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Why we (still) don’t invest in convertible debt

By Jon Callaghan, January 30, 2013

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Since founding True in 2005, we have been vocal about our strong preference for priced rounds over convertible note rounds, because we believe “converts” can create misalignment between Founders and investors at exactly the point when alignment is most crucial (and at True, we are all about alignment). Nevertheless, over the past three years, we have chosen to invest in seven companies initially via convertible note, versus a total of 78 initial priced rounds during the same timeframe. We love to work with passionate, visionary Founders, and in a few exceptional cases, we were willing to overlook our concerns about the structure of these deals for the opportunity to work with extremely talented entrepreneurs. As we now look back at the results of these decisions, however, we are identifying even more conflicts that can arise between investors and Founders in today’s convertible note culture. Namely:

1. Convertible notes create a structure that makes it possible for large companies to profit from the misalignment between investor and entrepreneur, putting tremendous strain on a Founder at exactly the time he or she is achieving a significant milestone. A tense investor-Founder relationship takes a Founder’s focus away from strategic fit, insuring good roles for his or her team in the combined entity, and thinking about product longevity.

2. There is a certain trust and closeness that comes from a priced seed round financing, and we are finding that on both sides of the relationship, there is a tangible lack of that same trust in a convertible debt round. Becoming partners with someone is a serious decision and takes a great deal of time and patience. Choosing someone to work with for the next 3-5 years (minimum) is not something to be taken lightly, and we believe that Founders and investors in priced rounds tend to be more invested in their partnership, which to us is the most important thing.

To provide more insight into our view on convertible notes, I’ve re-posted a piece I wrote in 2006 about why it’s not for us:

Our take on “converts” or seed bridges
Posted On Nov 17, 2006
by Jon

There has been plenty of discussion recently among entrepreneurs regarding bridge loans for startups, also know as “converts”. Josh Kopelman wrote a nice post here, and Matt Marshall posted a bridge loan calculator for entrepreneurs here. Lots of people ask us our view on these structures, because we’re focused only on Seed and Series A deals. Despite the convenience of converts, we at True don’t do them (though we did participate in a bridge-convert at Meebo, as angels prior to closing the True fund). We don’t like them because they have the potential to create multiple conflicts of interest between the investor and entrepreneur. Worse, these conflicts are inserted into this crucial relationship on day one.

As entrepreneurs ourselves, we started True with the core belief that the venture industry should be better aligned with entrepreneurs. We literally named the firm True in reference to aligning a bike wheel. Clear alignment of incentives between our firm and founders is critical to everything we do. I’ll discuss some of the potential for conflict below, with the caveat that for non-professional investors, there can be some advantages to the convert. If you’re an angel from another industry, I admit that it could be risky for you to price a deal in a market in which you don’t have knowledge or experience. For experienced entrepreneurs and investors, in our view the conflicts clearly outweigh the convenience.

Converts aren’t a new device by any means, they’ve been a common tool for startups to attract angel and seed stage capital since the earliest days of VC. The appeal of a convert is simple: capital can change hands quickly, and both sides can avoid and defer the uncomfortable discussion around pricing the equity. Perhaps the angel and entrepreneur are friends from another context, perhaps the angel would prefer to let the professional market price the deal. From an entrepreneur’s perspective, the allure of a faster, simpler raise is attractive.

Conflict one arises even when we assume success post bridge. Seed investors do a bridge with warrants, and the company performs well and pursues an A round. The seed investors who take lots of early risk are clearly aligned and motivated for the company success, but there is the obvious conflict that they’d prefer their early, small dollars to buy as much of the company as possible. This means a lower conversion price. These seed investors can be torn: of course company success comes first, but wouldn’t it be nice to own a bigger share of that company, at least on the margin? Conflict one: mixed incentives regarding valuation for bridge note holders.

As new investors consider a Series A deal, converts and outstanding bridges can be frowned upon. It’s seen as extra “baggage” in a round. Why? Quite simply because the new Series A investor now needs to “share” dilution with these conversion bridge holders. They’re buying the same stock at the same time, but the Bridge conversion holders get a discount (and a deserved one, given how early they invested). Some A round investors don’t like this. Surely others are fine with it, but this creates a discussion between the entrepreneur and the new Series A investor. There’s a risk that Series A investor calls the entrepreneur and says, “Wow, that’s a big discount for your angels, and they’re coming in right along side us, and we bring this big firm to the table. . . You’re suffering lots of dilution, and we want you fully motivated for success . . .can you re-cut the convert discount?” Conflict two: entrepreneur can be put in a very hard spot between two investor groups.

Some large firms do converts as a way to “spread the seed” around and see what works. This gives big funds access to deals earlier on than typical, and if something works, these funds can deploy large amounts of capital behind a seed. We’re pleased to see this type of activity resume (it was very prevalent in bubble 1.0), and we genuinely like and support all things that foster entrepreneurship and new company formation. Seriously, we like it because it fosters entrepreneurship, but these converts are pretty risky deal for an entrepreneur to take. Given a stated strategy of seeding lots of stuff and only following up investment behind the best, the absence of a follow-on investment from such a big firm creates serious difficulty for an entrepreneur. At a minimum it creates huge doubts and question, at maximum it kills outside interest. Obviously if the folks closest to the deal aren’t supporting it, then something’s not working.

Most potential new Series A investors will look at the existence of a big-firm seed as a right of first refusal. We’re all time constrained, why spend lots of time on a deal with an effective right of first? Most Partners in VC firms need only make one to three investments per year. Why waste time on a deal with such a cloud? If a deal with a big firm seed is progressing nicely, the big firm will do it. If not, it probably isn’t a great deal. After all, if the insiders won/t support it, why should we?

The moment an entrepreneur signs a bridge note, he/she hands effective control of the Series A round over to the bridge note holders. The big-firm note holders now have tremendous leverage over the company, and the entrepreneur just narrowed his/her options for future financing. Certainly not all firms will use this leverage, but the investor/entrepreneur relationship just got cloudy, and it happened on day one. Conflict 3: Bridge holders get option value, entrepreneurs get option constrained.

We always encourage entrepreneurs to create flexibility and option value. In our experience, success requires it. Though the money of a convert is convenient and quick, it comes at a huge price in terms of flexibility. We believe the solution is to do a priced A round, even for a seed amount of money. Once you price the deal, Seed (now Series A) investors are completely aligned with the entrepreneur. Let’s build success and valuation together, then raise money at higher prices, because we are all diluted together (with the obvious and notable caveat that investors are able over time to protect their position and founders continue to get diluted).

On day one the investor is on the same side of the table as the entrepreneur. The price is the price, both sides needed to agree to this price in order to transact. Once the deal closes, you go on to build a company, fully invested, and fully aligned. Subsequent investors to the company understand A rounds: there is no hidden right of first, no mixed incentives, and everyone understands how a B round functions.

The clarity of a priced A round serves the entrepreneur best because investors are immediately aligned for the company’s success.

Simple, clean, transparent. True.