Seeding with Convertible Notes - Watch for Thorns!

I've seen many startup and early stage companies present their idea and ask for funding in the form of convertible notes. This is a particularly common tactic in the US that has not quite found its way to Europe.

Far be it from me to say the emperor has no clothes, but.....guess what! The emperor looks likes scantily clad.

Mind you, that's not to say all convertible notes are bad.  They are not all bad.  All I'm saying here is that I have many more questions than answers.  Call me a frightened old toddy if you like.  But I have several concerns and that's among the reasons why to date Symfonie Angel Ventures has never bought a convertible note.

What's a Convertible Note ?

Those of you who are familiar with the structure can skip this part.  Those you who would like a bit of a primer - read on!

The convertible note is a way of the investor and the entrpreneur saying - "Valuing a startup or an early stage company is a thankless, almost irrelevant task. Rather than haggle over valuation and ownership stake, we'll agree to put that discussion on hold until there is a real business to talk about, which will be when we do a big financing called an A-Round."

So instead of selling equity the company issues a convertible bond.  The terms of the bond are something like the following:  

The bondholder gets a coupon of (for example), 8%.  Maybe this is paid in cash annually, maybe not. Maybe the interest will be paid in cash when the A-Round happens or when the note matures.  Maybe the interest will be paid in the form of shares down the road.  Every convertible note is different, no two are the same and the first question the noteholder should ask is - "when am I supposed to get my interest and how will it be paid."

The convertible note is a bond, so it has a stated maturity - say five years.  By then in theory the A-Round should have happened, supposedly, so its convenient to just assume maturity is not particularly relevant but just some notional fiction to be dealt with down the road.

So the second question the noteholder should ask is - how will this be repaid when maturity comes along?  Am I supposed to assume the business can re-finance the note?  Am I supposed to take it as a given there will be an A-Round and I will never see maturity?  What if the A-Round never happens at all?  What if the company can't repay?  What then?  Are we supposed to have a valuation discussion or am I supposed to assume the business will have failed?

Third element for the convertible note is the definition of an A-Round and what the note converts into.  Well, tough, to say!  Each note is a different animal, each has its own bells and whistles.  Typical I have seen is - "An A-Round is defined as being capital raising of at least $2,000,000.  When that happens the convertible note is converted into shares of the company at the same valuation as the the capital raising.  So for example, $2,000,000 is raised and the company sells shares with a valuation of $10,000,000.   The convertible note is $500,000 so therefore $500,000 converts essentially into a 5% ownership stake.

Often there is a bell on the convertible note called a "Cap."  The "Cap" is designed to ensure the convertible noteholder gets the benefit of the A-Round in the form of a reduced share price - say, for example 50% of the shareprice that is in A-Round.  So when the $10,000,000 valuation  A-Round comes along the convertible noteholder gets shares equivalent to a $5,000,00 valuation, so actually winds up with effectively a 10% stake, using the numbers above.  The bell is supposed to make the investor whistle away with the headline that there is a 50% discount to the A-Round.

The Devil is in the Details

For those of you who read the primer, you can see that I am just beginning to peel the onion on this topic.  For those of you who skipped the primer the bottom line is - this is a terribly thorny garden of roses so before you even consider walking in you'd best think not twice, but five times!

I went to business school at the University of Rochester.  I'm proud of that so I say that as often as I can.  To this day I marvel at the fact that the William E. Simon Graduate Schoold of Business accepted my application and moreover, that eventually, they gave me a merit scholarship. Priscilla Gumina was the admissions officer at the time.  She stayed there for many years after I left, so apparently my admission was not a disaster for Priscilla and certainly not for me!  Thanks again, Priscilla!

I had a professor at the Simone School by the name of Ron Schmidt.  This is where I get to pay tribute to him, which pleases me greatly.  He was undoubtedly among the best professors I had during my graduate and undergraduate training.

Professor Schmidt gave really hard exams!  They required essays for answers.  But in some ways they were easy.  You see, you got 50% credit if you just started your answer by saying "It depends."  The other 50% of the the credit you got by presenting a concise, well thought out answer that explained what it depends on and what the range of outcomes could be.

