Murphy's Law and the Convertible Note

From Venture Capital Brazil

In the US, we often quote something called Murphy's Law, which states, "That which can go wrong, will go wrong." I believe that the more VC investing someone has done, the more they come to believe in the universal applicability of Mr. Murphy's code. Just because things will go wrong, however, doesn't mean a startup won't succeed, it just means its going to be a lot harder than anyone can anticipate.

That's why entrepreneurs that have track records of success are so valuable to investors. They have proven that they can overcome the dozens of unexpected challenges that inevitably arise when starting a business.

It also points out why it's so important to invest in an industry in which the tide is rising. Often times, just being in an industry at a time of high growth can itself overcome many of the setbacks startups face.

Entrepreneurs, on the other hand, tend to flip Murphy's law on its head. That which can go right, will go right. It's not a bad outlook and, in fact, unrelenting (but not delusional) optimism is required to be a successful entrepreneur.

These two different outlooks, however, lead to one of the most common and difficult issues investors and entrepreneurs face: what is the valuation of an early-stage company?

Entrepreneurs focus on the potential upside to their business (otherwise they wouldn't bother starting it). They tend to approach the question of valuation from the point of view of, "We could be the next Google/eBay/Facebook/Twitter (etc.). Given that possibility, we should AT LEAST be valued at $10mm/$20mm/$30mm (etc.)."

Investors, on the other hand, tend to approach the valuation issue with Murphy's Law.

One of the ways to avoid the valuation issue is to use a convertible note for the seed investment. A convertible note is essentially a debt instrument that converts to equity at a discount to the valuation of the NEXT investment round. The theory is that, by the next round of investment, the company will have more of a track record and thus the valuation can be more easily and fairly determined.

For example, assume a seed investor provides $1,000,000 in convertible debt to a startup, with the agreement that the $1mm in debt will convert to equity at a 20% discount to the valuation of the next round.

One year later, the company completes a Series A round at a $10,000,000 pre-money valuation. Concurrent with the transaction, the seed investors convert their $1,000,000 into equity at an $8,000,000 valuation (a 20% discount to the $10,000,000 valuation). So, the seed investors own 12.5% of the company "pre-money", i.e., before the Series A investors put their in their investment.

The convertible note is a common and important tool in angel/seed stage investing in the US; I haven't seen it used yet in Brazil but it could be a useful adaption for use in Brazilian angel groups and seed investing.

Some early-stage VCs dislike convertible notes. Others, like many angel investing groups in the US, use them for every deal that they do.

On the good side, a convertible note avoids the problem of valuation: the newer the company, the less data available to do a meaningful valuation, i.e, the more subjective a valuation becomes and the more room for disagreement between investors and entrepreneurs. A convertible note solves the problem by acting as debt until the next round of institutional capital, whereby it "converts" into equity at a preset discount to the valuation of that round. (The assumption is that, by the time of that institutional round, the company has enough of a track record to enable a relatively accurate valuation.)

The primary case against the convertible note is that it limits the upside of the seed investor. Theoretically, since the seed investor is providing capital at the highest risk, his upside should also have unlimited potential. Yet, when the seed investor uses a convertible note, he necessarily caps his upside by agreeing to convert at a pre-determined discount to the next round.

Let's do some math. (I worry about posts that have a lot of math but, let's face it, the investment business is about return on investment, and calculating return on investment is about math.)

Scenario 1:

The seed investors put in $1MM into Startup X using a convertible note, which will convert to equity at a 20% discount to the valuation at the next round of investment.

A year later, a large VC firm makes a Series A investment in Startup X; they give X a $10MM pre-money valuation and prepare to invest $5MM.

Prior to completion of the Series A investment (as part of the Series A process, really), the seed investors convert their $1MM in debt into equity at an $8MM valuation (20% discount to $10MM). Thus, they own 12.5% of the company before the $5MM Series A investment.

12.5% of $10MM = $1.25MM, so, on paper, the $1MM seed investment has appreciated 25% in one year. Not bad.

After the $5MM Series A comes in, the seed investors still have an investment worth $1.25MM but they have been diluted down to 8.3% of the company.

As I said, not bad.

Scenario 2:

In this case, assume the seed investors decide to negotiate a valuation with the startup and get 33% of the company in exchange for their $1MM investment (i.e., the negotiated a $2MM pre-money valuation for Startup X, $3MM post-money).

A year later, the exact same Series A as in Scenario 1 takes place.

Since the Series A investors value the company at $10MM pre-money and the seed investors own 33% of the company, the seedf investors' stake is worth $3.33MM.

After the $5MM Series A investment, the seed investors own 22% of the company, (almost 3x what they own in the convertible note example).

In sum, by negotiating a valuation for their investment, rather than deferring it to the next round, the seed investors increased the value of their investment (on paper) and their ownership percentage by 300%.

Scenario 3:

Let's take another example, which is more interesting because it shows that, the more successful the startup up is, the more crushed the convertible note investors can be.

Assume the same scenario as example #1 – the seed investors use a convertible note – but this time startup does extremely well after the investment.

Instead of a $10MM pre-money valuation, the Series A investors give the company a $50MM pre-money valuation and decide to invest $15MM. Great! The seed investors scored a grand slam!!

Not really – let's do the math:

The convertible notes converts at $40MM, a 20% discount to $50mm. Their investment is still worth $1.25MM – a good paper return – but they only own 2.5% of the company. After the $15MM investment, they only own 1.9% of the company.

Is it really fair that the seed investors provided $1MM of high-risk capital to get the company to a $65mm valuation and yet they only have stock worth $1.25MM?

If they had negotiated for a third of the company upon investment, Scenario 2, they would now own 25% of the company after the Series A investment and their stake would be worth $16.5MM!!!

There are some other critical things to consider in the debate over convertible notes – whether the seed investors receive preferred or common shares upon conversion, what happens if the Series A is a "down round", what happens if there is no Series A, etc. — but this is already a long post so we'll get to it in a later post.