Friday, June 19, 2015

Racism and entrepreneurship

My Twitter stream in the last few days has been filled with outpourings of outrage about the killings of 9 people at the historically black church in Charleston, South Carolina.

What does all this have to do with the previous blog posts which have been about some technical aspects of convertible debt and crowdfunding?

The broader vision of many people involved in the activity of creating, launching and funding startups is that in some way we're all contributing to making the world a better place. We're also contributing to supporting opportunities of individuals to realize their dreams as founders and employees and customers, helping contribute to something of value in their lives.

All of this effort of humanity to better and better itself is horribly hindered by the threads of racism that still exist in our society.

Today the Wall Street Journal published the most amazing--amazingly horrible--article that says that these killings weren't about racism. It states that the institutionalized racism "identified" by Dr. Martin Luther King no longer exists.

The default that we are left with by the WSJ is that this young man was either (a) troubled or (b) evil. If you're secular you choose (a) and if you're religious you choose (b). But oh no, racism had nothing to do with it.

Of course he was troubled. But that doesn't mean that he didn't latch onto a culture where racism is prevalent. You have only to look at the statistics of both the number of African American's killed by their neighbors in their communities, the number of African Americans killed by police in comparison to the ratio of whites killed, and any one of many other statistics to see that the threads of racism are still wound tight within this society and within many of our institutions, warping all of our actions in bigger and smaller ways.

Does that mean things aren't better today than they used to be? Of course not. But to suggest we've washed our hands of racism, that we efficiently disposed of that ugly thing that Dr. King "identified" is mindbogglingly naive, blind, insensitive and well, racist.

Again, why does this matter in the context of entrepreneurship? Because to solve the world's problems or even simply provide great value to customers, you have to draw upon the best of people. You can't draw upon the best of people with deadly threads still wound around all of us. And so, in some way, all of our efforts suffer and many things are brought down. One of many things that is brought down, hindered, is the effort to better ourselves through invention, innovation and entrepreneurship.

Wednesday, June 10, 2015

the careful march forward of so-called crowdfunding rules

A while back I did a post that included a flow chart which was intended to give some guidance to entrepreneurs about the then new crowd funding rules. Recently the SEC approved additional regulation in its ongoing effort to implement the provisions of the Jobs Act. I've been asked by some entrepreneurs how this affects them. For early stage entrepreneurs it does not and it doesn't change the flow chart that I produced. Although nothing I write should be considered legal advice, I still think that flow chart is a useful tool. But here's an additional summary of the crowd funding rules.

Starting June 19, 2015, companies will have a new way to raise money from both accredited and unaccredited investors. These modifications to Regulation A, sometimes refered to as "IPO-Lite", allow a company to raise up to $50 million in growth capital. For early stage entrepreneurs, the operative word there is "growth". This is not something that companies raising a seed or A round should worry about. You aren't doing either an IPO or even a "lite" IPO. It might be something to consider at some point in the future but not at the early stage. Although the regulatory burden has been reduced, it's still not for a startup. If you want more information on this, Michael Raneri has been publishing some helpful articles in Forbes and other places.

The above is referred to as "Title IV" of the Jobs act, modifying Reg A. My flow chart refers to "Title II" which relates to the modification of Reg D. Those modifications went into effect in September 2013. The SEC took the old Reg D, the rules under which most entrepreneurs raise equity, and split it into two paths for entrepreneurs to raise private capital.

One path is 506b of Reg D. Under this rule entrepreneurs can not talk in public about raising capital. In other words, you have to be certain that you only talk with accredited investors not the general public. This is the old Reg D. Even though in the past people tended to talk publicly about their fundraising--in business plan competitions, for example--it really wasn't allowed. The modifications to Reg D clarified the regulations and essentially says that if you want to talk publicly--again, defined as an audience that may include unaccredited investors--you have to follow a new variant of the 506 rules, 506c.

The new Rule 506c of Reg D does allow you to talk publicly about raising capital ("general solicitation") but as with 506b, you can still only take in money from accredited investors. Why would you not always use 506c? The reason is that the reporting burden is significantly greater for the entrepreneur and places the onus on them, not the investor, to verify that investors are accredited. It is this rule that has opened up opportunities for general solicitation--crowd funding--from through platforms like AngelList. There's a good explanation of all this on the AngelList site.

What we haven't got to yet is regulation from the SEC allowing you, as an early stage entrepreneur, without the expense and time of Reg A, to take in money from unaccredited investors. This "real" crowdfunding is still not available.

