Ten Reasons Why Not to Use Convertible Debt

It seems like a majority of pre-Series A deals are done with convertible debt these days and I’d like to point out a few reasons why this is a bad thing for entrepreneurs and investors alike.

Just to get definitions out of the way, we’re talking about the decision to raise funding for startups by either equity investment in stock of a company, or in a convertible debt instrument.  Equity is pretty straightforward – invest money, get stock.  Convertible notes, on the other hand are not widely known to those outside of startup investing.  Convertible debt works like regular debt in that there’s a promissory note and an interest rate.  The interest is rarely paid in cash for convertible notes though, and it’s usually rolled into equity when the note converts into equity.  There are usually a few “triggers” for h

RVC Convertible debt vs. equity

aving the note convert to equity, but the most prominent one is that there is a “qualified financing round” which is usually around $1 million.  The idea is that the professional investors at that stage know how to value the business and set the terms. The first early investors who invest will convert at the terms set by the VCs, but usually with a 20% discount in price to compensate for investing earlier.  Convertible notes today also have a “valuation cap” which is equal to what the equity valuation would have been if the deal had been a stock transaction in the first place.  So, when the qualified round causes the note to convert, it converts at the lower of the 20% discount or the valuation cap.

Ten Reasons to Avoid Convertible Debt

Reason 1:  Convertible Notes do not qualify for Section 1202 QSBS Tax Breaks<a href="http://www.freepik.com/free-photos-vectors/business">Business vector created by Dooder - Freepik.com</a>

Angel investors get a 100% capital gains tax break if they invest in equity in early stage companies that meet certain criteria such as being a C Corp., being under five years old, under five million in revenue and they hold the 

 

 

 

investment for five years.  Convertible notes don’t qualify for this tax break, so if all things were equal, the investor makes 20% LESS on convertible note deals since they have to pay capital gains tax on the investment, whereas investors who invest in equity do not have to pay any tax at all.

Reason 2: Equity is cheaper than convertible debt

You may have heard that it’s cheaper, faster and easier to do a convertible note, but the fact is that convertible notes are going to end up costing the company approximately 25% MORE than an equity deal.  The reason for this is that when the note converts, then it converts into EQUITY.  That means that the company pays twice for the legal: once to do the note and another time to do the equity.  So if a convertible note cost $2500 in legal fees and the equity deal cost $10,000, then the convertible note all-in is going to cost the company $12,500.  Why not just do it right in the first place and put all that money to work for the company?

Reason 3) 80% of Angel Investors Prefer Equity

If you’re selling something to a customer, wouldn’t you want to sell them what they want and not some more expensive and inferior product?  The American Angel Survey shows that investors prefer equity and I suspect that if the remaining 20% of angels read this blog, they’d prefer equity too.

Reason 4) You can lose your company if you default on a convertible note

When you take out the note you’re confident that you’ll have a qualifying follow-on round within 18 months, but many times it takes longer and the note comes due and payable and you’ve already spent the money and can’t raise any more.  You’re in default and investors can take your company from you.  Most investors don’t want to do that, but why go through the heartburn and stress of facing the potential loss?

Reason 5) Investors have to pay tax on interest they earned but never got

As interest accrues on convertible notes, interest is due.  Investors need to pay tax on those notes, even though they didn’t actually get the interest in cash.  So, if someone invests $100,000 in an 8% convertible note, they have to pay $2640 in cash to the IRS on that income.  Nobody likes paying taxes on money they never got and also, BTW, there is no tax due for equity investments.

Reason 6)  You have to come up with a valuation for convertible notes just like equity.

Many people think that using convertible notes lets them “kick the valuation can down the road.”  Nothing could be farther from the truth.  Every convertible note has a provision called the “valuation cap.”    The formula for calculating the valuation cap is as follows:

Valuation Cap = Equity Valuation

This means that when someone invests in a convertible note, they should never have to pay more than what the company is worth today.  If the valuation cap were higher than equity valuation, that would mean that note investors would have to pay more than the value of the company.  Just because it may convert at a higher valuation some time in the future does not mitigate the risks that the early stage investor has today.  In fact, the only way that the higher valuation comes about in the future is that the angel investor puts in the capital early, when risk is highest, so it doesn’t make sense that they should pay more than what the company is worth.

