Converts versus equity deals

There has been a debate going on the past few days over whether seed deals should be funded using equity or convertible notes (converts). Paul Graham kicked it off by noting that all the financings in the recent YC batch were converts. Prominent investors including Mark Suster and Seth Levine weighed in (I highly recommend reading their posts). While this debate might sound technical, at its core it is really about a difference in seed investing philosophy.

I am a proponent of convertibles, but only with a cap (I’ve written about the problems of convertibles without caps before and never invest in them). I believe that pretty much every other seed investor who advocates converts also assumes they have a cap. So any discussion of convertibles without caps seems to me a red herring.

There are two kind of rights that investors get when they put money in company. The first are economic rights: basically that they make money when the investment is successful. The second are control rights: board seats, the ability to block financings and acquisitions, the ability to change management, etc. Converts give investors economics rights with basically zero control rights (legally it is just a loan with some special conversion provisions). Equity financings normally give investors explicit rights (most equity terms sheets specify board seats, specific blocking conditions, etc) in addition to standard shareholder rights under whatever state the company incorporated in (usually CA or Delaware).

To the extent that I know anything about seed investing, I learned it from Ron Conway. I remember one deal he showed me where the entire deal was done on a one page fax (not the term sheet – the entire deal). Having learned about venture investing as a junior employee at a VC firm I was shocked. I asked him “what if X or Y happens and the entrepreneur screws you.” Ron said something like “then I lose my money and never do business with that person again.” It turned out he did very well on that company and has funded that entrepreneur repeatedly with great success.

You can hire lawyers to try to cover every situation where founders or follow on investors try to screw you. But the reality is that if the founders want to screw you, you made a bet on bad people and will probably lose your money. You think legal documents will protect you? Imagine investors getting into a lawsuit with a two person early-stage team, or trying to fire and swap out the founders – the very thing they bet on. And follow on investors (normally VCs) have a variety of ways to screw seed investors if they want to, whether the seed deal was a convert of equity. So as a seed investor all you can really do is get economic rights and then make sure you pick good founders and VCs.

Seed investing is a people business. Good entrepreneurs understand this. Ron was an investor in my last two companies and never had any control rights but had massive sway because he worked so hard to help us and gave such sage advice. And most importantly, he carried great moral authority. We always knew he was speaking from deep experience and looking out for the company’s best interests – sometimes against his own economic interests.

Like it or not, the seed investment world runs on trust and reputation – not legal documents.

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mikemcgrath

best post on the subject yet. especially like the one page deal term rationale.
http://avc.com fredwilson

well said chris

which is why i am a big fan of the “non negotiated series A” deal docs that are out there

they don't have much if any governance/control language and just provide the economic structure

http://hdemott.wordpress.com Harry DeMott

One question on this Fred – playing Devil's Advocate here.

It seems like the “professional” investors like the standard Series docs that are out there more than the convertible structure.

Could this be that it is because they realize that both are essentially equity investments – but the standard series docs spell out more rights for the investor than the convert – and thus are going to be better for the investor in the long run?

Also, given the fact that you or chris here, or any other “named” investor is going to have more signaling value – doing a convertible deal with no cap is a complete waste of that signaling value – you are working against yourself.

Possible?

http://avc.com fredwilson

Yes and yes

http://www.cdixon.org chris dixon

What's the benefit over coverts w/ caps?

http://avc.com fredwilson

The deal is priced. The cap table is locked down. Everyone knows where they
stand. There is alignment. The docs and the precedents they set are put in
place by an entrepreneur friendly investor group. Those are the big ones

http://twitter.com/Rajnishr Rajnish

Agree that seed investment is always about what kind of people (Founders) you are backing and how far and how much time you are willing to devote to the team.
Gregg Freishtat

I think Chris nailed it. There is not enough paper in the world to protect yourself against investing in the wrong team if you are a seed investor. The team is the “seed”.
http://www.wac6.typepad.com William Carleton

Chris, new ventures that skip the legal docs can, and sometimes do, run aground. You can't always count on the morals or ethics of everyone involved; sometimes everyone has immense good faith, but just disagree when a challenge arises on what to do. Best example, you've written about repeatedly: founder vesting. Others would include IP assignments. I worry that when leaders like you come out and champion notes so un-reservedly, what some entrepreneurs hear is not just, hey, let's push valuation down the road, but let's not otherwise worry about getting our house in order. Taking other peoples' money is a big deal. It usually merits some involvement with lawyers.

jeremy_freeland

I'll second Bill on this one. I've spent the last couple of months helping clients negotiate deal terms post-dispute that would have been pretty straightforward to do at the outset (and much less expensive in terms of legal fees).

