Convertible Notes 101 for Tech Startups – Robert Neivert, 500 Startups
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Robert: So, the first general rule of thumb is notes are done when you’re doing a small amount, generally under a million, you are not expertise or haven’t had a chance to do the necessary research for an equity round, Fred Wilson is not financing you, because he doesn’t do notes. The other thing about notes is, they don’t define the valuation as clearly. We’re going to talk about that in a few minutes, because realistically, they kind of do.
But one of the biggest advantages to a note is you only need a little bit of information to move forward on it. So now, I’ll pose a statement to you. How many people here are thinking they’re going to do a raise of more than a million dollars? Okay. So, at this point, if you look on the notes, equity verse note, you actually read that carefully because it’s possible you may want an inequity round. Possible. I’m not saying you do, but it’s possible. Underneath that, it’s unlikely. Okay? Any quick questions, notes versus equity, before we continue? Okay.
Then let’s move on to the next section again, Bitly link if you have it. There are two types of notes that I am going to discuss today and one type that I’m not. One’s called debt and one’s called equity. And the first statement is, I just reuse the word equity. I’m not referring to an equity round; this is referred to a type of note. It’s going to get a little confusing, so I’m going to very carefully note it. We are talking about convertible notes here. One is a debt instrument. How many people have a mortgage on your house? Right, mortgage? How many people have a home loan or a car loan? Anybody? Few? That’s debt, right? Debt basically means, “Hey, you’re taking this money. You owe us the money back with some interest.” That’s what debt is in the United States.
A convertible note that is in the form of debt basically is very similar to that, except it has a clause that says, “If you do something, it converts to equity.” But what’s important about a debt is a few things in the U.S. law. The first thing about debt is it must carry interest rate. That’s U.S. I’m going to be specific, there are some international laws I’m not going to cover. It must carry interest rate, usually 3% or 6% is common these days. It’s as high as 8%, but it must carry interest. Which means the longer you take to convert it, the more the investor converts, the more equity they get when it converts. That’s the first thing.
Secondly, it has to have a due day. U.S. law basically says, “Debt cannot be forever.” Most commonly, it’s under a year. Due to certain ways that VC’s work, under a year. They prefer under a year. Long story, I’m not going to cover it about bookkeeping. Sometimes you can get 18 months on it. Okay, you’re ready? Take out a car loan. I’m sorry, what’s your name?
Robert: Ash. All right, Ash, take out a car loan. Eighteen months go by, what happens at the end of it? What happens at the end of a loan after 18 months? You come to the end of the loan. You’ve been paying interest on it. What happens at the end?
Ash: You’ve got to give the car back.
Robert: You’ve got to give the car back or pay the loan. So, you’ve just taken, say, $100,000. Successful raise here. Congratulations. He’s got $100,000 debt note. It’s 12 months long. At the end of 12 months, it’s the due day. Either it’s converted or he’s got to pay it off. Well, you’re a start-up. How are you going to get that kind of money? You don’t. That was the problem with debt instruments, is that they have due dates. The reality is, most of the time, you renegotiate that debt. The problem is, sometimes that’s a difficult discussion. Company’s not doing as well, things like that. So, debt instruments are basically loans that have come due, but instead of repaying it, if you do a round or something else, they convert it to equity. That’s the basic structure of a debt instrument. Questions on this so far? Yes?
Sean: What happens if an investment calls a note?
Robert: Calls the note. Okay, now we get into some interesting terms. So, let’s assume Sean here financed my company. Thank you very much. It’s a 12 months. At the end of twelve months, my company is doing okay. I didn’t call him ahead of time. Tomorrow the note is due. Technically, so let’s start with the first thing, he can call the note and ask for the money. “I don’t have it.” Guess who owns my company?
Sean: Would I ever do that?
Robert: Would he do it? Unlikely. It’s not profitable for a VC, but the threat of it is significant. It’s one of the reasons that you’ll notice when we talk here today, we talk about KISS, one form, and safes. These were created to avoid the sort of problem,
which is debt was arbitrarily used to create a situation which is basically convert to equity and it has to follow certain U.S. laws, so it becomes a little bit funky towards the end. Normally, if you’re talking to your VC…I’ll call Sean a VC here.
Sean: I just played one on TV.
Robert: He just plays one on TV. In fact, he does play one on TV. Starting in September, he will be playing one on TV. The VCs, normally, you talk to them ahead of time; you renegotiate it. But the point is, he’s got all the leverage in the world on me. This is why debt convertible notes are problematic, because they basically can force your hand on many things. If you want to get into all the legal structure, let me tell you exactly what happens. He calls the note, theoretically, basically takes me to court. He basically owns the company until I can make due, right? He owns the car if you can’t make the payment. He basically repossesses your company.
It’s conceptually the same. It’s a little more complicated than that, but he could. Normally, what actually happens behind the scenes is, Sean would never do this. But other VCs will force you to give them better terms, advisory shares. This is what most of us call shenanigans. And let me tell you, it happens a lot. I myself have been on the short side of a few of these discussions. It’s never fun. The fact is, remember, VCs make money by making money by getting money from you. It doesn’t make money for them to take the company, most of the time; sometimes it does. But it does make them more money if they can say you get an extra 3% or 5% of your company for nothing. So, this is debt convertible notes. Let’s talk about equity convertible notes, and compare them. Yes?
