Bridge Loans vs. Preferred Equity

Over the last few years, my fund has made over 20 seed-stage investments. While we strive to be the "first money" into a company, we recognize that we typically don't provide enough capital to get a company to profitability.  So we invest with the assumption that there will be another "institutional" (or venture) round after us.    

Brad Feld recently posted a great overview highlighting the two leading structures for a pre-VC investment -- convertible notes and preferred equity.  I, like most investors, have a strong point of view on the topic -- and wanted to share my thoughts.

In general, I have a strong preference for Preferred Equity.  While there are a few circumstances where I would go with a Convertible Note (which I'll outline later), I believe that:

• Preferred equity better aligns the interest of the Investor and the Entrepreneur.
  A typical convertible note allows an investor to convert from debt into equity at some discount to the Series A price (typically 20-40%).  I believe that this often has an unanticipated outcome -- it puts the seed-stage investor and entrepreneur on different sides of the table.  The entrepreneur wants the Series A price to be as high as possible, while the note holder wants the Series A price to be as low as possible (since the conversion price of their note will be based on the Series A price).   This misalignment of interest creates a number of problems for me.  Once I invest in a company, I would like to focus on adding as much value as possible - I want to help the company refine their strategy and business model.  I want to help them build their team. I want to introduce them to business development partners.  I want to help them generate PR.  I want to introduce them to several VCs so they can raise their next round on good terms.  However, as a note holder, there is an economic penalty for adding value -- the more I try to help the company, the more expensive my equity ultimately becomes.  In effect, I have to pay for any value I help create.  If I was an equity holder, those conflicts would not exist.  I would benefit directly from any value I help create.

• Preferred equity prices in all of the risks facing seed-investors
  There are a number of risks facing every company - technical risk, execution risk, team risk, marketing risk, customer acceptance risk, etc.  However, I believe that the #1 risk factor facing seed investors is funding risk.  Since I know I am not giving the company enough money to get to breakeven, I need to assess the probability that they will be able to raise additional money.  In my opinion, a convertible note does not effectively price-in this funding risk.  

• Preferred equity typically does not create liabilities for the venture round.
  The main reason I'm given when people choose convertible notes instead of equity is that "setting a valuation for a seed-round makes it challenging to get a higher valuation for a venture round." In my experience, as long as the venture round occurs more than a few months after a seed-round, this is not the case.  I have recently participated in several seed-rounds that raised much larger venture rounds at valuations that were multiples of the seed-round valuation.  Venture firms understand that the later they invest, the more progress a company makes, the more risk gets removed from the deal -- and valuations reflect that. In fact, I often see companies use the progress they've made during the interim period as a rationale for increased valuation (ie, we were worth $3M before we had a complete team, a customer pipeline, a working product -- so now we're  worth $5-7M).  This, of course, assumes that the terms for the equity are standard market terms.  (I prefer to use the National Venture Capital Association's Model Documents -which are drafted to reflect current practices and norms and  "avoid bias toward the VC or the company/entrepreneur."

 
So what are the cases when I'm OK with a convertible note? 
 

• When a VC round is already underway or imminent.
  There are times when a company is already in talks with a number of venture firms, but wants to take some money in advance of the round.  This money often lets them make key hires or purchase necessary hardware so that they can have a stronger hand in their VC negotiations. In these cases, I'm comfortable participating in a bridge note -- provided that I am reasonably confident that a venture round will close within the next 60 days. 

• When I'm not expecting (or expected) to be an active investor.
  While I try to help create value for all my portfolio companies, there are sometimes circumstances where I am not the lead investor -- and am not expected to be extremely active.  These tend to be situations where I have a smaller investment and am more "reactive" than "proactive". 

• When the discount (or warrant) coverage increases over time.
  When I invest in a note, I prefer that the notes are structured so that the conversion discount (and/or warrant coverage) increases as time progresses.  If a company closes their venture round two months after I purchased my note, I should get less of a benefit than if takes the company eight months to raise a VC round. 

• When the note has some equity-like protections.
  Any bridge note should have provisions that (1) prevent the company from pre-paying the note without the approval of the noteholders (otherwise I could get redeemed for interest only without converting into the next round); (2) provide a pre-specified payment in the event of a change of control prior to a venture round (so if a company gets acquired before the note converts, the note holders get a return of X); (3) put a cap on the amount of additional debt a company can take (so you don't end up with a company that raises millions of dollars via bridge loans); and (4) provide basic protective provisions.  In addition, if I'm leading the seed-round, I also ask for a maximum conversion valuation -- so that I'm protected if the Series A valuation is dramatically higher than I expected.

This analysis is by no means comprehensive.  But in general, I believe that if an entrepreneur wants a seed-investor who can add real value, it is not productive to economically penalize that investor when they add it.  Structuring a seed-round as equity allows the investor and entrepreneur to be completely aligned and share one goal - to create as much value as possible for the company. 

Comments

[Mr. Doody]

Josh:

For those unfamiliar with First Round Capital, could you clarify how much money you typically put into a seed stage preferred equity deal?

IME the argument of convertible debt vs. preferred has always been fairly contextual. How much value can likely be created with the funds in question over what timeframe? If it's not adequate to move the needle for an A to B valuation increase, debt is a rational approach.

Could you also share some (sanitized, of course) numerics for the several rounds you allude to where the B venture round achieved a notable multiple over the A first-money? How much were the A rounds and B rounds, what was the time delta between A and B, and how big was the valuation bump?

Thanks,
Doody

[Jeremy Wright]

Josh, thanks for sharing this. We'd been approached about convertible several times by VC's already so it's good to get some perspective on it.

[Dharmesh Shah]

Extremely helpful. As both an entrepreneur and an angel investor, this is as good an articulation of the pros/cons of convertible note vs. private equity that I've seen.

One point that I'd add (and one of the reasons convertible notes are attractive) is their simplicity. Beyond just deferring disussions on valuation, many of the standard terms that would be in a preferred equity agreement are not needed for a convertible note. So, the documents for a convertible note tend to be less "daunting" and more expedient. Not sufficient rationale to use them, but it does play a factor.

[audibletype]

Thank you very much for this post. It certainly was very enlightening for me. wow!

[Brian Magierski]

Josh,
Great post and mostly covers what I would say. One question though, how do you determine the conversion percentage on the equity-like protection you mentioned in the event of a change in control before a funding event? It would seem that it needs to be a percentage (possibly with a fixed minimum), since you don't want a fixed upside.

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[Joshua Zhao]

I do agree that preferred equity does better align the interest of the angel investors with that of the founders than convertible notes. However, it is a valid concern as to properly valuing a company at this stage. What do you think about the following scheme to address this valuation issue in a balanced manner? Entrepreneurs propose a target pre-money valuation for the subsequent first VC round, and price the seed round accordingly, taken into consideration of discount and interest. If the VC round turns out to be at a higher valuation, all is well. If otherwise, a provision can be made to treat the seed funding as convertible note. Hopefully, with the scheme, it will not be too difficult to agree upon a valuation for the seed round. Any thoughts on this proposed scheme? Happy New Year!

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