I think that most early stage investors go in realizing they could lose all of their investment. But the realization is subject to an assumption that both the investor and the entrepreneur have fairly set expectations with each other. Typically, the tricky situations I see seldom involve outright dishonesty, but more often a failure to understand and communicate what the investor would see as material, often followed by a change in circumstances that the entrepreneur didn’t expect.

It’s a question of risk management that I approach from the same place as many years (pre-family) of what life insurers call “willful exposure to needless peril”: just because you may be willing to take some risks with big consequences shouldn’t make you ignore every risk. Your best way of making your big risk worthwhile is to be careful about mitigating the more easily manageable risks.

So I’d look to get some basic reps and warranties, less because I think the legal remedy is going to be useful, as because I want to be sure that the entrepreneur has communicated or addressed issues that are important to the investor (and the company). For example, I’d want to know what the company’s liabilities are (so I know my investment is going to true working capital), that there’s no litigation or other disputes (because I don’t want my investment going to pay lawyers or ending up in someone else’s pocket), and that all of the IP has been assigned to the company (because the business plan won’t work if the company doesn’t control the underlying technology).
http://www.cdixon.org chris dixon

Oh I definitely believe in properly incorporating, founder vesting, IP assignments etc. I should have made that clearer.

http://bothsidesofthetable.com msuster

The Ron Conway angle / lesson are insightful for all. The biggest VC deal we (at GRP) ever lost was to Sequoia. We had a term sheet agreed other than some niggly founder issues. They came in and just did the deal quickly with no hard fights. Their view (I assume) was we're either backing a great team we trust or we aren't.

That company IPO'd. They made a lot of money.

It was before my time at GRP but that story always sits with me.

http://lmframework.com/blog/about David Semeria

I'm seduced by this wholesome investment world being painted all over of the blogosphere — where deals are sealed with a spit and a handshake round the camp fire, and where a Real Man would rather lose his ranch than his reputation.

So warm and fluffy!

But… wait a minute… where does all that stuff on The Funded come from?

When the VC door opens, who's behind — Gary Cooper or Freddy Krueger?

http://www.cdixon.org chris dixon

there are definitely sketchy people in our business. hard part is knowing who.

http://hdemott.wordpress.com Harry DeMott

Public or private it is all the same:

if you are in business with bad people – you have no chance

you also can't abdicate on pricing.

If you do convertible debt without a cap – you are a bank and should therefore have all the security banks have.
http://blog.myprojecttracker.com Barney Austen

Hi Chris. Thanks for sharing this – I didn't even know about the existence of converts as an option. Learning here as always.
Cheers
http://donaldryan.net DonRyan

Every post you write on seed investing comes back to the builders vs. extractors principle which is why, as you state, seed investing is a people business (for both the start-up and the investors).

http://www.cdixon.org chris dixon

Yeah, it is a recurring theme isn't it.

http://www.rch-phd.com Rick Harris

Corollary: If you think you need to put tight controls on a deal, you're probably looking at a cool idea headed by a bad team = bad investment.
http://reecepacheco.com reecepacheco

Amazingly refreshing input on the topic, Chris.

It always comes back to the people involved and “moral authority” is a great intangible of the deal.

Curious though, are you speaking purely as an angel, or does this apply to Founder's Collective as well? If so, how does this perspective fly with your LP's?

http://www.cdixon.org chris dixon

Both as an angel and from my perspective at Founder Collective (FC is a diverse group so other people's opinions could certainly vary).

http://bsiscovick.tumblr.com/ bsiscovick

I just blogged this (http://bit.ly/d0H603) and am reposting here because I think it is highly relevant.
—
'Like it or not, the seed investment world runs on trust and reputation – not legal documents.'

No argument here.

Everything that can possibly be said about convertible notes vs. equity has already be said by much smarter and more experienced investors than me (see Wilson, Suster,Levine, and Dixon). I'm not going there. But I do think the entire context of this and many other VC vs. entrepreneur discussions needs to be completely reframed.

