We have our bullpen at Bullpen – an outstanding group of advisors from companies like Facebook, Twitter and Google who have permission from their companies to come join our meetings every few weeks. We ask one of our companies to come in and present, facing a gauntlet of astute questions from people in the trenches of the leading social companies. Our companies welcome the feedback (although not as a steady diet!), our advisors enjoy the interaction, and we learn a lot.
Part of our payback to the advisors is to take them through Venture School, exploring questions they have about the ins and outs of the venture business. The most recent set of questions all centered around the terms of trade in the new shadow venture system of super-angels, accelerators (DST), second markets and even little ole Bullpen.
We started with the fad of the moment: convertible notes as seed financing vehicles. They come in two versions: uncapped converts, typically with a discount; and capped converts. The uncapped convert means the note converts at whatever the next priced round turns out to be set at, often with a 20% discount. The capped convert picks a line in the sand, where below that they convert at the price of the next round, and above that they convert at the cap. Sometimes they add a 2-3x fixed return if an acquisition occurs instead of a financing round.
We think these converts have their place, but are over-used and often poorly structured. Explaining why was lesson 1 of Venture 101.
First, a little historical context. Every financial boom comes with some sort of new financial invention, which starts out ok but gets overused and abused, and often its own contradictions cause a subsequent financial collapse. Some recent examples:
- The Moral Obligation Bond. Before John MItchell (yes, that John Mitchell, of Watergate infamy), cities had to get taxpayer approval for raising a muni bond issue. After him, they could issue bonds with a “moral obligation” to repay. Cities went deeper into debt, John got rich, and NYC went bankrupt. He later went to jail.
- The Highly Confident Letter. Before Michael Milken, junk bonds were a sorry back alley of finance. After him, they became the tool of emerging growth companies in cable (TCI, later Comcast), broadcasting (Turner), telecomm (MCI) and mobile (McCaw Cellular). Rather than leave well-enough alone, his firm, Drexel Burnham, came up with the clever Highly Confident letter, that they were highly confident they could fund a takeover – but without having any legal obligation to live up to it! The LBO craze was on. After the bubble burst, Milken went to jail.
- Dot-Com Stock. Before Henry Blodgett, the new Internet stocks were valued like companies of old. After his $40 stock call on Amazon, he and other influential analysts could set a high bar and the market would race to hit it. The bubble was on! At the end, AOL used inflated paper to buy Time-Warner. Henry did not go to jail, but was disbarred from the securities industry. He now runs an influential blog.
- Subprime Securitization. Before 1997, the subprime mortgage was a niche product largely created to serve the 1977 CRA, which tried to force lending inside poor “redlined” areas. After political pressure led to amending the toothless CRA, the subprime took on a new life. In 1997, Bear Stearns began securitizing subprime loans by putting them into bundles and reselling the bundle. Other investment houses followed, government entities like Fannie Mae and Freddie Mac guaranteed those bundles of subprime, and rating agencies like Moody’s rated the bundles’ risk as much less than the individual pieces. The greatest bubble in US history was on, and housing ran 4x higher than a 200-year trendline. Remarkably, no one has gone to jail, but Bear Stearns’ subprime funds were the first to signal trouble in 2007, and Bear was the first Investment House to go under in 2008.
Uncapped converts are nowhere near those levels of financial infamy, and in some cases are quite useful. They are the prime vehicle used to bridge between rounds of finance. Yet they have problems. One of my partners who has angel funded since 1998 will not invest in them. My other partner has had experience with them and dislikes them. They contain the seeds of their own destruction:
- They put the angels at odds with the founders. A holder of an uncapped convert does better with a low price in the A round, while the founders do better with a high price.
- They can make the quick flip problematic. The uncapped convert holder gets no benefit, unless they added some protection (like a fixed 2x return), and could even try to block.
- They can create signaling problems. Charles River tried a quick $250k uncapped convert, but founders figured out that if they took it, and Charles River declined to lead the A round, they were dead. The other VCs were scared of by Charles River’s presumed superior perspective.
- They can undermine the A round with too high a cap. We looked at a deal with multiple capped converts at different prices, and knew if we bid below the higher caps the angels would be at odds with each other. Also, management had taken the final, overly-high cap as a signal of expectations for the priced round.
Converts are seductive in the ease with which an angel can get into a round. No hard decision has to be made; it is punted to the institutional VC. Capped converts tend to be capped at too high a level, to avoid a hard valuation decision and offending the founders. Perhaps it is no surprise then that the super-angels prefer to price a round.
One final story to put a cap on these converts. When Y Combinator got going, Sequoia put in some capital in exchange for a first look. The brand association with the premier VC firm helped elevate Paul Graham’s incubator, but he ran into signaling problems: the deals Sequoia declined to fund were harder to get funded. He later opened all deals to an organized auction, and was more successful. More recently, the indubitable Yuri Milner of DST has offered to fund every Y Combinator graduate with a flat $150k in an uncapped convert. This use of the convert neatly avoids signaling problems, since Yuri is a later-stage player and is not expected to lead the A round.
Yuri’s use of converts has thrown a monkey wrench into the VC community. Maybe that is not his goal, but it sure is a creative use of a financial invention. And just as creatively, his move was mocked in this year’s TechCrunch April Fool’s article.
If you want to use the convert in a seed deal, at least cap them and give yourself a 2x return on a quick flip.