Many companies get confused about this.  One company told us that the valuation would be $5 million, but it would be $7 million valuation cap “because it’s going to convert at $12 million some day.”   It’s crazy to think that somehow using a convertible note makes a company worth $2 million more than one that uses equity. This kind of thinking makes no sense and hurts the startup community.

Putting valuations on early stage companies is something that is done every day and there’s no magic to it.  Seed Funds and Angel Groups have well established valuation methodologies that work well on pre-revenue companies.

Reason 8) Entrepreneurs get diluted with convertible notes

Entrepreneurs should be cautious about the cumulative dilution that paying interest which will be rolled into equity will create.  The longer the note goes on, the more startups will be diluted with the interest that they have to pay in the form of equity.  It would be better to preserve that equity for future growth.  Founders who chose equity over convertible debt don’t have to worry about interest accumulating and diluting their shares.

Reason 9) Equity creates better alignment between investors and founders

When convertible debt is used, there is a misalignment between investors and entrepreneurs.  Founders want to use high valuation caps or worse, no valuation caps, and prolong the amount of time before conversion, so that investors get the short end of the stick.  Some founders openly state that they want to use convertible debt to preserve their equity.  Those are founders that every investor should avoid – not because they want to build a strategy that preserves equity, but that they want to create unfair terms that preserve equity at the expense of investors.

Reason 10) Equity deals have all the terms defined

With a convertible debt deal, the conversion price is negotiated, but all the other terms which are extremely important to the relationship between the founders and investors are left open.  This represents a risk to investors and also leaves many matters unsettled.  One example is that there are usually terms about board representation which are not found in convertible notes.  Investors in early stage companies can offer much more to companies than just a check if they can serve on boards and help move the company along.  While there’s nothing to say that companies with convertible notes can’t have boards, in fact many don’t and that’s bad for both investors and entrepreneurs.

Last Words:

With all that being said against convertible notes, they can still be useful for the FFF rounds with friends and family who don’t know how to value a deal and who are investing primarily to support the entrepreneur.  Convertible notes can be better than some of the amateurish deals that get put together for early family investors who are often non-accredited that can make follow-on investments difficult or even impossible for the company, thus limiting its chances for success.

Visit www.rockiesventureclub.org to learn more.

 

Peter Adams

Managing Director, Rockies Venture Fund I, LP
Executive Director, Rockies Venture Club, Inc.
 Buy Venture Capital For Dummies on Amazon

 

Angel Investing is not as Risky as you Think.

It’s a common misconception that angel investing and venture capital is extremely risky.

But when best practices for investing are followed, tax breaks and portfolio returns can consistently outpace even the best mutual funds.  If you’re wondering how this can be true – read on!

Angel investing involves capital investments by accredited investors (people with a net worth of $1 million or more excluding the value of their primary residence, or with income of $200,000 or more per year/ $300,000 for a married couple).  These investments are in startups, usually with less than $1 million in revenue and less than five years old.  These startups have high growth potential and angel investors look to invest in companies that have a believable plan to be able to return 10X their investment or more within five years.  

Yes, some of these companies will fail, but let’s compare two investors.  The first one, Freddy Frugal, invests all of his money in mutual funds yielding a healthy 8% return. The second one, Andy Angel, invests his money in ten startups.  Both investors hold their investments for five years.  Let’s look at  their returns.

Freddy’s returns are 8%, but he must withdraw $2,640 in the first year, and more each year to pay taxes, so the compounding is based on his after tax returns each year.  After Freddy pays his taxes, his actual return is less than 5.93%.  Not bad, given the relative lower risk of a mutual fund and the liquidity it provides when funds are needed.

Freddy Frugal – $100,00 at 8% compounding
Year Investment Returns Failures Taxes Returns After Tax Portfolio Value After Tax
Initial Investment $100,000 -100000 -$100,000 $100,000
1 0 $8,000 0 $2,640 $5,360 $105,360
2 0 $8,429 0 $2,782 $5,647 $111,007
3 0 $8,881 0 $2,931 $5,950 $116,957
4 0 $9,357 0 $3,088 $6,269 $123,226
5 0 $9,858 0 $3,253 $6,605 $129,831
Total $44,524 $14,693 $29,831 $129,831
IRR Before Tax 8.83% $144,524
IRR After Tax 5.93% $129,831

 

Andy’s returns are a bit more complicated.  