Female: Do they always have the right to call a note? Because it’s [inaudible 00:06:29].
Robert: Ah, do they always have the right to call a note? So, a standard debt instrument only has the call date on the last day. They cannot call it at any time. Now, I say standard because you can always change the contract. But normally, it’s only on the last day, which is why you always want to talk to them well ahead of time to make sure that date doesn’t happen without an extension. The most common case is a few months ahead of time you negotiate an extension. Here’s the thing, and we’re about to compare.
In an equity case, an equity note, they cannot take your company. It’s only got equity; it’s not dead. It doesn’t follow you as law for debt. Therefore, if it reaches the end, they can get common shares, common stock, get an extension. They cannot take your company. That’s the primary difference between them. There are some other differences, but that’s the primary difference. So, I’m going to ask a question to you, given what you’ve heard. Why would you take debt? When would you take debt? When would you take an equity note? What’s the advantage of debt?
Ash: Initially convertible notes were mostly [inaudible 00:07:36] bridge financing and extension of equity rounds [inaudible 00:07:40].
Robert: Oftentimes, it’s true. Good. An excellent point. So, if oftentimes people use debt because the investors are more familiar with it, they know it, it also gives them more leverage, oftentimes an investor will negotiate a debt instrument versus an equity. But most of the time, I’d say 80% of the time for me, it’s just because that’s what they know, that’s where they’ve come from, that’s where they’ve been. But unfortunately, the equity version, the KISS equity and the safe equity versions are a little bit of what we’ll call entrepreneur-friendly. Good.
Let’s do a very quick example of it. Great, congratulations. How’s the iWatch? You like it? I like it, too. It looks just like…no, I like mine better. Okay, so, you want to raise funds? So, if you are raising funds…he’s raising funds; he thinks it’s going to be 14 months till his next raise. How long should he make his convertible note due day? Eighteen or twenty-four, as long as you can. Twenty-four is a little tricky. Most people won’t go 24, but 18. Why?
Female: It gives them more wiggle room.
Robert: Yeah, it gives him time so he can raise another round. If you do an equity round before the due date, what happens to notes? Any guesses?
Male: [inaudible 00:09:00].
Robert: They convert, right. If you do an equity round before the due date, they convert. So the idea is you take notes longer than you need so you have time to accomplish tasks, do an equity round, etc. If he doesn’t have time, he decides he doesn’t need money, an equity would convert to? What are the standard methods? What happens to it?
Female: Common stock?
Robert: Common stock or negotiate an extension. Those are common. All contracts are different but I’m just covering the common one. With me so far? Debt, equity – two main types of notes.
Male: If you raise another round of debt, does it also…
Robert: Ah, good question. All right, he raises a half a million dollars on a note. He’s very successful. I like the jacket, very nice. So, wow, I should own one of these. Nice material. Okay, so he raises $500,000 on a note. How about two months later, he decides he wants to raise more money. Can he do it on a note? Yes. The thing about equity rounds is, every time you want to raise again, you’ve got to redo all the paperwork, all the renegotiation. A note, you can just keep raising along the way. Oftentimes you’ve heard of high-def fundraising. You could raise this month, again next month, against the month after.
There is one clause that this is a problem, and we’ll cover that in a few minutes. It’s called an MFN clause. Aside from that, generally speaking, you can raise month to month. That’s one of the great advantages of notes. So, he raises 500,000. Decides next month he’s going to raise another 100,000. No problem, he just issues another note. In fact, he can keep issuing it. The only problem that will come down is – and we’ll talk about this in a few minutes – the first one that if it’s, say, 18 months, he’s got about 18 months before he really wants to do an equity around. You really don’t want notes hanging around for a really long time. I mean, this poor guy, he could lose his car. He’s got six notes. He’s got six cars in hoc [SP]. At some point, things come due.
Male: [inaudible 00:10:50] effect the extension of existing notes?
Robert: Generally speaking, you can keep issuing notes. They’re all independent. I’ll make an exception in a few minutes, I’ll explain. There is one clause which is not any KISS document. It has something called a series, which means that the documents are in fact linked. But I’ll cover that when we get to that.
Male: The debt convertible notes, does it mean that on due day, you just pay back and that’s it? [inaudible 00:11:20].
Robert: Debt. In Silicon Valley, the most common thing is on that due date…you don’t want that due date to come up. It is you either extend it, or you finance an equity round before it. You’re not supposed to repay it. It’s not expected here in the Valley. I say in the Valley, because in other parts of the world, that’s not true. The debt is expected to be repaid. Not here, not for what we’re talking about today.
Male: So if you raise an equity round before the due date, [inaudible 00:11:46], what do you do…
Robert: It converts. The note automatically converts. Ah, so he’s bringing up the next topic. Thank you so much for introducing the next topic. So the next topic, if you scroll down on the Bitly link, which I know now you all have, we’re going to talk about the terms that exist within the notes. I’m going to start with the first statement, and then we’re going to cover something else. He brought up the statement “What happens to a note?”
Almost all these instruments contain a few clauses about what happens if you raise an equity round or you don’t. So my first statement to you is, if it doesn’t contain these clauses, you’ve got a shitty lawyer, or you downloaded the wrong document from Clerky, one of the two. So, let’s talk about the first one. Most of them state one of two things. “Upon a qualifying equity round, this note will convert,” and then it’ll give a bunch of terms for how it converts; that’s the first one. That’s safe, S-A-F-E, documents. That’s their language. KISS documents state, “Upon qualifying equity round of a million dollars or more, this note converts.”
