The Silverings by Mikala Dwyer, currently at Te Papa in Wellington - photo by me.
During 2021 I published this newsletter weekly, in an effort to flush out a long list of drafts I’d been sitting on for way too long. That nearly broke me, but did leave me with a lot of content. I’ve spent the time since studiously moving it all into longer form essays that are available on my own site:
Today I’m pleased to push “Publish” on a block of writing that was in some ways the backbone of the newsletters last year - my series on the “ecosystem” of technology startups in New Zealand.
Here are some links to the full set, in the order I recommend:
How do we build on Paul Callaghan’s vision for New Zealand, and update it for our current reality?
Building An Ecosystem
How can we build an ecosystem of innovative technology startups in New Zealand?
How do we know when something is actually working?
How to Scale
What a founder in one of the poorest areas in Kenya taught me about how to start and how to scale
How do all of the programs designed to support startups actually help?
To encourage more people to work on startups, we often try to make them fun. How does that hurt?
Reality Distortion Field
Rather than looking for reality television inspired short cuts, maybe we just need to embrace sucking while we get started?
Rather than complaining about how difficult it is to raise venture capital in New Zealand, we need to start being honest about why it’s hard.
When a startup is sold, in part or in full, it is just a trade. As a country that’s entirely dependant on trade for our prosperity we should understand this better.
When we ask the best startups what’s holding them back they all point to the challenges of finding and keeping great people.
How do we create an ecosystem? We plant a seed and let it grow!
40,000 words later, I’m pleased to finally have all of this in a place where I can easily share it. And I hope it’s useful to some of you who take the time to read it.
When a startup needs to raise capital there are two important questions to answer:
How much to raise?
At what valuation?
Founders often agonise about the second question, unnecessarily - as I’ve written elsewhere, a valuation can be easily calculated based on the percentage ownership that new investors need in order to convince them to take the leap.
For example, if the company needs to raise $1m and the new investors want 20% ownership then the pre-money valuation is $4m.
Assuming sufficient thought has been put into how much new capital is required to achieve the next unit of progress, the only variable that needs to be negotiated with potential investors is ownership percentage. Founders who think their valuation should be higher are implicitly just saying that they think new investors should own a smaller percentage. And vice versa, investors who think the valuation should be lower are suggesting a higher percentage ownership for themselves (and correspondingly lower ownership for the founders and existing investors).
However there is an alternative to this approach which seems suddenly popular (at least based on the sample of pitches we’ve received recently, assuming those are some indication of wider trends) and which tempts founders with the idea that they can avoid this difficult second question altogether.
I’m talking about Convertible Notes.
With these, rather than issuing new shares to investors the company “borrows” the money, with an agreement that it will convert into capital if and when new shares are issued in the future. To entice investors to provide this sort of funding various incentives are normally offered to those lending the money, and these introduce many new variables:
Discount Rate - when notes convert to shares in the future the price is discounted compared to the price that investors then are paying.
Valuation Cap - this is the maximum future valuation used when converting notes to shares - if the future round is completed at a higher valuation note holders don’t pay more than the cap price.
Interest Rate (sometimes called coupon) - like a term deposit, note holders can receive interest on the notes - this is typically capitalised and added to the amount converted to shares in the future, rather than paid in cash.
Term - this is the maximum amount of time the company has to raise a future round before the notes need to be repaid or converted.
Note: some of these might be excluded - e.g. not all convertible notes have an interest rate, and it’s possible to setup a note with no expiry date (effectively an indefinite term), but those are still details that need to be discussed and agreed.
When I’ve asked founders why they are choosing this option the answer is often because it is seen as a “quick and easy” way to raise capital.
But, is it? Really?
I’m not sure that those who are advising founders to do this are supported by empirical evidence. It actually seems to me to be the opposite: slow and complicated.
Anyway I think the more honest but unspoken reason why founders prefer convertible notes is because it allows them to pretend they are avoiding or at least deferring the question of valuation. In the current climate, where public market valuations for technology companies have dropped significantly from recent highs, I can understand why that is attractive. Sometimes it’s better to not ask the question, if you don’t want to know the answer!
Convertible Notes are not a new concept, but they are relatively new to startups. They were popularised in the US by Y Combinator, when they open-sourced their recommended legal documents in 2013.Since then they have been used by almost all companies that have gone through their accelerator program, as well as lots of other startups.
“SAFEs are intended to provide a simpler mechanism for startups to seek initial funding”.
When a startup is trying to raise the very first round of financingthis sort of structure can make sense: It allows founders to accept money when it is offered, rather than waiting for a full “round” (although that advantage is lost where it ends up being a “round” of convertible notes, which is the worst-of-both-worlds) and it allows founders to negotiate different terms with different people if required - e.g. the first investors to commit could end up with a deeper discount or a higher interest rate.