First of all, because Andy is investing in a Colorado company he is eligible for state investment tax credits of 25%.  (many other states have similar credit programs)  This means that he gets $25,000 back immediately from the state government, so he actually has only $75,000 of his capital at risk.   We’ve shown this below by adding the $25,000 cash returned by the state to the value of his portfolio.

Also, Andy’s returns for his portfolio match the HALO report of thousands of Angel investing deals reported, so in the second, third and fourth years one company totally fails each year, resulting in a complete loss of investment and another is liquidated and returns $.50 on the dollar.  This results in a tax loss of $15,000 each year which he can take accelerated write offs against ordinary income thanks to IRS Code Section 1244.  This results in a cash benefit to Andy each of these years in the form of reduced taxes which we’ve calculated at $4,500 per year.

In the fifth year, the remaining four companies have exits ranging between four and ten times the initial investment amount, resulting in a $295,000 positive cash flow.  Because Andy made equity investments in early stage C-Corporate startups and held the investment for five years, he is entitled to a 100% long term capital gains tax exemption thanks to IRS Code Section 1202, so his tax bill for that year is zero.

 

Andy Angel – $100,000 in ten startups at $10,000 each
Year Investment Returns Failures Taxes Returns After Tax Portfolio Value After Tax
Initial Investment $100,000 $25,000 $25,000 $125,000
1 $0 $0 0 $0 $0 $125,000
2 $0 $0 1.5 -$4,500 $4,500 $114,500
3 $0 $0 1.5 -$4,500 $4,500 $104,000
4 $0 $0 1.5 -$4,500 $4,500 $93,500
5 $0 $295,000 0 $0 $295,000 $333,500
Total $320,000 -$13,500 $333,500 $333,500
IRR Before Tax 31.5% $333,500
IRR After Tax 31.5% $333,500

 

There is a lot of mythology about how many startups fail on average.

So, how risky was Andy’s Investment?

The statistics about how many startups fail on average can be deceiving.  Many of those statistics come from the SBA or local Secretaries of State who report failures of hair salons, restaurants and lawn mowing services along with other companies.  But, companies that receive venture capital investment have to reach a higher bar than just registering with the state.  They need to have gained significant traction and have gone through a lot of due diligence and had to jump the hurdle of convincing dozens of angel investors to write a check.  These companies are far less likely to fail than the general population of company formations.  In fact, HALO report data shows that about 52% of these companies will return less than $1.00 for each dollar invested.  Of that 52%, about 18% will be complete failures.  So, we’ve been a little hard on Andy Angel and had him with three total losses and three returns of less than a dollar.  On the upside, we’ve also been a bit conservative.  About 5% of venture backed startups will return 30X or greater, and there’s a good distribution of returns between 10X and 4X.   These winners more than pay for the losers.

Andy’s key to success was that he diversified his portfolio into ten investments.  Smart angel investors know the value of spreading out the risk so that the winners can more than offset the losers.

Another point to observe is that we’ve valued Andy’s portfolio at the value of the investment only until the returns came in.  Despite that conservative accounting, he barely dipped below his $100,000 investment amount in year four with a portfolio value of $93,500.  This means that if the four remaining companies had returned only 1X, his loss would have been limited to $6,500.  

But, his returns were a more typical 3X over the portfolio, resulting in a return of $295,000.  We can add in the $25,000 state tax credit and his $13,500 in accelerated write-offs  from the $45,000 loss, and his net cash return AFTER TAX is $333,500.

Andy was hardly more at risk than Freddy, and yet the internal rate of return on his investment was more than FIVE TIMES GREATER.

So, who is the smarter investor?  Freddy Frugal with a 5.93% after tax return or Andy Angel with his 31.8% return and $333,500 in cash after five years?  Angel investors have figured out how the system works and have been profiting handsomely from it for some time.  Accredited Investors should consider contacting their local angel group, preferably groups that are members of the Angel Capital Association, like Rockies Venture Club, and consider membership so that they can benefit from great deal flow, a community of smart investors, group negotiation and high quality due diligence.  

Visit www.rockiesventureclub.org to learn more.