So, you raise a $750,000 equity round. What happens? You. Congratulations, you raised 750! She’s doing a 750 equity round. She has one safe document, one KISS document. What happens? Oh, she’s ignoring me. She’s reading ahead, I’m sure. She’s so excited by my talk, she’s reading ahead. So, 750, the safe document upon equity round automatically converts.
However, the KISS document requires a million dollars or more, therefore it does not. So you’re going to do an equity round. You’re going to issue equity to everybody except that KISS note holder. He still has a note. So, sometimes they convert, sometimes they don’t. Generally speaking, you want to convert your notes; you don’t want them hanging around. So, the first clause is…there’s a bunch of clauses in these notes that explain how and when they convert, upon equity round. That’s the most common one. Second, reached the end of the date. Most KISS notes convert to common shares. If they have not been renegotiated by default, they simply become common shares. Not a good thing. Certainly not for the investor, generally not so great for you either.
Male: Can I ask why do we do that? [inaudible 00:14:16].
Robert: Yes. Why would they do it? So, generally, it’s a fallback position. And so let’s explain it. Who wants to be a VC? Besides him. Besides you, you already are.
Thank you for volunteering. You’re a VC. So, she puts money in. She gives me money and it’s 12 months. The 12 months come and my company is doing very poorly. Now, it’s not debt, it’s equity, so she can’t force my hand at all. I can simply not do anything. What happens with this and the reason it converts to equity automatically is a fallback position in case nothing else happens, at least they get common shares.
They don’t want common shares – and I’ll cover that on another topic, the difference between shares. But it’s a fallback position. What she’d rather do is renegotiate with me and extend it and wait for the next equity round. But at least she has shares.
The reason it exists is because in debt, if it’s a debt instrument, the law is on the side of the lender. You basically can own the company; you have all kinds of leverage. In the case of equity, there is no law; there is nothing for them to enforce it with. So at the very least, they get common shares. So the most common language is upon reaching the expiration date, if there’s no acquisition and there’s no equity round, it converts to either common shares, or upon discretion of the investor, they can choose to extend it. Most common cases, extension. Questions? You’re an awesome VC. Thank you so much.
Okay, so, let’s talk about this. So, equity rounds cause them to convert. No actions if you reach the end. How about acquisitions? If you get bought, there are two different sets of clauses that will exist. I’m going to cover what’s in the KISS document. KISS document says upon acquisition or…actually there’s a bunch of language about if your assets of the company get bought more than 50%, they get paid back to X, which basically means, she gave me a $100,000, I have to give her $200,000 before I get any money out of this deal.
So this is called 2X preference, and it’s actually listed in more detail in the document. If he signed a safe, when he’s done reading whatever he’s reading here, if he signed a safe with me, it only has a 1X, which means if he paid $100,000 to me, he gets paid 100,000 and then all the rest of the debts the company can be covered. You know, the money goes to the founders and everybody else. In case of acquisition, note holders are paid first. That’s basically the statement. Debt or equity. Those who follow U.S. law, debt by default. U.S. law says debt is always paid first. You don’t have a choice on that. The convertible note for equity actually specifically has to stipulate “we get paid first.”
Male: So, safe is more on [inaudible 00:17:06]?
Robert: Safe is a little bit more. At the bottom of the Bitly link is a comparison between the two. Basically I cut and paste that from a really smarter person than me who’s a lawyer, so you can see the exact comparison. Good. So, let’s talk about…somebody asked the original question.
Male: Do you want me to project it? I can project the doc maybe [inaudible 00:17:26]. Anyone here has read this? Let me have a show of hands. [inaudible 00:17:32].
Robert: Okay. If you don’t have the Bitly link, that’s the link up there as well. Okay, real quick, so the question got asked, what happens at the end of 18 months, what happens to the note? By default, notes will convert upon equity round – that’s your desired outcome. If you get acquired, they get repaid their money, and then everybody else gets their money. If the time due comes around, they’ll either convert to common shares or get an extension.
If it’s a debt instrument in the time due and you haven’t negotiated it, they basically call the shots. They basically own your company until such time as you renegotiate. Makes sense so far? Good. We’re going to move on to the next clause that is common in notes. Discount rates and value caps. Okay, quick question. How many people know what a discount rate is when related to a note? Perfect. Okay, good. I know what I’m dealing with. So let’s talk about it this way.
Very commonly, a VC will come up to you and say, “I’m going to give you $50,000 just for that jacket,” but no, no. “Fifty thousand dollars, and I’m going to give you a five-mill cap 20% discount,” and you smile and go “awesome,” and then you go away and go “What the hell does that mean?” Let me tell you what that means. When the notes convert on the equity round, how much shares they get depends upon those two things they just said – the cap and the discount.
I’m going to first talk about the discount. Most of you have gone shopping. You know what a 20% discount on an item is. It’s similar. It’s actually not quite the same, but it is very similar. So here’s what a discount is. When the next round happens, that million dollar equity round you close, they get the shares at a 20% discount, 20% less than everybody else pays for the shares. So if your shares in that round are a dollar, they pay 80 cents for their shares.