But, for later stage companies there are other pros and (mostly) cons that need to be considered…
The most obvious is that investors don’t know either the price they are paying (and the corresponding percentage ownership they get in return) until later or the other terms that might be negotiated as part of a future round.This makes it likely that somebody is going to be unhappy later - if the valuation of the next round is above the cap on the notes, then that’s good for those who are converting notes, but can create a big gap between the price being paid by those earlier investors and anybody investing in the later round (which we can assume will be a drag on the valuation that can be negotiated in that later round, assuming the price will be set by new investors and not existing note holders); and if the valuation of the next round is below the cap on the notes then earlier investors might not feel they have been sufficiently rewarded for the risk they took by investing early - e.g. if the discount on the notes is 20% (which is common) but the company has grown in size by 50% or 100% in the meantime, the earlier investors don’t really capture the full value of the growth in the valuation they have partially funded.
Of course, there is also a third scenario, which is even worse for everybody, and the reason why I put “borrow” in scare quotes above - the company runs out of time and money without raising the next round. In that case it’s very unlikely the company has the cash to repay the notes and interest, so the only option is for founders to try and agree a fair equity split and further funding with notes holders. And that assumes that the founders are willing to continue working on the venture at that point (which isn’t always the best decision anyway). From an investor’s perspective those notes are then really no different to a regular equity investment, in that the downside risk is they are worthless.
It’s always hard to predict what investment discussions might happen in the future, so just kicking the can down the road isn’t always smart - as we’ve seen in recent months the climate for venture investment can shift on market sentiment very quickly, so companies with notes can find themselves negotiating future rounds in very different external climate than they might have anticipated when setting the terms of the notes.
Here is my alternative advice, for what it’s worth:
If you are working in a brand new venture and have investors who are keen to invest immediately then a convertible note can be a quick and easy way to facilitate this. As long as all of the investors taking these notes understand the risk they are taking (i.e. in the worst case they still lose all of their money) then it defers some otherwise distracting discussions.
But if you haven’t found investors yet or you are working on a later stage company then keep it simple. Work out how much capital you need to fund the next stage of the business and then choose the best investors you can to provide that capital (each company will have their own definition of “best” - but in my experience it often comes down to how much investors can help rather than how much they can invest).Don’t be scared to discuss a valuation. Agree a fair price based on what you have achieved so far, rather than trying to price in too much of the future growth. And make sure their investment gives them enough ownership to encourage them to roll-up their sleeves and help. Then work together with your new investors to win together.
This doesn’t have to be as complicated as we often make it.
As well as the recently completed ecosystem series I linked to above I now have more than 60 essays available, which capture lessons I’m keen to share, including lots that have been published in the last three months.
Some of you may have been following along on Twitter, where I post all of the links as they are completed. But for everybody else, here are three you may like to start with that are a little different:
If you had to choose, would you rather be rich or famous?
We only get to be each age once. How many will we waste trying to be something that we’re not?
We Are Still Divided
The world is still divided, between you and me, baby, you and me.
As always, I’m very interested in any feedback you have, once you’ve read these or any of the others. I am keen to treat them as evergreen, and update them when needed. So your comments help make them better!
Sometimes, writing is opening up your laptop, looking at a blank page on Final Draft for about 8 hours, and then feeling sad, and closing it again. That’s still classified as writing.
Source: The Project
There is a nice point here about the difference between inputs, outputs and outcomes… but I’ll maybe save that for the next time I open my laptop.
Sometimes there are other minor questions that work their way onto term sheets. For example, if the company has a complicated balance sheet (e.g. with outstanding loans to founders) then those will often need to be dealt with ahead of valuation discussions. Likewise, if the company doesn’t already have an employee share-option plan in place, new investors will typically want that to be setup before their new money goes in, which can create additional dilution for founders.
But, in my experience, when founders and investors can agree on the amount of capital required and the valuation then other things can usually be worked out.
“Pre-money” is just startup jargon for “the valuation of the company before the new capital is invested”.
Kindrik Partners published a local equivalent in 2015.
I also recommend their blog post from 2020 which explains some of the things that they think need to be considered when using this form of agreement:
Sometimes the very first round is called a “friends and family” round, which itself is problematic because it says out loud the awkward truth that having friends and family who are in a position to make very uncertain early stage investments is a rare privilege.
For example, Convertible Preferences on shares, composition of the Board of Directors, or other special Investor Approvals.
If the price of the future round is being set by note holders then that is itself problematic because the incentives are not necessarily in the company’s interest.
That capital could be a mix of equity or debt. If you are growing fast, and especially if you have stable recurring revenues then there are more and more debt financing options that can compliment pure equity investors and reduce the amount of dilution for founders and existing investors.
This price on SAFE’s is really useful thanks Rowan. Appreciate the insight.