mod (Andy) note: this was originally posted in July but he's still answering q's for those interested in VC.
In following the solid threads of the 10x leverage, harvardgrad08...I am offering a Q and A on all VC related questions.
As some of you know, I am a non-target graduate with 2 years middle market investment banking experience and a short stint at a multi-billion dollar hedge fund prior to my current VC gig. Ask away
Great question - and the answer absolutely varies in terms of the type of company, round, etc. For example. if we are in a seed round (pre-revenue, generally proof of concept stage) the analysis is more on the market, eventual product and especially management (this is huge, especally if this isn't their first rodeo). When you are talking Series C and beyond, this is where modeling can be of use (not to say it isn't at earlier rounds, but it is purely assumptions as you would imagine). Analysis is more focused around exits, cap tables at various rounds, dilution, irr, etc. Furthermore, it depends on the structure of the deal (we typically do equity or debt w/ warrants, etc.) so that can decide if an in depth model is of use. By nature, I tend to put models together for each deal I am on - I guess it is the banker in me (but some of the GP's won't review them, it is just a good tool for me to have if and when needed and of course helps if/when we have multiple rounds occuring)
We have several funds (pre-seed all the way to series e, etc), allowing us to go in with as little as $100k initially with our later round funds investing into the tens of millions....in order to preserve anonymity, I will keep the actual amounts to myself.
It was definitly an uphill battle in the beginning, as VC's tend to dislike bankers (probably because they fuck around so much during sell time for portfolio companies). The interview process was rigorous, as my tech knowledge was put to the test. Luckily, I am a techie @ heart and could really sell my passion for that in the why VC portion - since I had healthcare banking experience I made sense for that portion of the business. I am most certainly the finance guy, as I always make a comment in pitches regarding the outrageous hockey stick projections, but I have learned to give entreprenuers a break. They are the true talent, we are just providing the capital for them to re-create the wheel, and giving them guidance in how to derive value from their ideas. As time passes, I am continuing to shed my banker personality, which will only improve my success in the VC game of life.
Something I thought I would share with the forum, and can give you some insight how we early-stage investors utilize convertible debt:
Convertible debt is a widely used early-stage financing structure. Compared with equity, it allows the financing to move ahead without having to reach an agreement on the valuation, is somewhat cheaper in terms of legal fees and offers investors some downside protection.
Convertible debt instruments usually convert into equity at the next financing event under the same terms and conditions as the subsequent investment and at the same valuation, less a discount to compensate the convertible debt investors for the higher risk they take. The discount usually varies between 10% and 40%. Several online articles have argued that convertible debt with a discount is a sub-optimal structure. Such articles typically provide a narrative of how and why convertible debt is not optimal, but do not provide a mathematical rationale or discuss at what thresholds convertible debt may be equivalent to equity.
At the usual discount rate of around 30%, if the company increases in value significantly, convertible debt returns are almost always inferior to equity returns. This comes from the mechanics of the structure, leaving aside other imperfections of the convertible debt structure, such as the alignment between the entrepreneurs and the investors and the fact that discounts can be, and often are, negotiated away at the next financing round.
Let’s assume that an investor already decided he or she wants to invest an amount “Y” in a company’s Series A financing round and has to choose between structuring the investment as equity or as convertible debt. For an equity round, let’s assume a pre-money value of “VA”. Post money, the investor will own Y/(Y+VA) of the company. Assuming the company value increases, at Series B, the pre-money value of the company will be “VB”, and VB>VA+Y. Immediately prior to Series B, the equity investor owns:
Y/(Y+VA)*VB (1)
If doing a convertible debt round, assuming a discount “D”, and no interest, the investor will have the right to convert the amount invested Y into the Series B round at the discounted Series B pre-money valuation. Immediately prior to Series B, the convertible debt investor owns:
Y/(Y+VB(1-D))VB (2)
What should be the discount D so that the return from a convertible debt round is equal to or greater than the return from an equity round? Using (1) and (2) we have:
Y/(Y+VB(1-D))VB ≥ Y/(Y+VA)*VB (3)
Solving for D:
D ≥ 1-VA/VB (4)
The discount D needs to be greater than 1-VA/VB in order for the return from a convertible debt round to be equal to or greater than that of an equity round.
Let’s assume “R” is the growth in company value from Series A post-money to Series B pre-money expected by the investor. In other words:
R = VB/(VA+Y)-1 (5) Extracting VA/VB from (5) and substituting it into (4), we get: D ≥ R/(R+1)+Y/VB (6) The second term, Y/VB, is always positive so the discount D is always higher than R/(R+1): D > R/(R+1) (7) Defined this way, the discount D depends on the expected growth rate in the value of the company. The higher the expected growth rate, the higher the discount. Table 1 shows the minimum discount rate required to fulfill condition (7) above, at various expected company value growth rates between Series A post money and Series B pre-money. Value Growth Rate Expected Min. Discount Rate Required 10% 9% 20% 17% 30% 23% 40% 29% 50% 33% 100% 50% 200% 67% 300% 75% 400% 80% 500% 83% Table 1 What is usually considered a fair discount to the next round of around 30% corresponds to an expectation that the company value will grow in value by about 40-50%, if the positive scenario is realized. If the company value doubles for example, the investors should ask for a discount higher than 50% to get the same value they would get from investing in equity. A 50% discount is usually considered unfair at Series B as the general tendency is to underestimate risks after the positive scenario is realized. Investors in convertible debt with a discount of around 20-30% often “leave money on the table” if the upside case is realized. For investors, convertible debt may offer downside protection if the company has assets that can be monetized, an argument usually valid for companies in later stages of development. Convertible debt may also offer protection in down rounds. Sacrificing the upside is, however, hard to justify from the perspective of the early-stage investor.
The remedy for the investors is to structure the financing as an equity round, ask for common stock or warrants with the convertible debt, or set a conversion price cap. For entrepreneurs, convertible debt helps preserve some of their equity but it is a double-edged sword as their investors’ interests will be aligned with those of the new investors in seeking a low valuation at the subsequent equity round.