Here is why it’s not quite the same as when you go shopping. I’m going to go shopping and I’m going to buy this white shirt. That is an awesome white shirt. So I’m going to buy this white shirt. Normally it would be “Hey it’s 10 bucks, 20% off,” you would pay $8 and get the shirt. So you pay less money. That’s the way a discount works. Discount here, they actually gave you the money already, $50,000, so they can’t get less money. That doesn’t work. They simply get more shares. What the discount is actually referring to is the price per share that they pay. It’s important that you keep track of that so you don’t…it gets very confusing otherwise.
So, if Sean comes in on the A round and he pays $1, he has a 20% discount; he pays 80 cents. Now here’s the next thing: valuation cap. Valuation cap is the maximum value they will pay when they convert. So let’s do an example. Somebody else who’s doing awesome. Steph? Steph’s doing awesome. He has a note with a five-mill cap, and he goes to do an equity round and it’s a $2 million equity round. Doing great. It’s a 10 million valuation. It’s called pre-money. I’ll explain more in a bit. Pre-money valuation. So now let’s say it’s your note. His note’s at five million but everybody else is at 10. So you scratch you head, going, “How does that work?” Here’s what that means.
Since he was smart enough to buy in early at the five-mill cap, he will never pay more than the five-mill valuation for his shares, which means he’ll pay about actually not precisely 50%, but he’ll pay about 50% less for his shares. So if the investors on the A round pay two dollars a share, he’ll pay about a dollar a share. I say the word about, because there’s actually some complexity here. I’m just explaining how cap works. Cap is the largest valuation they will pay for their shares.
Now, I’m going to point out a very interesting statement. I’ll make it very clear. Largest, they may not pay that number if…you’re not doing so well. You took his five-mill cap note, things aren’t going so well. He does an equity round at a four million valuation. He’s not going to pay five million [inaudible 00:21:46]. The way this works is the investor picks discount or cap, whichever he wants, but he’s never going to pay more than that cap. So, let’s look at it. You go to do it. It’s at four million. He says, “Do I want a discount or the cap?” Anybody want to guess which one he’s going to pick?
Robert: Discount. So how much does he pay? What valuation would he be paying at?
Female: [inaudible 00:22:14].
Robert: Yeah, 20% less than that 4 million, so about a 3.2 valuation or so. I’m going to cover that more; there’s some math examples here. But the most important concept is that the investor with a note gets to pick which one they do, either discount or valuation cap, whichever is better for them. So, if you’re doing awesome, the cap is what matters. If you’re doing not so good, the discount becomes relevant. And there’s some math figuring this out exactly, but that’s the concept here.
Male: Is it a choice between the cap and…
Robert: Investor chooses, not you.
Male: Is that always the case?
Robert: Always. I’ve never seen a note where it wasn’t. It’s certainly possible, but I sure as shit wouldn’t invest unless there was a choice by me. Makes sense? And the reason is, think about it this way. Who wants to be a VC? You want to be a VC? He’s going to put money in. If you’re phenomenally successful and he doesn’t have a cap, he’s only going to get a small discount on this round. He gets very little for his “giving you money early,” right? And if you do really shitty and he doesn’t have a choice, well he’s going to just do shitty. He doesn’t get anything for being in earlier. You need to make sure your early investors make more, make something from giving you money earlier. They took that risk on you earlier, they should be an advantage to the later investors. Does that make sense? So, I’m going to cover…yeah?
Male: Quick question. In that case, in terms of a signal about how well a company [inaudible 00:23:49] in the future, isn’t it always better if the investor takes the cap? If other investors know that…
Robert: They’ll not going to pick until the inequity round happens, so there’s no signal at that point. They’re just going to pick their conversion rate. So, what I think you’re referencing, however, and this is common…I’ll give you a difference between 500 Startups and YC, actually. So, YC, if you look at the valuations, the caps on their notes, they’re very, very high. There’s some things going on that I’m not going to cover called advisory shares, but for the moment, this isn’t as positive as you might think. So let’s cover what I mean by that.
You’re ready? He puts it in. He’s a little bit of a junior investor. He invests in you very early at a 20 million cap and at 20% discount. His company does okay, but the next round is only at 10 million. Well, the 20 becomes irrelevant, right? He takes the discount on the round. I think what you’re referring to though is, because he went in at 20 million, everybody goes “Wow, 20 million cap! That company must be awesome! Who would agree to that unless it’s awesome?” So there is some of that in the market – the higher the valuation caps that people perceive, it’s a more successful company. And I won’t say that it’s not true. It is true; there is some of that. Here’s the problem. If his next round is below the cap, people call it a “down round” and then you have all kinds of other problems from that.
So there is a negative. Let’s imagine what down round means. So your employees go “Wow, we have a 20 million cap! We’re doing awesome!” and you end up doing your round at, say, seven. Your employees are like, “Oh man! Why are we doing so shitty?” Actually, you’re doing well. Going after the maximum cap, most entrepreneurs try to get this big maximum cap, but I usually recommend don’t do that. You’ll create this problem. You get this really high perception, you can’t keep up with that run rate. It’s really hard to grow with that. And then you end up with a bunch of employees who are upset and options that have problems, and investors that are pissed off.
Oftentimes, I tell people, “There’s actually a middle ground here. You want to choose enough valuation where you don’t dilute, but not so much that you create an impossible problem for yourself.” Oftentimes there’s a large number of down rounds on YC companies, because they come out, they’re glorious, they have huge valuations, their next round is down.