So - here's the question:  An entrpreneur wants to fund a startup.  An investor wants to invest in a startup. Is a convertible note a good choice for the investment structure?  

The answer is, of course, "It depends."  Now - onto the meat and potatoes.  There are at least five things every entrepreneur and every investor should think about before walking into this supposed garden of eden.  Here they are:

1. The interest rate - is that paid in cash or in kind.  If paid in cash when is it paid?  Annualy?  Monthly?  Quarterly?  At maturity?  Upon conversion into equity?   A cash coupon is nice!  If the company is successful finding other investors or the company starts generating some revenues, or if the company manages to hang around long enough - say really five years, at 8% I stand to get back 40% of my initial capital.  Forgetting the time value of money, there's something to be said about getting back some capital that was placed at serious risk. 

2. The maturity - What happens if the A-Round never happens?  Or what happens if the A-Round happens but not at a threshold valuation to trigger a conversion?  How will the company repay?  Will the company be able to refinance itself?  Or will the company be bankrupt?  What are the noteholder's rights as a creditor?  Is there any security at all is just a lottery ticket?

3. The business prospects - What has to happen for the company to have an A-Round?  What are the milestones and thresholds that need to occur?  What should the company look like in terms of revenue and profits?  Will the company still be loss making when the A-Round comes?  Will the A-Round be one on a long series of capital raisings needed to keep a company afloat while it looks to build moment and traction?  Some companies lose thousands, millions, even hundreds of millions and stay in business a long time and have multibillion dollar IPOS and make fortunes for the early investors.  That's the exception rather than the rule.

Startup City is littered with a pile of companies that received lots of investment only to go down in a ball of flames when there was no more capital to be found or the next great widget came along.

4. The Convertible Valuation - is it reasonable?  Can it be somehow economically and quantitatively justified?  Does the discount to valuation and the time until A-Round comes compensate for the risk?  Does an A-Round represent a real exit opportunity or is just another step to the exit?  When will the exit finally come and what can the return on exit potentially be?

5. Investor Rights - Does the investor owning the convertible have any rights in corporate governance?  What reports will the investor receive?  What say does the investor have in major corporate decisions?  How much more debt can the company take on?  What are the anti-dilution provisions?  Is the company obliged to set aside cash from capital raising, revenues or profits to repay the convertible? Can the entrprener and equity holders get dividends, bonuses and other cash out before repaying the convertible?

The Bottom Line According to Mike

Here's another tribute to Professor Schmidt.  Once he was lecturing about corporate structure and corporatae taxation.  To this day I remember him pounding his fist in the air and stressing the economic reality. I will paraprhase here, the quote might not be exact.

"You don't tax corporations, you tax people.  Someone owns the economic rights in a corporation.  Some derives economic benefits from the corporation.  When you tax the corporation you are taxing people!   Corporate taxation is one of the five greatest idiocies of the twentieth century."

I never asked Professor Schmidt what are the other four idiocies.  Suffice to say, that in my very humble opinion, Convertible Notes for Startups are a good candidate for one of the other four idiocies.  Hopefully they will not come to the shores of Europe anytime soon.  

Stay Tuned!!!

I laid out a fistful of problems.  I have a good friend and colleague named John Vax.   I had the pleasure of working with him for many years and he used to tell me that when he ran the Capital Markets desk at Commerzbank in Prague his staff would come and tell him about problems.  His reply was often (and again, I paraphrase):

"I know there are problems.  That's why I hired you.  I need the solutions, so tell me how you think we should solve the problems."

Having presented the problems with convertibles, the next blog I write will offer solutions.  Real, practical, honest to goodness solutions I will bring!  How's that for service?

Until then - remember - investing money is easy.  Investing takes no talent, takes no guts.  Investing successfully - well, that's a completely different story.

Want more information about my Angel Fund?  Click here!

10 ReasonsWhy We Invested in Venzeo

I often write about criteria angel investors should consider when making an investment.  Recently the Symfonie Angel Fund invested in one of the few companies that fit our criteria - Venzeo.  Time will tell if we were right or wrong with Venzeo and there is much hard work ahead in order for us to make this investment succeed.  I hope my post is helpful to all the other angel investors out there who are considering their next investment. 