I am well aware that historically VCs have taken advantage of their opaque positioning, and thanks to increased transparency afforded by blogging, twitter, thefunded.com and the general web, we are seeing the death of that trend and practitioners of shitty deal terms. After years of shitty practices, I understand the need to rebalance by over-weighting the discussion towards 'entrepreneur friendly'. But with the rise of VC2.0, we need to shift the meme around deal terms from 'entrepreneur friendly' to the more reflective and sustainable meme of 'structurally healthy' – i.e. deal structures that effectively and fairly promote the interests of both entrepreneurs and investors. Absent *fairness* for both sides, the 'marriage' stands little chance of success.

With respect to control provisions – this must be viewed through the lens of 'structurally healthy' deal terms. Why are control and protective provisions anti-entrepreneur? There are most definitely certain structures that are parasitic and imbalanced (multi-liquidation preferences, overly restrictive forced sale or no-sale provisions, etc.), but there are also plenty of provisions that are completely fair and reasonable for investors to request in return for their risk capital. Good entrepreneurs working with good investors know this and understand that all parties need to be fairly and reasonably compensated and protected. This works both ways.

And with respect to introducing these types of deal terms at the seed stage, we must consider the fact that there are different investment models at the earliest stages. Some angel/seed investors invest small amounts across a wide basket of early stage companies. They create positive network effects that benefit all companies within their broad portfolio. They generate returns by being in *every* good deal with the hopes that one or more will produce a grand slam and carry the fund.

Others, like our fund IA Ventures, take a much more 'venture' like approach to seed stage investing. While we invest more broadly than traditional later stage folks (our opportunistic strategy), the bulk of our capital is allocated in a much more concentrated manner where we invest in relatively large chunks (for this stage) and aggressively allocate reserve capital for follow on support of our portfolio.

I am not advocating one approach to seed stage investing over another – in fact, both might produce highly attractive returns and only time will tell which strategies are most viable. But given our investment philosophy – one which necessarily involves heavy allocation of our capital, time and resources – we deem it completely and unapologetically appropriate to receive fair economic AND control rights. This is not entrepreneur unfriendly, this is structurally balanced.

Entrepreneurs who chose to work with us are well aware of what we bring to the table and, as a result, are comfortable and supportive of this balanced approach.
http://www.victusspiritus.com/ Mark Essel

Whoa, you had Ron Conway invest in your businesses. I had no idea.

Out of curiosity, how did you approach Ron?

http://www.cdixon.org chris dixon

A friend intro'd me. That's always the best way (perhaps only way).

Florian Feder

I absolutly agree, legal documents at this stage a way over-hyped (and I say this as a lawyer). It should be all about people, relationships and collaboration. Legal documents won't help you if any of these are not right.

And by the way: Entrepreneurs are certainly more often screwed by investors than vice versa. Common sense will tell you that debt is the more appropriate way of investing in somebody else's business. You are providing capital, and interest has always been the appropriate compensation for providing capital. If you want equity, found your own company.
http://www.abhayspace.com/ Abhay Vardhan

Great post!
Eric Paley

Founder Collective is definitely diverse as a partnership, but David and I completely agree with Chris here. We’re very happy to do converts with cap and not get bogged down in negotiating control issues.
Dinesh Vadhia

A sort of related story on investor “trust”. Recently, I have been prospecting for seed finance from various sources including a large world-renowned institution with multiple seed funds. At our last meeting they wanted to proceed with due diligence but said the cost would be borne by our startup. If that wasn’t bad enough, the cost would be financed with funds from their seed funds. The icing on the cake was that they had all the paperwork lined up, marked in yellow for me to sign on there and then.

This was for due diligence and not the legal cost of finalizing the deal. Naturally, I signed nothing, made my excuses and left.
http://www.freddestin.com Fred Destin

Are there instances you have seen where the cap on the convert ends up dragging down the price at which the Series A can be done?
http://www.cdixon.org chris dixon

not yet but who knows…
http://www.garyvaynerchuk.com garyvaynerchuk

Chris this is a great post! It is and always will be a “people” game, and that’s all business! Stay well
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pete

This is so true. Tech Coast Angels insisted on an A round for raising our seed round of $200k. It was ridiculous. Spent way too much on lawyers, created a ton of mutual suspicion, and in the end the additional lawyer fees became such an anchor that ended up stinking and sinking the company. Gawd i wish converts were the norm. Like you said, they are investing in YOU, the entrepreneur, why do they suddenly want to Screw you.
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http://technbiz.blogspot.com paramendra

I like the one page thing. It should be the industry standard. http://goo.gl/fb/5n5zP
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Anonymous

Great Article!
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Chris Dixon