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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 firstname.lastname@example.org.
Last night I gave a talk hosted by SVB at their Palo Alto office. It was part of the “Never Ending All Old Is New Again Venture Deals Book Tour.” I had a ton of fun talking to and answering questions from about 75 entrepreneurs who – at the minimum – enjoyed eating the great food and wine that SVB provided on a luscious evening in Palo Alto. Oh – and I signed a bunch of copies of Venture Deals.
Several questions came up about Convertible Debt. We touch on it in Venture Deals but realized that we didn’t cover it in enough depth so Jason recently wrote a Convertible Debt series on Ask the VC. The series is now complete – here are the links to the posts in order.
- Convertible Debt Series
- Convertible Debt – The Discount
- Convertible Debt – Valuation Caps
- Convertible Debt – Conversion Mechanics
- Convertible Debt – Conversion In A Sale Of The Company
- Convertible Debt – Other Terms
- Convertible Debt – Warrants
- Convertible Debt – Early Versus Late Stage Dynamics
- Convertible Debt – Wrap Up
If you feel like we missed anything, or got anything wrong, or were confusing in our explanation, please chime in on the comments on the post. If you want to see an actual convertible debt term sheet or the actual legal documents, take a look at the TechStars Open Sourced Model Seed Financing Documents.
As a bonus to the evening, I got some direct, constructive feedback from one of the attendees via email later that night. While the “thank you” and “good job” notes are nice, I only learn when someone criticizes me (hopefully constructively, but I can handle it in any form.) The feedback was:
May I make a constructive criticism regarding your talk tonight? Your answers to audience questions tend to be overly long and rambling…..you “overanswer,” to invent a word. You start strong and respond right to the essence, but then your focus blurs and you keep taking verbal baby steps away from the thought stream. If you trim a minute or two off each answer, you can call on more people and hear more questions, which sends more people home happy. I think if you self-critique a video of yourself in a Q&A session, you’ll arrive at the same conclusion.
It’s a good suggestion. I often try to provide additional context to the question, but it sounds like – at least for one person – I went off on a few space jams that weren’t additive. I love the phrase “overanswer” – it’s a lesson from TV interviews 101 (e.g. just answer a question – any question – quickly). Something to ponder as I continue the Never Ending All Old Is New Again Venture Deals Book Tour.
Recently, several entrepreneurs and investors have asserted to me that they don’t think the terms on a convertible debt deal matter much. I was perplexed by the statement and asked each of them to tell me more. In every case, the person hadn’t really thought through the issues. Rather, they were just spouting what they believed was conventional wisdom about terms for seed deals.
In one of the entrepreneur cases, I explained how it was likely that they were going to be on the wrong side of the valuation discussion in the next financing based on one of the terms. In one of the investor cases, I explained the difference between a 2x return and a 15x return – using a real example – based on the way the note was written. And in a third case a separate potential angel investor in the deal brought up a specific term that was important to him that addressed a real concern.
We rarely do convertible debt at Foundry Group – we much prefer to do equity rounds, even at the seed stage. However, many of the seed rounds done in TechStars are done using convertible debt as are many financings of less than $1m. So, if you are an entrepreneur or seed investor, I think it’s important to understand how convertible debt works and what the impact of various terms are.
In Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist, my partner Jason Mendelson and I touched on convertible debt but didn’t go into much detail on the specific terms. A number of people have asked us about them since the book came out so we’ve started a Convertible Debt series on AsktheVC. The first three posts are up:
There are nine posts in the series – coming out every Tuesday and Thursday until we are done. If you notice anything confusing, or incorrect, please comment and/or ask questions so we can clarify and/or fix.
Before we invested in MakerBot, we bought and assembled a Thing-O-Matic. When I say we, I mean me, Jason, and Ross. It took us about 20 hours (Jason and I did the first half; Jason and Ross did the second half) and was a blast – think of it as an adult lego project. Our Thing-O-Matic has been steadily printing stuff – you can play a game of chess with our Thing-O-Matic pieces. the next time you are in my office.
As part of the endless series of Amazing Deals I bring you from my deal site, today’s offer is a fully assembled Thing-O-Matic. If you want your own 3D printer, but you don’t want to assemble it, you can buy it fully assembled for $2,500. But, through the magic of daily deals, there are 20 available for a 20% discount ($2,000). This is a one time offer from my friends at MakerBot so grab ‘em while they are available.
And finally, for all of you that have written asking for a “Convertible Debt Series” like our term sheet series, we’ve just started one on AsktheVC.com. The first post is up and introduces the series – we’ll be working through all of the terms in a convertible debt deal over the next few weeks.