1. The product fills a market need.  Any business that uses photos for documentation or evidence can save time and money by using Venzeo.

2. Similar businesses are successful in other markets.  Look at the US.  Fotoin (www.fotoin.com) and pdvconnect.com have emerged and are growing rapidly.

3. It's not all plug 'n play. Venzeo's service is easy to use.  The application downloads easily into many mobile phones.  But once business start to use the service and they realize the benefits, they come back to Venzeo, ask for more devices and ask for customisation to their specific systems and procedures. Customers that integrate a solution into their business are customers that are in for the long haul.

4. Wayra - Venzeo received an investment early on from Wayra, the tech incubator affiliated with Telefonica. Venzeo and Telefonice both come out ahead.  Venzeo developed a relationship with local units of Telefonica to distribute Venzeo service to Telefonica customers.  This partnership has already begun winning customers.

5. Proven demand - Vezneo is winning customers.  The typical customer starts with trial use period.  Once they start to use the service and realise the benefits, they quickly add users to the installation base.  Today's small subscriber becomes tomorrow's key customer.

6. Scaleable  - Adding more users means adding more servers, not building factories or leasing more real estate.  Sales can be outsourced and franchised to re-sellers who are already close to the end customer. When local subidiaries of large international companies share best practices with each other, Venzeo wins additional business.

7. Hard to displace once embedded -  Venzeo's service is not particularly expensive.  Once a customer starts using the service and likes the service, there's no great incentive to switch to another supplier.  If anything, changing suppliers can be painful.  This is why first movers like Dropbox, Facebook and LinkedIn are so successful. Customers like to stay with something that works.

8. Highly fragmented industry - There are only a handful of companies like Venzeo operating and there are hundreds of thousands of companies that can become customers of firms such as Venzeo. Fragmented industries mean there is ample opportunity for new firms like Venzeo to compete and succeed.

9. Not easy to replicate - Developing the application takes  time money and effort.  Venzeo had a small, but dedicated, team of developers working full time for more than a year before it could launch a version of its service.  By learning from customers Venzeo develops value added solutions that enhance it's marketability.

10. The modest investment we make can have a large positive impact on the company.  Venzeo's core solution is developed, tested, proven and operations.   What's needed now is build out of sales and marketing, coupled with value added improvements. The marginal dollar invested today goes quickly to the bottom line, so the company is well positioned to become self sustaining.

Find out more about Venzeo at www.symvest.com/prereg/venzeo. Feel free to contact me directly at  msonenshine@symfoniecapital.com if you have questions or comments.

Equity - Crowdfunding - The Good, The Bad and The Ugly

Anyone who knows me well knows that I am not the sort of person that makes foul noises at tea parties.

But investing is a serious matter. An investor takes hard earned money and puts it to work in hopes of obtaining a return on investment. An investor who puts money to work and doesn't expect a return on investment is not investing, at least not in my dictionary.

Where did the term "Angel Investor" come from anyhow?  Are we angel investors really angels or are we simply investors who might happen to be in the right place at the right time and make an investment when  it is sorely needed or wanted?

I manage an Angel Venture Fund which I creatively named Symfonie (that's my company) Angel Ventures.  The fund is great fun to manage.  I get to look at all sorts of interesting projects, I get to meet creative, dynamic people and I get to work with a team of dedicated smart professionals each of whom brings enormous value to the fund.

The investors who put their hard earned money into my fund most certainly did not tell me they didn't expect a return on their investment.  On the contrary, each of them told me in no uncertain times that they want my colleagues and I to do our best, select good companies and make investments that will pay off.   No dollar in my fund is allowed to slack off.  Each dollar must work.  No dollar is allowed to just wander off on its own without agenda or mission.

Recently the Ministry of Finance here in the Czech Republic offered me the honor of presenting some thoughts on crowd funding to an audience at a conference hosted by the Prague High School of Economics (not high school like what we have in America, but high school meaning a school where people earn higher level degrees).