And then employee turnover and a lot of problems for it. The funny thing is, they’re actually doing well. But suddenly, it’s perceived as a down round. I’m using the term “down round,” does anybody…how many people understand what a down round means? Okay, pretty…okay, I won’t cover that any further.
Male: Lower valuation [inaudible 00:26:22].
Robert: Your valuation comes down, you take a financing at a lower valuation. What happens to a lot of people is there’s a lot of issues. VCs don’t want to fund down rounds, employees tend to quit after down rounds. There’s a lot of problems with them. It’s mostly psychological, but it’s somewhat real too.
Male: [inaudible 00:26:43].
Robert: A little bit louder for me, please.
Male: Is there a [inaudible 00:26:47].
Robert: Well, sure. The lower the valuation, the more the dilution. But at the same time, one of the bigger problems is normally at that point you’re desperate for money, so you end up agreeing to terms that you don’t like. Let’s review what I was talking about here. We talked about discount rate and valuation cap. And before we move on, does anybody got any questions on discount rate and valuation caps? Yes?
Male: You said normal is 20 [inaudible 00:27:16]? How do you…
Robert: So when should you go up and down on 20, 30, 40, and 50? By the way, I have seen a note with a 50% discount. Dave wrote it, actually.
Male: Okay, he’s crazy enough to do that.
Robert: Yes. It’s a little complicated, so I’m going to say it. If you don’t know subtleties, 20% is enough, and here is the expectation. If you’re doing really well, the cap is what matters. So if the investor goes in and you’re doing great, they care about the cap. So, imagine you’re an investor, you really want them to succeed. Obviously, the cap is what you’re focused on. The discount is sort of a backup plan, “Okay, if they don’t do well, at least I make an extra 20% on my money than the next guys in.”
So, should you push around? Unless you’re planning for an okay medium company, it’s not what you spend a lot of time on. Here is an occasional exception. He brought it up. Dave did this. Dave McClure [SP], who heads 500. I got approached to do an investment to a company that I would have valued at about six million. They asked for a 12 million cap because they already had a 12 million cap note. See the problem that’s creating? I won’t do it. They need my money.
The problem is, if they take it at a lower…we haven’t covered this yet, but there’s something called an MFN clause, which would cause all the investors to come down to my terms. This is a horrible problem for them. So they can’t lower the number, but I won’t accept the cap, so I say, “Fine, I’ll take a 12 cap with a 50% discount.” What that means is, unless they do absolutely phenomenally, my discount is what’s going to end up mattering.
So my answer to most people is, look, 20%, usually don’t muck with it too much. The only exception is if you have certain clauses like MFN and a few other things in the way, and then sometimes you’ll use that. Now, for those of you who know this, and we’ll cover it. [inaudible 00:29:08] not here. He’d know this. What I just described is a very risky situation, and I’ll explain it in a few minutes. If you issue convertible notes with superior terms, that is to say they’re a better language than previous ones, if you have a clause called MFN, most favored nation, everybody moves down to it. This is called a ratchet, or a full ratchet. Very problematic.
I’ll explain that in a few minutes if we have some time at the end. Here’s the summary of it. Remember I said don’t go too high on your valuation because it causes problems. That’s one of the fucking problems. The idea is to get your valuation to slowly rise up. If you have a dip, you have these ratcheting problems. By the way, there are quite a few founders here that have lost control of their company accidentally because of that. They took on like a million dollars at like an eight, and they ended up doing a down round. It came down to like four, three, and that million all of a sudden converted to 30% of the company. They thought it was only going to be 10% of the company, it turned into 30 or 40. All of a sudden they lost control of their company. Again, we’re back to down rounds are bad. Don’t do them. Try to avoid doing them.
Male: That MFN clause, that’s not an entrepreneur-friendly clause.
Robert: It isn’t, but it’s common, especially in KISS documents. And the reason is, if I’m an investor and I invest in you and things go shitty, I want the ratchet. You’re going to screw me. I want to come down to the new valuation. So they’re common. FYI, they are not by default in the safe document. They are in the KISS document by default.
Male: Question regarding to just the number of equities that the investors [inaudible 00:30:53]. So if the founders have 80% and then there’s a 20% of the company that’s [inaudible 00:31:00], who’s equity does it come out of if the…
Robert: So, dealing with option pools, I’m going to cover it briefly, and then say you should be using something like capture or [inaudible 00:31:10] just let it calculate it, but I’ll give it to you basically. In general, dilution [inaudible 00:31:14] everybody who currently owns shares, that’s a very important statement. Currently own shares. Notes don’t own shares until they convert. Accelerators take shares after round, post round conversion. If you create the options before the round, then everybody takes the dilution. If you create the option pool after the round, it changes who gets dilution. Now the new investors get diluted. So, this is a more complicated topic unfortunately, and I’m going to say please use cap sharing and e-shares to do these sort of calculations. They’re really complicated. But the bottom line is, everybody shares in dilutions when new money comes in.
There is almost no anti-dilution clauses. I say almost because they’re actually is, it’s just too complicated for me to cover it today. It uses something called warrants. There are people who get issued warrants that basically say if they take new money, they automatically get more shares. Pain in the ass. I hate those. Don’t want to deal with them. Okay, let’s cover some other stuff. We’ve talked about valuation. Interest rate, this is fairly straightforward; I’m just going to cover it. Debt instruments contain an interest rate. It’s U.S. law they must contain an interest rate. Interest rate basically means that they get more shares.