 

Peter Adams

Managing Director, Rockies Venture Fund I, LP
Executive Director, Rockies Venture Club, Inc.
 Buy Venture Capital For Dummies on Amazon

Life Science Investing is Different than Software Tech Angel/VC Deals

Life Science Investing is Different than Software Tech Angel/VC Deals.

 

Companies seeking early stage investment in their biotech, life science, medical device or digital healthcare companies face al

 

l the hurdles that software tech companies face – and then some more.  Many of the hurdles have to do with misconceptions that people have about life science investing, and others have to do with the real differences that exist in this market.  Companies raising money in the life sciences have to go through all of the things that tech companies do, plus more, in able to successfully raise funding.  

Life Science companies should consider attending the RVC/CBSA BioScience HyperAccelerator to help them through the process. We guarantee participants will be amazed with the quality and usefulness of this unique content that can be found nowhere else!

 

What BioScience Companies Need to Know

Time-Lines – there are a lot of investors who think that all life science deals take ten years or more because of the huge regulatory hurdles that have to be overcome, and that the capital requirements could be in the hundreds of millions before the company gets to an exit.  These investors are missing out on lots of great opportunities.  What they don’t realize is that companies rarely move all the way down the regulatory pathway before achieving exits if they’re developing a novel drug, for example.  Usually the hurdle is Phase 1 Clinical Trials before a company is acquired, so the pathway can actually be shorter than for some tech investments.  Also, many companies are working on repurposing existing drugs for new uses.  In this case, all they need to prove is efficacy for the new use which can be a relatively short process.  Devices, in contrast to drugs, can achieve FDA approval in just months in some case.

 

FDA Regulatory Risk – many investors who don’t understand the biotech space have heard horror stories about the capricious, costly and time consuming process of FDA approvals.  While these fears are not totally unfounded, most companies pass through the process in a relatively short time and at low cost.  We budget about $50,000 and six months for a 510K approval process in some cases.  Angel investors have special opportunities to invest in pre-FDA approved companies because valuations typically double or triple after FDA approval, resulting in good returns for investors.  

 

Liquidity Events (Exits) are more obvious for many biotech, medical and life science companies because there is a clear playing field with companies that are regularly acquiring companies as a part of their innovation strategies.  There are enough players that companies who are intentional about crafting the best exit can create a situation with multiple bidders to result in the highest exit valuation.  Even if the exit pathway seems clear to founders, their presentations should include a clear description of their exit strategy in order to bring the most investors on board.

 

Intellectual Property is Critical – while most tech and software companies have dropped patent filing altogether, IP is the core to creating value in the life science and medical space.  Granted patents are always best, but at least having patents pending with a strong defensive strategy is critical for success.  Companies will also need to be able to demonstrate that they’re not infringing on the patents of others.  We’ve seen companies who we’ve found to be infringing on patents which made them uninvestable.  This is something that companies should research well and be able to demonstrate instead of doing a lot of work, only to have investors find that the project is dead on arrival after several years of effort.

 

Team Considerations – tech companies often suffer because they have a bunch of coders who’ve been working for years to come up with a product, but they don’t anyone on marketing, finance, or business strategy.  Life Sciences can have these problems when they’re staffed with teams of smart PhDs who don’t have the experience or track record to be able to raise funds, transform from a research organization to a marketing organization, or to understand value creation for acquirers.  Make sure your company has the appropriate finance and marketing team members on board before raising money.

 

Market Fluctuations – it seems like biotech is always way up or way down and the current market position may influence investors’ desire to jump on-board with these companies.  Founders should be prepared to talk about trends in the industry and why their company will be providing value that either transcends the current market situations, or that the investment cycle is expected to be long enough to stretch beyond any current market challenges.

 

Marketing Strategies for life science companies are going to be significantly different than for tech or other physical product companies.  Some life science companies build an expensive and time consuming strategy that involves hiring and training a sales force who then try to forge relationships with doctors and hospitals in competition with some of the largest and well funded companies in the world.  If the company survives that process and gets to an exit, then the first thing that the acquiring company is going to do is to fire all those salespeople and add the company’s product line to their own and get their own sales people up to speed on marketing it.  So, life science companies should think about how they add value to their acquirers.  Is their value primarily the product itself, the team, the market share, the sales organization, research under way, or something else?  Make sure that you’re not pouring resources into something that won’t create value for your acquirers.  With that being said, companies will need to establish a market presence in order to validate that the product is of interest to customers and will be a success in the market.  This benchmark may be achieved with as few as one thousand sales.  These can be achieved through forging partnerships with sales organizations rather than starting from scratch.

