While convertible debt with a “kicker” of some sort (typically either in the form of warrants or a discount on the conversion price) was first used primarily as a structure for bridging companies between rounds of traditional venture capital financing, more recently it has become a popular vehicle for seed financing in advance of the first (A) round of venture investment. The structure offers two major plusses for entrepreneurs and investors. First, it postpones the valuation negotiation until both parties have a better handle on the key variables. Second it is faster and cheaper to implement than a formal Series A round.
That said, like most ideas that have been around for a while, convertible debt has found its way into more situations where it may not be a very good fit. Today, my focus is exploring the situational limits of the convertible debt financing structure in the startup context.
Conceptually, the convertible debt structure works when an entrepreneur seeks a modest round of risk capital to achieve a significant milestone in a short period of time, the accomplishment of which will set the stage for a substantially larger subsequent A round of financing. Framed this way, the terms “modest” and “substantially” are linked, while the terms “significant” and “short” are more or less independent.
Let’s start, then, with the “modest” and “substantially” discussion. Essentially, the notion here is that the bigger the difference between the seed round need and the A round need, the more a convertible debt structure makes sense. Depending on the kind of deal (think bigger in capital intensive businesses) and the seed capital market (think bigger in venture capital centers) a convertible debt seed round might be anywhere from $5k to $1 million or more. The critical point is that the expected A round be substantially larger. How much is that? In general, the A round should be at least 2x and ideally 3x or more the size of the seed round.
The reason the A round should be at least twice the size of the seed round is that if the seed round gets much bigger, the impact of the seed round kicker on the A round valuation negotiation will at some point cross the fuzzy line from marginal (and thus largely overlooked) to central (and thus problematic). For example, consider a $500k convertible note with a 20% discount on conversion. If the subsequent A round is a $5 million raise, the seed round kicker (basically, the seed folks will get an extra $100k worth of A round stock) represents roughly 2% of additional dilution to the A round investors. In theory the A round investors might factor that 2% into the A round valuation discussion. In practice, probably not.
On the other hand, if the A round in the above example is just $1 million, the overhang from the 20% kicker looms much larger. In fact, it now represents roughly an additional 10% dilution to the A round investor. At this point, what was a theoretical issue for the A round investors, in terms of the valuation negotiation, might be a practical issue as well. As such, it will likely complicate the A round valuation discussion, and likely result in a lower A round valuation – and corresponding additional dilution for the entrepreneur. (Alternatively, some or all of the additional dilution might be shared with the seed round investors, if they can be persuaded to waive some or all of the seed round kicker.)
Let’s turn now to the significant milestone variable in the seed convertible debt scenario. What constitutes a significant milestone? Essentially, two related concepts play into what constitutes a significant milestone. The more central of the two is the notion that significance is measured by how much risk the accomplishment of the milestone takes out of the deal. Particularly at the early stages of a high impact business, the primary driver of value is risk reduction. The seed milestone should be well-defined, and the accomplishment thereof should reduce the risk that the deal will get to a satisfying exit by, say, 25% to 50%. (That might seem like a lot, but really it just reflects how risky high impact entrepreneurship really is.) In addition, though in fact another way of framing pretty much the same issue, the accomplishment of the seed milestone should provide a much firmer foundation for the valuation discussion at the A round.
In my own world, I see a lot of web-centric startups where the seed round milestone is the delivery of the proverbial minimally viable product coupled with some modest customer validation. The significance of the same – the transformation of the entrepreneur’s idea into an actual product that at least a handful of folks in the target market will buy – is pretty obvious, both in terms of risk reduction and firming up the A round valuation parameters.
Finally, let’s consider the short time variable in the seed convertible debt scenario. This is in some ways the trickiest variable because it doesn’t so much depend on the practical demands of the convertible debt structure as the extant market dynamics. By that I mean that the bounds of the time variable are more a function of the market’s determination that an acceptable seed round kicker is something between 10% and 30% than any conceptual limits on the amount of time expected between the seed round and the A round. The notion here is that the seed round investors will accept a relatively modest 10% to 30% kicker on the assumption that the return will be over a reasonable period of time.
What is reasonable? In my experience, no more than 18 months, and generally less than 12 months. Why? Because if the implicit rate of return on the seed debt falls too far below the expected A round return (which might eye-ball at something like 100% from A round to B round) the seed round investors will quite rightly wonder whether their generosity in providing seed capital with only a modest kicker has crossed into philanthropic territory. And while I have known a lot of seed investors who think giving back some of their own good fortune by supporting the next generation of entrepreneurs is a wonderful thing, I have not found many who think giving away their good fortune to a next generation entrepreneur is a good thing.© MICHAEL BEST & FRIEDRICH LLP