Yesterday I was a judge at the Northeast Regional Finals of the Venture Capital Investment Competition, featuring teams of MBAs from some pretty fancy schools. The big idea is that the MBAs form imaginary VC firms, look at real startups, and get judged on how they handle due diligence, investment structures, etc. So it’s the MBA “investors,” not the startups, who are being judged. Needless to say, we heard lots of great insights and ideas from the teams; but there were also several teachable moments that we’ll examine in this and future posts.The most surprising area of confusion concerned “next round notes” or “convertible notes.” These are the loans early stage investors make to startups on the premise that the principle will convert into equity in a later, institutional investment round… but at a predetermined discount to the value the institutional investors set. It’s become a very common way to fund the earliest rounds, because, obviously, it kicks the difficult valuation can down the road until more is known, and circumvents other contentious issues as well.
One extremely surprising mistake two teams made was to ascribe negotiating value to the “note” feature because it purportedly affords superior investment protection, as compared to common stock, in the startup. Of course, creditors are indeed superior to equity holders during liquidation; but who cares if you’re first in line to recover money from a bankrupt startup? First and last will get the same thing: zero. Extraordinary cases aside, next round notes do not afford enough practical extra investment protection to justify the investor “giving” on other open negotiation points.
The second surprise was that the teams failed to negotiate valuation caps for the next round. (Here is a great explanation of valuation caps). If you don’t do that, you could be kicking yourself when the company becomes highly successful and raises a huge up round. Now, sure, you have your equity at a discount as compared to the institution; but you also own only a tiny portion of the company’s stock and haven’t been properly compensated for your risk. It was odd to hear the “VCs” argue, on the one hand, how much upside their target company had; but, on the other, fail to structure their investment accordingly.
And the third mistake the team made in negotiating their next round notes was simply not getting enough of a discount: two teams accepted 10%. That is simply not enough to compensate the early investors for the huge additional risk they’re taking … 20 or 30% is much more like it. In fact, if someone offers you a 10% discount on a Next Round Note, just change the order of the words and ask them to send you a note when they get to the next round. A 10% premium is nothing compared to the value you get from avoiding the risk and having the use of funds in the interim.