 

Valuation  for life science companies seems to have a significant spread which may be caused by inexperience on the founders’ side, or by the uncertainties in the market.  Companies that want to raise funds quickly should price their shares competitively with other startups and keep in mind that not every startup ends up with a five hundred million dollar exit.  

 

Life Science founders have a lot of opportunity in front of them if they understand their market and how to take advantage of it.  Founders should be prepared to dispel myths and to focus on the clear strategy they have for product development, regulatory strategy, marketing and exit.  These will lead to most investor interest and fastest pathway to funding.  Life science and medical investments currently comprise about 30% of venture capital investment which shows that investors recognize the opportunities that this space brings.  Founders and investors alike should have a clear understanding of the differences between life science and software/technology investments and how to take advantage of them.

 

All companies raising capital should be well versed not only in the specifics of their industry, but should also prepare solid strategies and complete the following steps before starting their fund-raising activities.

Ten Steps for LifeScience Companies to Prepare for Venture Capital

  1. Exit Strategy Canvas – identify comparable transactions in the market for both dollar amount and multiples of revenue.  Identify early, mid and late stage values the company presents to acquirers. Identify who the acquirers are at each stage of the company’s development.
  2. Business Model Canvas – this is the core business strategy document that allows a company to understand their unique value proposition, their customer, the channels used to reach customers, core metrics, partners, and how they spend and make money.  This one-pager is key to understanding the key concepts behind any company.
  3. Strategic Plan – Not your grandpa’s strategic plan, but a two-page document that provides a roadmap from where the company is today through its growth.  This is the difference between success and failure during Q&A with investors and for the company overall!  Research shows that companies with written strategic plans outperform those without plans by 65%.
  4. Go to Market Plan – people take this for granted when they’re heads-down in the science or tech development, but this is the key risk companies face – getting customers to actually buy the product.  Without a strong go to market plan, you’re out of luck with investors who are always concerned about this key risk.
  5. Proforma – you need more than a great idea to raise money, you’ll need to model out your use of funds, needs for capital, revenues and expenses.  A good detailed proforma that is well researched and validated is a must for planning your business and for determining your capital needs and valuation.
  6. Finance Plan – you need to know how much to raise now (this is harder than you think) as well as your future raises between now an exit.  You’ll need to know this to help model your cumulative dilution and to understand what the major milestones are that you’ll need to achieve at each level of funding.
  7. Valuation – let’s make this simple.  You can’t raise money without knowing your valuation, regardless of whether you’re using equity or convertible debt.  Go through five valuation models and play them off of eachother to have a defensible position when it comes time for negotiation.
  8. Term Sheet – this is the key document used in negotiating the deal.  Make sure that you’ve got a term sheet in your pocket before you meet with investors so you have a solid understanding of the key terms and how they’re used in venture deals.  
  9. Executive Summary – When investors ask for information, they’ll want a two-page executive summary and pitch deck.  The executive summary has all the core elements of your company in a concise format that investors can use to determine their interest in moving forward.
  10. Pitch Deck – when you get in front of investors you’ll need a pitch deck to present your information.  Get this done professionally so that you can communicate effectively in a highly competitive capital market.

 

Life science companies can get templates, education and mentor assistance in creating all of these in a two-day BioScience HyperAccelerator hosted by Rockies Venture Club and the Colorado BioScience Association.   The two day workshop is $995.00 per company and includes a one-year membership in the Rockies Venture Club for the primary participant and a free subscription to the IdeaJam platform to help companies securely get feedback and input on their Provisional Patent Application.  Companies using the IdeaJam platform can file patent applications in a fraction of the time and cost of using patent attorneys.

Apply to Join the BioScience HyperAccelerator here ===> https://rockiesventureclub.wildapricot.org/event-2614776

 

The Next Session is August 29-30th in Denver.  Apply by August 22 for preferred admission.

