Thursday, March 11, 2010

I know it's a good deal for you.

In the past few months I did not invest in a couple of companies whose businesses I really liked because they were raising seed financing through convertible debt.

Convertible debt is essentially a loan with an option to invest in the next equity round at a discount. So, for instance, a typical seed stage convertible note might give the lender the right to roll the principal and accrued interest into the Series A at a 20%-25% discount.

Chris Dixon posted about the reasons why convertible seed rounds are a bad idea. I agree with his reasons. But I have another, more investor-centric, one: seed stage convertible debt is usually a bad deal for the investor.

There's an old saying in the venture industry: lemons ripen before pearls are cultured. Startups that are going to fail usually fail quickly. Look at Scott Shane's numbers on startup failure rates, in the graph below. While these numbers are for all small businesses (not just venture-backed ones) and for companies started in 1992, they seem to jibe with what I have observed over my thirteen years of venture investing.

If you invest in companies at founding, 40% will survive to year six. If, on the other hand, you invest in the companies that survived their first year, 53% will survive to year six.

Let's say that, like Fred Wilson, 33% of your early stage investments fail, 33% go sideways (1.5x return) and 33% return 5x-10x*. (I assume that "early stage" means investing one year into the company's life.) Then, if 25% of businesses fail between year zero and year one, seed investors should expect 50% failure, 25% sideways and 25% success.

For a Series A investor (assuming the average successful exit is 7.5x and exits are five years after investment) the IRR of the fund under these assumptions before management fees and carry is 25%. Until the last decade, this was close to the average return for VC as a whole.

As a seed investor, I should expect higher returns (I am taking more risk): I want a 30% return, rather than 25%. I should also expect it takes six years to exit the investment rather than five. For sideways and successful investments, the return is the same dollar amount as the Series A investor (so, if I invest at a 50% discount to the Series A, I get 3x for sideways and 15x for successful exits.)

Running these numbers, I need to invest at a 50%-60% discount to the Series A to get my target return.

Even if my simplifying assumptions are too simplifying, the discount has to be at least 40% for a convertible note to be economically rational**. I doubt whether any Series A investor would let that stand because, in hindsight, the seed investors took very little risk***.

I've had a couple of entrepreneurs tell me that they wanted the round to be a convertible note because they wanted to limit dilution. What they are really saying is that they want me to invest at a higher price than I would if we actually agreed on a price. I understand that, and I sympathize, and I even recognize that many angels turn a blind eye to this because they want to pretend they are not getting a bad price. But let's be honest, they are getting a bad price.

As a matter of discipline, I have a handful of rules I won't break, no matter how much I like your company. One of them is that I won't invest in seed-stage convertible debt.

* There is some evidence that venture backed firms are less likely to fail than startups as a whole, and there's a lot of evidence that Fred Wilson is a better than average investor, so his failure rates may not match Shane's. There is also some evidence that VCs keep companies afloat until about five years after their investment, then give up, so the failure rate curve for VC-funded firms may be distorted.

** Disregarding that some angel investors will take a worse return in the hopes that the Series A will be lead by a great VC, allowing them to take a carry-free ride on that investor's coattails.

*** To be fair, I think the VCs really just take the entirely sensible viewpoint of caring more about the ongoing management of the company than the people who put money in a year ago and haven't been involved since.