Convertible Note Conversion Discounts

I passed on a deal this week because the terms were bad.  It was a seed stage deal, I like the entrepreneurs, the technology was cool new stuff invented in a university, and they seemed to understand the landscape well enough that I was willing to break my "no pre-revenue" rule and my "no hardware" rule.

The deal breaker was the convertible note terms.  The typical convertible note deal (for Boston in the past couple of years) has 2 terms: an interest rate and a conversion discount.  The note for this company had a single-digit interest rate and no conversion discount.  If you spend 10 minutes with a spreadsheet to compute the post-money valuation of your investment, you can determine that the discount is the main incentive to do this kind of deal.  A convertible note without a discount would have to carry an interest rate of 20%-30% to make up for it.

When I asked about the lack of a discount, they told me they had their agreements done by a Silicon Valley law firm, and this firm strongly advised them to not offer discounts since A-round investors would push back on the discount and make it harder to raise the next round.  I explained that without the discount, there was no risk premium to justify investing now versus investing later.  Their hands were tied since they had already closed money under these terms, so we parted ways.

So now I really want and need to know if A round investors make a practice of crushing convertible note investors like this, or if this is an echo of deals done after the dotcom crash?  Were the entrepreneurs poorly advised by their law firm? Or are Angels just fodder for follow on investors?


Quick Hits

H.R.4213 American Jobs and Closing Tax Loopholes Act of 2010: The House of Representatives is taking another shot at taxing Carried Interest as regular income.  I don't see why this is controversial.  Carried Interest is not Capital Gains.  If you want Capital Gains tax treatment, you should have actual Capital at risk.  Trying to argue otherwise is disingenuous.

I'll be at the Angel Bootcamp in Boston on June1.  It doesn't sound like a regular bootcamp; it starts at noon instead of 4am and I don't expect to have to do any pushups.

Angel Renaissance at Nantucket Conference 2010

I just returned from the 2010 Nantucket Conference. The prevailing theme was that the "traditional" model of venture capital does not work for software any more, and this creates a golden age for angel investing.

In the 90's, you needed millions to get a software company to market. Today, software startups might need 5 figures to prove a market, 6 figures to launch the 1.0 version. On the other hand, software startups do require a lot of operational help. Traditional VC firms have an impedance mismatch for software startups: they don't need the large amounts of capital that VC firms need to deploy. And since they don't need the capital, a VC partner cannot justify making a large investment of time. So angels (and small vc funds) can step into this void. Angels can invest 5 figures in a true seed round to prove the market, and can spend the time required to provide operational guidance to the team. The challenge for angels (besides coughing up the cash) is picking winners, and cultivating your picks. This was the basic message at a number of panels and side conversations. There is also an angel bootcamp in a month that will hopefully help grow the population of potential angel investors.

A critique of this message is that it doesn't address the concerns of angels. It's all well and good to talk about how angels should take a chance on young entrepreneurs, and how entrepreneurship is our best chance to avoid economic decline in the US. But, unlike a VC, an angel's concerns in priority order are (1) not losing money, (2) making money, and (3) everything else. So angels will tend to be more cautious investors: there is no pressure to deploy capital, there is the normal human loss avoidance behavior, and once you've made your money it's easier to shrug off opportunity loss. So while the community organizing efforts may grow the population of investors, I don't think we should expect that this will make it easier for entrepreneurs to raise capital.

Nor should we want it to. Based on my short experience as an angel, the problem is not enough good ideas and good teams. Northeast Angels gets dozens of submissions per month on Angelsoft. Most of these are weak ideas that are not suitable for investment. Some are good ideas with a good but inexperienced team. I suppose this is the area where a larger population of angels can have the most impact on the economy.

Best (paraphrased) quote from the conference: the participation trophy for life is called a tombstone. (Jason Calacanis via skype)