By: Paul A. Jones
Convertible debt financing structures, with or without equity kickers, are a popular choice for many seed stage entrepreneurs and investors. (Disclaimer: this blog is about first money in seed investments, and not about the many other situations where convertible debt structures can be profitably employed.) The ability to punt on the contentious and often problematic valuation issue until some combination of greater opportunity visibility and/or attracting larger post-seed investors to the table can be very attractive to the entrepreneur and seed investor alike. However, while the concept is based on the notion that a valuation will ultimately be established in the context of a future, larger round of equity financing, what happens if no such round ever takes place? Presumably, the seed investor will want to have the option to convert at some valuation (to participate in the upside) – without being obligated to convert to equity at any valuation (to protect on the downside). It thus seems that while convertible debt financing makes the valuation issue at the seed stage less contentious than it might otherwise be, it doesn’t completely remove valuation from the negotiating table. The entrepreneur and seed investor will still have to agree on a default conversion valuation if the anticipated post-seed “conversion trigger” financing doesn’t, for whatever reason, happen.
Before talking about the default conversion valuation, let’s consider when it comes into play. A typical seed convertible debt financing anticipates that there will be a larger downstream “conversion trigger” financing, with the valuation in that financing serving as well as the valuation for conversion of the seed debt. Usually, entrepreneur and seed investor alike put a lot of thought into how big the future finding has to be to trigger conversion of the debt. While each party may have its own ideas on what the trigger valuation needs to be, those ideas are more often than not relatively easy to bridge. Both sides will want a trigger financing to be big enough (particularly if there is an equity kicker associated with the convertible debt) to assure that the “convertible tale does not wag the trigger investment dog” so to speak. And both parties will presumably have some more or less similar ideas on at least the minimum amount of next round capital the business will need to get to the round after that (or exit, if you are an incurable optimist).
But there is a more subtle piece of the trigger financing question. How long does the company have to pull it off? Put differently, besides defining the amount of capital that must be raised to trigger conversion of the seed convertible debt, you also have to set an outside time limit on that financing: a time after which, if no trigger financings has occurred, the seed convertible debt will have the option to convert at the default conversion valuation. On that score, sooner is better for the seed investor and later is better for the entrepreneur – but at the end of the day, the entrepreneur should not rush into a short fuse no matter how certain she is that the trigger financing will happen sooner rather than later. In my experience, most seed investors will accept a 12-18 month time frame for the trigger financing, and, well, the longer the better.
Finally, we get to the heart of this blog. Given that higher is always better for the entrepreneur, and lower is always better for the seed investor, how should the parties approach setting the default conversion valuation?
Let me cut to the chase and then circle back on the rationale. In my experience, a good default conversion valuation is one that will, if the seed investor decides to convert at that time/price, result in a fully-diluted ownership stake in the 10-20% range. If that sounds arbitrary, well, it is. But capricious it is not. Here’s why.
Lets start by predicting the future of the entrepreneur’s business, focusing on just those futures that are most likely if you assume that no conversion trigger financing ever takes place. It seems to me that the vast majority of such futures will fall into one of two buckets. Either the business the business tanked without ever getting additional financing, or the business took off without needing additional financing, or. In the later case, the seed investor will not want to convert, it being all but certain that remaining in their creditor position will maximize the amount, if any, of their investment that is recoverable. And this should be fine with the entrepreneur (who, of course, was wise enough not to sign any personal guarantees (which, if you think about it, makes sense – but that is a digression).
So what about the case where the business became wildly successful, without ever needing to raise additional equity capital? Shouldn’t, in that case, the entrepreneur fairly expect a very high valuation for the conversion of the seed debt?
In theory, yes, but lets look at the practicalities of the assumed outcome. The entrepreneur will, in my 10-20% dilution scenario, find themselves with 80-90% ownership of a business that, short of an exit transaction (or perhaps bank or other non-dilutive financing), by definition does not need additional equity capital. Sure, at a higher default conversion valuation, they would own an even bigger piece of the pie. But at some point, shouldn’t the entrepreneur ask herself something like the following question: “Just how rich does the seed investor have to make me before I will be satisfied – given that the seed investor’s money is what got me all the way home, and that my expectation going into the seed round was that there would ultimately be a lot more than 10-20% dilution before we got home?”
Now, every situation is different, and there are situations where my 10-20% default conversion rule of thumb may not be the “right” answer (whatever that is). But it does seem to me that an entrepreneur who hits a home run so much faster, and with so much less risk capital than even she thought possible, well, she ought to be able to share a little of her good fortune with the seed investor who made it possible.