The longer you take to do your equity round, they just get a little bit more shares. Interest rate increases the amount. Let’s pick a new person. Who hasn’t? Congratulations. He loaned me $100,000 a debt instrument, 8% interest rate. One year goes by, what’s the value? Before I convert it to shares, how much in shares, how much in dollar value do I owe him in shares, one year after he does the invest? Come on, come on, this is easy math.
Robert: $180,000. It’s usually called simple interest. They usually don’t do things like daily compounding or anything like that. It’s basically simple interest. So you owe him, in this case, about 8% more. If you take two years to do your round, you’re going to owe him about 16% more. That’s actually compounded yearly, so it’s actually 16 point something. So, that’s what interest does. Not a big deal, you shouldn’t be spending a lot of time on interest. If you’re doing a debt instrument, interest rates are pretty low these days. Here is the only time it actually matters. Those of you who are old enough to remember, was it 1976 when interest rates were like 20 something percent, then it actually mattered. Twenty, thirty percent interest rates, it mattered.
Today, interest rates are low enough, they’re barely considered. “Pro Rata.” One of my favorite phrases to get wrong. Oops. Okay, how many people know what a pro rata is? It’s a professional rata player, come on. So, pro rata, of course you know. Pro rata goes something like this. Many convertible notes will contain the phrase that basically says, “Whatever percentage I own of your company, I want the rights to give you more money to keep that percentage.” That’s the basic concept of pro rata – “That which I own, I continue to own.” That’s basically the translation.
So if I give you a convertible note, and the note converts to 16% of your company and you do a round, I want to say not on the conversion, but after that round, you do another one, I say “I want to be able to pay more money and keep my 16%.” Here’s the important facets of it. The investor gets to choose. It’s not your choice. It’s their choice if they want to. But you set the price by the round. Whatever the rest of the round is at, they pay that amount. So they’re not getting a discount here, they’re paying like anybody else in that round. Why is this? Anybody want to guess why VCs are very big on keeping pro rata in most of these terms? Not you, you can’t guess.
Male: Avoiding dilution.
Robert: Avoiding dilution, very important. Why is that important to a VC?
Ash: I was going to say, also they probably have some good information or knowledge about the company, so they can…
Robert: They know. They have lots of information. They’ve seen it grow. It’s called doubling down. Most investors double down, triple down, quadruple down on their winners, and dump their losers. That’s how they make money. Anybody who doesn’t know this whole thing, it’s called the Black Swan. Basically the bottom line is, the investor needs the ability to get more money into their winners. If you’re doing well, they want to be able to put more money in. A pro rata is the right to do that. You can’t refuse them. But you don’t give them a discount; they just get the right. Good. That’s pro rata. If I own 5%, I can keep 5% the follow round. Yes?
Male: Is that only when there’s a trigger of it on the raise, or can it be another pro rata at any time?
Robert: No, no. Pro rata is only kicked off upon raising. To be more technically accurate, after they convert, they have a pro rata phase, you must notify them 30 days before a raise and they may then choose to say “I want to participate in that race,” and then they join it. Most notes contain what’s called a single pro rata, which means just one round afterwards, they can participate in. It’s a single pro rata. Some of them ask for lifetime pro rata, which means all the rounds after, they always get to participate. Generally speaking, are these dangerous? Here’s why. Let me give you some quick guidelines.
Generally, all major investors last for this. Fighting about it is actually sort of foolish on your part, because a VC can’t make money if they can’t double down on their winners. Really makes it attractive for them and it’s not that big a cost to you. Here is the one reason why you don’t like them. I want to cover this as well. You do a round, you’re doing well, you get somebody from Sequoia comes in and says “I want to join your next round. You’re raising two million, I want to take the whole two million.” Well, you have a bunch of pro rata people who have a million dollars of “pro rata rights.” Sequoia comes in and they go, “Fuck yeah, I’m in.”
Now your round just became three million because they want their two and all the pro ratas will want in now, so that makes it three, which means you have more…? Anybody want to guess why that matters to you? Dilution. You just ended up with more dilution. The good news is, you got the money, and the good news is it’s at whatever the round is. But here’s what subtly is happening. Sequoia comes in the round, they’re going to negotiate probably a much lower cap than almost any other investor, and that means all the pro ratas come in at that rate too. So, pro ratas are pretty investor friendly. You shouldn’t fight about them a lot, but be careful if you have a lot of them. Rule of thumb is, major investors get them, minor investors don’t.
One last note on pro ratas: don’t offer them to little guys. And here’s why. The paperwork is a pain, because you’ve got to keep including them in the next round and you end up people sending you $273 checks. Your lawyers like it, but you don’t. So generally, it’s only for a major investor. That’s called pro rata. I want to cover one terminology called…I know. I’m actually running really long, but a lot to cover. I want to cover another term called participation. 500 Startups uses a participation clause, not a pro rata clause. Participation clause says, “If you do a new round, I want to be able to contribute up to $250,000 into it.” You know, it’s a slight difference there.