Tuesday, June 02, 2015

some important thinking on convertible notes and liquidation overhangs

Two blog posts on convertible notes popped up recently and I thought I'd detail them a bit more in my own language. But you might be better served to just jump over to Brad Feld's post "The Pre-money vs. Post-money Confusion With Convertible Notes" and Mark Suster's post, as well as a further post, The Problem in Everyone’s Capped Convertible Notes by José Ancer.

The issue being discussed is a problem that has resulted from the use of convertible notes as investment rounds in and of themselves instead of as bridge notes to the next financing round, which is how they were originally intended. If a convertible note is used as a bridge, there is relatively little increase in value between the notes and the next round. But if a convertible note or notes stay in play for a longer period of time--say 12-18 months--then in the ideal case scenario, the value of the company has grown significantly. The problem is a feature in most convertible notes where the holders get an increased liquidation muliplie upon conversion if the valuation cap on the notes is exceeded.

Here's how it works.

Let's assume...
  • you're an entrepreneur who has issued $500k in convertible notes to investors
  • the convertible notes carry a $2.5MM valuation cap
  • new money invests $1MM in a Series A at $1 per share
  • the Series A is participating preferred with a 1x liquidation preference
Scenario 1

In our first example, we'll say that the next round investors invest at a pre-money valuation equal to that $2.5MM cap. New money would get 1,000,000 shares in Series A stock ($1MM * $1 per share) and the convertible note holders, upon conversion, would get 500,000 shares in the same Series A ($500k at $1 per share, ignoring interest in this example). The post-money would be $4.0MM. The new money gets 1x participating liquidation preference. In other words, regardless of what the company sells for, everyone with Series A gets $1 per share back on top of their participation on a pari passu basis with Common Stock holders.

Here's what the cap table looks like:

Common Stock: 2,500,000 shares or 62.5%
Series A (new investors): 1,000,000 shares or 25%
Series A (former convertible debt holders): 500,000 shares or 12.5%

If the company sells for $4.0MM, Series A would get $1.5MM out, and then get their pro rata portion of the remaining $2.5MM (37.5% in this case). This sort of participating preferred is pretty standard--almost every single one of the deals we at Long River Ventures have ever done has this feature.

If the company sells for $10MM, new investors get $1MM, note holders who are now Series A get $500k, and then both share in the remaining $8.5MM with Common.

If the company sells for $20MM, the Series A would get out their $1.5MM and then their pro rata portion of the remaining $18.5MM.

With me so far?

Scenario 2

Now let's assume that the $2.5MM cap comes into effect because next round investors think the company has done really well and are willing to invest above the cap set in the convertible notes. Let's assume that next round investors invest not at the $2.5MM cap but at a $10MM pre-money valuation. Let's assume they still invest $1M in a Series A and still get shares at $1 per share. They would get the same 1,000,000 shares as in the above example, but much less of the company. The convertible note holders wouldn't get 500,000 shares, they'd get 2,000,000 shares--remember, they have a $2.5MM cap and the valuation was $10MM. Therefore, they get 4x the shares in the first example. As an entrepreneur, you may not like that but that's what you signed up for.

Here's what the cap table looks like:

Common Stock: 10,000,000 shares or ~77%
Series A (new investors): 1,000,000 shares or ~8%
Series A (former convertible debt holders): 2,000,000 shares or ~15%

What you don't realize you signed up for is the same thing on the liquidation preferences.

Let's also assume the 1x participating preferred liquidation preference also holds in the second example. Just like in the first example, new money would get $1MM upon liquidation regardless of the company selling price, and then get their pro rata portion. However, the convertible debt holders would get a 4x liquidation because these liquidation rights are written on a per share basis, not on the amount of money invested. In other words, they are guaranteed to pull out $2MM off the top on their original investment of $500k.

If the company sells for $4.0MM, new investors get their $1.0MM back, note holders who are now Series A get $2.0MM back, and then all share in the remaining $1MM (pro rata of Series A in this second example is 23%).

If the company sells for $10MM, new investors get $1MM, note holders who are now Series A get $2MM, and then both share in the remaining $7MM.

If the company sells for $20MM, new investors get $1MM, note holders who are now Series A get $2MM, and then both share in the remaining $17MM.

Compare this second $20MM example with the same example above. The difference between $18.5MM and $17.0MM after payment of preferences is where the liquidation overhang lies.

To keep the illustration simple, I didn't include the discount on the next round that convertible note holders are also likely to get. In most cases, there would be a discount on the next round as well as the valuation cap so they would do a little better than this example. If you think that convertible debt holders get enough recognition for their risk in that discount and with the valuation cap, and that the liquidation overhang is overreach, go to the above blog posts for some solutions to this problem.