 

Social Proof

At the beginning of summer, I was brought on as an AngelList associate intern at Rockies Venture Club. Unsure of what that would entail, it turns out, I was going to be building a following on AngelList, one of the most disruptive, and uniquely social investment platforms to date. The focus of this post is not about the platform or how useful AngelList is, because it been vindicated by many notable Venture Capitalist and by the amount of capital that has been raised on the platform already, but to rather talk about AngelList in accordance with social proof. Read more

Marketing Dilemma: Time and Capital is Key

The marketing dilemma in todays start-up world can be defined by the need for capital to increase marketing, but also the need for marketing to gain capital. Read more

How does a co-investment Leveraged Venture Capital Fund Work?

To understand how a leveraged venture capital fund works, you first need to understand some basics of how a traditional VC fund operates.Leveraged venture capital fund

VC funds collect capital from Limited Partners who invest in the fund.  The fund then invests this capital, assists the companies in growing and working towards a liquidity event and then returns capital and profits to investors.  The fund typically charges a 2% management fee and 20% carried interest to compensate them for all the work.  This means that after an investor receives 100% of their investment back, they also get to keep 80% of the profits.

A leveraged fund works just like a regular fund, except that it works double hard to benefit Limited Partners by creating “syndicates” or groups of investors on a platform like AngelList which then charges a carried interest to those platform investors.  The AngelList carried interest is also 20% and the platform keeps 5% and the syndicate lead, who in this case is the venture capital fund, gets to keep the 15% carried interest which it then distributes to its Limited Partners.How venture capital works

So how does this work?

Imagine that the VC is going to invest in a company that is looking to raise $1 million.  The VC may invest $500,000 of its own money in the company and then act as syndicate lead on AngelList for the remaining $500,000.  If the company was selling 20% of its equity, then the VC would own 10% and the AngelList syndicate would own another 10%.  Now imagine that the company has a 3X exit, so the VC gets $1.5 million and $1.3 million is distributed to Limited Partners.  (LPs get their original $500,000 plus 80% of the $1 million profit)  The AngelList investors get $1.3 million too.  But now, the VC also received another $150,000 in carried interest from the AngelList syndicate which is also distributed to its LPs (less the 20% carried interest), so they receive an additional $120,000.  The LPs thus had only an 8% net carried interest on the deal thanks to the leverage strategy and they put an additional $120,000 in their pockets which they would not have seen from a traditional VC fund.

For a leverage fund to work it has to have all the elements of a great Venture Capital fund in the first place.  They have to have a lot of deal flow and have the ability to pick the best opportunities and coach them along the way to a successful liquidity event.  They need to have a solid portfolio of companies that would provide excellent profits to LPs without the leverage.  But if all these things are in place, and then a leverage component can be added, then Limited Partners can see a significant benefit.

To learn more about Rockies Venture Fund and leveraged VC fund investing, visit us at www.rockiesventurefund.com

 

Venture Capital for DummiesPeter Adams is Executive Director of the Rockies Venture Club, Managing Director of the Rockies Venture Fund and teaches in the Colorado State University MBA Program.  Peter is co-author of Venture Capital for Dummies, (John Wiley & Sons 2013) Available at Amazon, Barnes and Noble and your local book store.

 

What you need to know about Angel Investor Syndication

There’s a lot to know about angel investing, but the one thing most people miss is how to syndicate a deal.  Almost every angel investment deal in an entrepreneur’s company is a syndication and there’s a lot more to it than just getting a bunch of investors together.   Read more

Angel Capital Summit 2016: Syndication 2.0

ACS-2015-logo_transparent

Better … Faster … Deal-Making
A Track Record of Success

Pursue your own successful investment strategy. Engage with thought leaders and experienced Angel investors. Don’t just take our word for it.  Explore these recent success stories made possible by the Angel Capital Summit (ACS) hosted by Rockies Venture Club (RVC). Read more

SEC Adopts Rules to Permit Crowdfunding

Rockies Venture Club is pleased to share the news that more than three years after passing the JOBS act, the SEC has adopted new rules to permit crowdfunding.  This means that those who could not previously qualify as an “accredited investor” with $1 million or more in assets or $200K in annual earnings or more, can now participate in early stage investing.

Read more

How to Become and Accredited Investor

A company can broadly solicit and generally advertise selling securities in order to raise capital for their company as long as the investors in the offering are all accredited investors. That brings us to the title of this post; what in the world is an accredited investor, and how does one become “accredited?” Read more