One is a percentage and one is a dollar amount. How big a difference? Not a lot. Just understand that they are slightly different. I’m not going to cover the subtleties, but basically 500’s is because most of our investments are 100K, so this effectively allows us to add a lot more money in the next round. But since our funds are designed for early, we can’t do millions, so it works better for us. Both of these are very similar. Same thing, major investors, okay. Minor investors, generally not. I want to cover one last topic, because I’ve seen a couple of these terms floating around lately called super pro rata, where they say, “I want to be able to double my percentage. I want to be able to buy more.”
These are a little more dangerous. If somebody gives you a note for, say, 10% of your company and wants a 2X super pro rata, that means they can take 20%. They can buy up to 20% of your company. That’s a lot. If you’re taking on additional investors and they want 20%, you no longer are going to own your company. So being a little leery of these, generally I don’t like super pro ratas. It’s just not what I want. And here’s why. An investor comes to you and says, “I want super pro rata.” My advice to you is negotiate.
“Well, if you’re really valuable to me as an investor, I’m going to let you double down anyway. But I want that choice.” Super pro rata means they choose. You can always choose to let them in without it, but super pro ratas guarantees them. Generally, super pro rata’s not real friendly. These are not standard in any of our notes from 500, or safe notes. I covered participation. Liquidity preferences. Always fun. This is a very difficult to understand topic.
I’m going to give you some simple examples. We’re going to play around with this a little bit. Liquidity preference works something like this: who gets paid first. Now, this can make a really big difference if you have a small exit. It tends to make a less difference if you have a big exit. I’m going to do a very simple example. I want to first ask, has anybody here dealt with liquidity preferences before? Okay, what was the liquidity preference you dealt with?
Robert: 1.5X. So, it was equity or note?
Male: It was equity and note.
Robert: Note that converted to equity?
Male: [inaudible 00:40:51 to 00:40:53].
Robert: Okay, I’ll cover it under a generalized condition. So what this means is…I’m going to use his example. He had an investor give 100,000. I’m just going to make up the number. Let’s say 100,000. Converts in, he has 100,000. There’s something called shadow shares, which I hope he did. If not, then we’ll deal with that later. So, he has a 1.5X liquidity preference, which means he gets $150,000 before anything else. That’s liquidity preference. Now the rest of everybody else gets money. Why does this matter? Let’s do an example. Here we go. He’s going to do a $2 million round. They’ve got liquidity preference called 1X, which means they get 1X their money, and that’s it. For the moment, I’m not going to deal with anything else. Just that. I sell the company for $3 million. What happens to that money? Anybody want to guess?
Ash: He either gets his percentage back or he can chose to take back the two million.
Robert: Okay. So, he gets a choice. First I’m going to do…there are two versions of this. Participation, there is liquidity preference with participation and liquidity preference without. The first one is, he gets his $2 million. That’s liquidity preference without participation. He can choose his $2 million or he can convert to common shares and take his percentage, whatever that is. That’s pretty straightforward.
Here’s the problem. It’s the sentence that follows that one. It almost always says, “I have 1X liquidity preference with participation.” This is a much nastier clause. That stupid word at the end changes it. Here’s what happens. That means he gets his $2 million. He then converts and gets his section of the one million, say, 50%. He hands you $500,000. He walks away with 2.5. Yes, that’s how that section works.
So, let’s review what just happened. Liquidity preference means they get paid first. That’s pretty straightforward – 1X, 2X. I’ve seen as high as 7X, by the way, which is ridiculous. But nonetheless, I’ve seen it. That means they get paid first. This matters. If you raised a lot of money, and I won’t say it but Uber, raised billions of dollars, they have liquidity preference. If anything ever happens, those guys get paid first. That’s a huge chunk of their total value of their company in some cases. So first thing is that gets paid first.
The second part is called participation. Participation means they get paid and then they convert and get paid a second time. That is probably the least understood term in notes or in equity in general. People don’t understand that that’s a big fucking deal. If your investors own 50%, let’s assume for the moment, just for math, own 50% of your company, they will get their paid off money and then 50% of everything that remains. Only after that will employees get anything.
I’ve actually seen $15 million deals go down, and founders walk away with under a million of it. It happens. Because somebody didn’t read participation and liquidity preferences. So this is the one section I’m going to advise you read carefully. There are a bunch of clauses which are pretty straightforward. This is one of the ones where people miss the sentence structure, and it’s important. That’s why I’m spending a little bit more time to emphasize that one.
By the way, on convertible notes, this doesn’t apply. Convertible notes can’t participate. They can stipulate that they will participate when they convert, but notes themselves can’t participate. A note either converts or it doesn’t. It doesn’t have that. So, a reason I covered it today, if you write a note that stipulates that it converts with liquidity preference and participation, you’re jamming yourself up for later.
There’s my rant on participation. Am I the one projecting? No, somebody else is projecting.
Male: Yeah, mine is.
Robert: Oh okay. I’m like scrolling and I’m like, “Hey. I’m dumber than I thought. I can’t figure out how to scroll my machine here.” So, I want to talk a little bit about this, like triggers. We talked a little about triggers, the event that causes these things to happen. I’m not going to cover too much. You can read some of the notes on this. Debt, we already covered this. Go ahead and scroll down. We covered some of this before, and the rest is pretty detailed. I don’t have time. Scroll up just a little bit to section 20.
