Pre-COVID-19, I told someone that I did not like SAFEs and convertible notes. I wish I could find that person now; I would assume a little more credence. Regardless, for what it’s worth, I didn’t like convertible debt or SAFEs before COVID-19. Now, I really don’t like them.
I did not like them pre-COVID-19 for a myriad of reasons: issues concerning a lack of clarity when notes get stacked; issues concerning calculation of options upon conversion; difficulty calculating the cap table when using; issues concerning the cap acting as too big a liquidity preference; issues around pre- and post-money calculations on conversion; and issues concerning the cap affecting later rounds. It amazes me how many issues surround a now fairly prevalent financing instrument, but I guess it is what it is.
I do not like them now because both convertible debt and notes are based on the assumption that upon the achievement of certain milestones (either explicitly stated or part of the deal), a larger investor — typically an institutional investor — will come in and set a price for the round and have the notes converted. Two assumptions are inherent here. First: the company will reach a level that will merit the investment. The investor’s job is to price the risk in having that happen. The second assumption is that a larger institutional VC will come in and value the company. This later assumption is in question in this new era. Because we do not yet fully understand the effects COVID-19 will have on investing, the second assumption is not fully understood. Thus, a layer of complexity and risk is added to the equation. Obviously, additional risk is never helpful. Worse for the founders: this risk is outside their control; they can do everything right, and if the financing market does not work, their notes will not work.
While I expect venture capital to survive, I do expect changes. It’s interesting to speculate but impossible to accurately forecast what changes are to come for the VC world. I expect a more intense focus on basic economics, but that is just speculation. In the next 3-12 months, the looking glass may become more clear. However, in the back of every investor’s mind is the thought I wonder if they will ever get to a “qualified financings” because I have no clue anymore how a qualified financing will get done.
So what to do? In my family, we have a rule that if you nix the restaurant that’s offered as a choice for dinner, you have to suggest an alternative. In that spirit, let me suggest the following:
- Price the round;
- Use a low-interest note coupled with common to serve as a preference and achieve a lower valuation (and less early stage dilution);
- Use a royalty agreement or shared earnings agreement (see previous blog for links); or
- Some combination thereof.
My main point, though: don’t base your company’s or your portfolio’s financing on an external force over which you have no control.