        • Timothy Johns

          Speaking for myself: I know I’ll listen to anyone, I know I’ll respond to my “board”.

          – Tim

          (“Board” in quotes here since I agree that it doesn’t have to be a “board” per-se — but that seems like one reasonable well-understood structure for getting advisors to feel like they’ve got a little more skin in the game.)

  • Timothy Johns

    Thank you Ari, and Brad — this approach makes tremendous sense to me — and what I’m really struggling with next is the ‘how’. I’m generally immune to analysis paralysis, except I’m very definitely finding myself there when it comes to deciding with whom to get deeply involved. I feel like getting ‘corporately organized’ is taking me about a thousand times longer than it should.

    I totally and intentionally avoided this last time by bootstrapping, but what I’m working on now isn’t nearly as capital-efficient, and more to the point of this story — I WANT a board this time. Sure there’s some effort, risk, and strings attached, but for the very reasons you’ve identified above, the upside outweighs the downside.

    I’d REALLY love to see the sequel: the flip side of the ASC story, wherein the original founder finds and approaches the cofounder, and the right Angels and VCs, complete with timeline and dialog. I know I’d pay full price to go see that in theatres!

    – Tim

    • Lots of examples in Do More Faster – And Ari’s company Filtrbox is a good example as well.

      • Timothy Johns

        Just ordered it, thanks!

        • Timothy Johns

          Per Kindle, I’m 19% finished — pure gold to this point. Best candidate anecdote for ‘the sequel’ so far: meet at nice restaurant, buy wine for everyone else. :-).

  • Fantastic advice! And yes, these pitfalls happen more often than you’d think. It seems crazy that some startups keep their investors in the dark, whether equity or debt. Knowledge, connections etc. from these are a resource you should leverage.

  • Nasir

    Awesome post Brad! Right on the money as usual. Funnily enough, this link was also forwarded to me by the founder of a StartFast team that is currently closing a seed round. The point being made was that he understood why Chuck and I were making him set things up for running a real company even at this early stage. Thanks for all you do share these best practices 🙂

  • Williamsacks

    Right on Ari, and thanks Brad for sharing. I’ve been surprised at how keeping our investors regularly updated has paid massive and unexpected dividends as we’ve progressed. Many of our investors told me they would not have invested had it not been for the weekly updates I sent over a period months. The hard part is to be honest in these updates and present the good along with the bad so there are no surprises in a few months time. As an entrepreneur it’s hard to report to my investors that I didn’t achieve an objective I said I would achieve. However I’ve found that doing just that is the key to “upgrading my thinking” and getting better results in the future. Reporting bad news keeps me anchored in reality as opposed to drunk on the company kool-aid. I think a lot of companies resist sending updates when it seems like things aren’t going well and I think that’s a mistake.

  • DJ

    This is a great post. Not to mention Ari is a badass DJ too.

  • Leith Stevens

    A lot of great points here, Ari. But I think your real point is that a functioning board of directors has significant value–I agree.

    But why does that mean convertible debt is bad? Not having a board is bad, and as you mention, a convertible debt round doesn’t preclude you from having one. Although I agree that most pre-seed/convertible debt funded startups don’t have a board like you outline.