In a recent blog, Fred Wilson concluded that early stage investors and founders would be better off being financed directly with equity in its early stages rather than through convertible notes or, the recent Silicon Valley hybrid, the SAFE. http://avc.com/2017/03/convertible-and-safe-notes/?utm_source=dlvr.it&utm_medium=twitter Both instruments delay the transfer and value of equity until a later date. True enough, debates about later stage dilutions and valuations arise. Rather someone has forgotten how notes, convertible notes, and equity play a role in risks, return, liquidation rights, and dilution.
First year business school finance paradigm states that the cost of capital is far less for debt as opposed to equity for shareholders. Much of this makes sense: founders prefer to get capital without dilution. Another incentive comes from investors, who are only looking for a decent return, know that debt is on the top of the food chain of liquidation rights. (What this means is that if the company were in bankruptcy, the debt holders get preferential treatment over shareholders. And more compelling is that all debt holders – from banks to other noteholders – can get a piece of the pie to be repaid. And, if there is anything leftover, the shareholders receive the crumbs.)
Now, in terms of bank debt, I have witnessed that the financing institutions delve into substantial negotiations to establish the pecking liquidation order of the debt being issued. There can be as 4-5 tranches of debt instruments, each with different liquidation preferences. Hence banking institutions are particularly sensitive to where they stand in the event of a company’s liquidation.
Then came the convertible note: it is a hybrid debt instrument that can be converted to equity. That gave the financier the option to protect himself during the early stages of the company and, if the company prospects look excellent, the note can be converted into equity at some predetermined value. But what is the value being criticized by Mr. Wilson. There can be so many hallmark events that can impact any equity’s valuation. And sometimes the conversion is precipitated by the needs of the company based on the dilution aversion and financial status.
A year ago, an investor colleague made a convertible note investment for a Colorado company for about $50k. I asked him why he did it and he stated the company promised an interest rate of 8%, an interest rate much higher than sitting idle in a savings account. I commented that he could have achieved such returns with a far less risky investment in junk bonds – companies with track records. But investments in that area tend to be more complex and advanced for some investors. Rather, the Colorado company was an early stage startup with apparent, positive prospects in RFID technologies. However, after a year, the company never reached the cash flow it projected and exhausted its capital through its operations. It decided to convert those notes into equity. From a quick glance at their financials, the company didn’t have the cash to pay back the noteholders after their notes reached maturity. In other words, it had no other option other than to convert the notes or renew them.
From its short history, this Colorado company needed the least expensive capital to sustain its operations. It marketed promissory notes, which could be converted into equity. When early stage companies cannot get bank loans, it peddles “paper”, namely, debt instruments. Even publicly traded companies seek debt financing through the markets as an alternative to issuing more stock – which would depress their value – or bank debt. (Today’s financial markets contain the level of sophistication to trade billions of dollars of notes, even junk bonds, to satisfy any investor’s appetite for risks and returns. I myself developed the creation of bank debt securitization with TD that churned about US$2 billion a month. So any type of debt market can be created overnight.)
What convertible notes offer is an upside to just receiving fixed/variable interest rates for capital. And like anything else that deals with equity, it has its risks – dilution, swings in valuations, and changes in liquidation rights. So, regardless of what Mr. Wilson feels, I don’t foresee substantial changes in how startups get financed.