The day of the conference I had a schedule conflict.  I had to be in Warsaw with Bruce Pales of 360 Cities (www.360cities.net) and Radovan Grezo of Click 2 Stream (http://www.click2stream.com)  and the best Symfonie partner in Warsaw, Ewa Chronowska.  Since I couldn't be in Prague and Warsaw at the same time (I'm only human, after all) I asked Pavel Kohout to attend the Prague conference and present his views on crowd funding. Pavel did an excellent job and I thank him for that.

All this leads me back to the crowd funding tea party, where I should be social and polite.  I can't help myself, however. I must be honest.  The entreprenuers in search of money and the crowd funding platforms in search of commissions would like to have you believe otherwise, but in my humble opinion, the investors at the crowd funding party are likely to wake up with a hangover.

Why?  I'll tell you why with my top 10 list of thoughts on crowd funding.

1. Most startup companies fail. To make up for the failures, the success stories must have hugely positive outsized returns to compensate. According to Harvard Business School, upto 75% of venture capital funded companies become loss-making investment.  VC backing comes only after lots of meetings and lots of research on the part the VC firm.  How can the crowd realistically expect to do better?

2. The surviving companies, those that don't fail, may have  to go through several capital raising rounds over several years before finally offering those initial investors an exit.  The returns at that point may be substantial in absolute terms, but when annualised are not likely to have been such great investments after all.

3. There are enormous information assymetries between the founder/manager/entreprenuers and the crowd of investors.  The crowd is simply not in a good position to make very informed judgements.  Either the information the crowd receives is way too little or the information is sugar coated, mainly because the investee company is in fund raising mode. The crowd in practice is likely to know very little about off-balance sheet financing, obligations the company may have to pay bills in arrears, the skills and ability of the management, or the competitive landscape the company faces.

4.  The crowd is not likely to be well represented in the corporate governance structure.  The crowd usually has a weak minority position with no liquidation preferences, no dividend stipulations, no particular ability to monitor and control the company and its activities.  Even if the crowd invests through a nominee holding structure, the nominee is likely to do little and will almost certainly refrain from attempting to act for and on behalf of the crowd or will not even be empowered to act for the investors.

5. The crowd can do little if anything to add value to the company or influence its development.  The crowd's message to the entrepreneur is basically - "here's the money, now go forth and multiply."  The problem is - the company might not simply have the tools and expertise to go forth and multiply.

6. The crowd funding platforms do little more than review the company's business plan and investigate the background of the entrepreneurs.  The crowd funding platforms don't have significant due diligence budgets, nor do they have the incentives to invest in due diligence.  Think about it! If a crowdfunding platform will sell $500,000 of equity and take an 8% commission (about $40,000) after it pays its staff and its marketers and its website programmers how many accountants and lawyers and smart researchers can the platform realistically engage? This is partially why crowd funding platforms have such broad disclaimer language in their terms and conditions.

7. Unless the crowd funding platform has a serious investment in the company, the crowd funding platform is not likely to work to add value to the company.  Rather, the crowd funding platform will have its eyes firmly focused on the next beautiful piece of merchandise to put in the front window of it's internet storefront.

8. Most investors don't have the benefit of day to day, week to week contact with the investee company after the deal is done.  They won't be able to effectively monitor or control or help lead the company to success.

9. The crowd doesn't get the benefit of proper quarterly, semi-annual, even annual transparent accounts and financial reports.  Few startup companies have the skills or staff required for reporting and even if they do, more than likely their lawyers will advise them to say as little as possible, lest they risk opening themselves up to lawsuits.

10. Crowdfunding and computer/internet technology have dramatically lowered the cost of starting a company and obtaining financing.  This means more startup companies are likely experiment and take on business plans without fully understanding or evaluating the risks.

I can go on and list another 10 things, but by now I've probably worn out the welcome mat.

Don't get me wrong.  I'm not totally against crowd funding.  On the contrary, I think crowd funding platforms have an enormous opportunity and can be successful if they invest heavily in selecting the companies for their platform, mentoring the companies, and finding ways to help the companies succeed.

In the next blog I will explain why (in my dramatically biased opinion) investors are far more likely to succeed by working with a good angel investment manager or a smart investor who arranges a syndicate.

Until then.....