Ownership Percentages. Okay, I want to cover one quick example. I’m running almost out of time, so I want to cover one more example. You go to issue a note, how much of the company do they own? So here’s my first one. I’m going to give you a quick and dirty rule of thumb. I’m going to absolutely state this very clearly. This is not accurate. It’s close but it’s not precise, so I need you to understand that. Please use some of the capture [inaudible 00:45:41]. I want you to do some of the actual calculations. There are lots of things that changes a little bit.
As a general rule of thumb, it’s the value of the note, so they give you $200,000 divided by, if it’s a cap, the cap plus the note value. So, Sean gives me 500,000 and a five-mill cap. That’s 500,000 divided by 5.5. That percentage is the approximate percentage of the company they will own upon conversion if cap is used. That is to say, if you’re successful. Rule of thumb, though, if you’re in your negotiations and it’s on the fly, this is a good estimate.
So, what was it? Five over 5.5. I can’t do the math on that. Twelve, thirteen percent, something like that? That’s the approximate amount. That’s a pretty good rule of thumb to figure it out. I’m going to stipulate this one last time, just because I want to make sure nobody…it’s not actually accurate. The reason is, if you do option pools, if there are other types of warrants, if there are some stipulations, like 500 Startups does a conversion post round, it fluctuates a little. But it’s a pretty good estimate. What means is some people make this mistake, they take like a million dollar note on a four-mill cap. That’s actually a fair size of your company, 20% right there. Assuming it’s that cap. If you do a down round, it’s going to be a lot more than that.
So the first thing is, and I put in some examples here, the easiest way to figure out your percentage ownership is that quick and dirty formula. Here is how it actually works. I’m not going to cover this in detail. This is more complicated. Normally what happens when the equity round comes along, the way it actually gets done is by looking at what’s called “price per share,” which is a formula that gets used. And I put in the example here that you can take a look at. But basically what you actually do, is you do a first statement, is there a trigger?
So, I’m going to walk you through a note conversion. You get to it; you do an equity round. Here is your note. You’re ready? The note is a standard KISS note. It is a five-mill cap, 20% discount. It converts on a one million sized round. And then I’ll cover some other exceptions later. Now, if you do a $750,000 round, what happens to the note? Louder. Nothing. It doesn’t convert, it stays.
You do a $2 million round. Does it convert? Okay, good. Now it converts.
So, how many shares are they going to get? Are they going to use the discount or the cap? Just a quick review, it’s a five-mill cap note. You’re doing a round at ten million. Which one gets used? The cap gets used. What is a 20% discount on a 10 mill valuation? It’s bigger than five. It’s eight. But it’s bigger than five; that’s what matters. Investor gets to choose, they’re going to choose the cap.
Approximately how much cheaper are their shares than the new investors? They have a five-mill cap, the rest are paying at a 10 mill pre. They’re paying about half the price per share. Does that make sense? Now things get a little more complicated in figuring out the exact number of shares because it just does. I’m just not going to cover it all. But I put in some examples here, and I linked to Founder’s Club, which actually has a really nice webpage that walks through a bunch of examples as well. But that’s the basic concepts for note conversions.
I think I’m almost out of time. I want to make reference. I did not cover at least three or four topics, just short on time, that are in the notes. I also want to mention…so you’ve got my email. I’m going to mention three things. If you’re going to send me an email, if I have some time I’ll be happy to answer it. Please understand, I get 100, 200 emails a day. A lot of times I don’t get to stuff, but always happy to help if I can. But please do not ask me a legal question.
I’m not going to offer legal advice. I’m not a lawyer, not going to touch that. I am on Twitter if you want to follow me, fine. And lastly, because I have to do this, 500 Startups, I’m running batch fifteen. We’ll be going batch 15. If you know anyone who’s interested, let me know. I’m starting recruiting. Hey, Adam, nice to see you. Hey, you want to do my batch? But certainly you’re welcome. I’ll try to answer some questions.
Female: When do you start batch 15?
Robert: Batch 15 starts October 13 in Mountain View. It’s my two cents pitch. I get invited, I have to pitch for my batch. One last note, now you get the two-minute summary. Convertible notes, good for smaller raises. Equity good for bigger raises. Good thing about it, debt versus equity, equity does not have this “due on the end of date and they own my company” problem. Debt is more common only because investors are more familiar with It, so you use it.
Common terms are interest rates required for debt – not that significant. Cap, significant, especially if you’re doing very well, tells you how much they’ll convert at it, what discount later. Discount rate, generally 20%. Don’t muck with it too much until you get fairly expertise. MFN, most favored nation, basically means any future [inaudible 00:51:02] issue. The previous guys can take the new note terms. MFN, most favored nation, we covered a little bit of that. What else did we cover today? I covered the conversion, the price.
Robert: Liquidation preferences and participation. Liquidation preference, they always get paid first. Whether they get paid 1X or 2X, make sure you know it. Participation, they get paid and then get paid a second time. I didn’t cover it, but the whole effect of option pools basically messes up all the math. I didn’t cover that today. Last note, don’t get greedy on valuation caps. You will regret. I’m not going to cover it again. Just try to get a good valuation. Yes, it reduces your dilution. Too much, you’ll end up with down rounds, difficulty closing, MFN problems, all kinds of things like that. Get a good valuation. Don’t go super greedy on it, you’ll end up with some problems, unless you’re very talented at handling the situation.
Questions? All right, just crammed into an hour.