# How does Convertible Debt work?

Let’s start by understanding that because we are talking about something called “Convertible Debt”, it means that whatever it is will start out as one thing, and potentially convert (or “change”) into something else. In this case, what the investor receives in exchange for his or her cash starts out as debt, and potentially converts into equity.

Debt is a fancy word for a “loan”. That is, I lend you money, and you agree to pay back the money that I loaned you at some known point in the future, along with a specific additional amount of money (called “interest”) which is your payment to me for having been willing to loan you money in the first place.

Equity is a fancy word for “ownership”. That is, I give you money and you give me part ownership of the company. Because I’m now an owner right alongside you, you don’t ever have to pay back the money to me (remember, it wasn’t a loan), and even if the company goes broke you still won’t owe me a penny. HOWEVER, also because I’m now an owner right alongside you, I get my share of any increase in value that ever happens with the company.

The difference here is that debt results in a fixed payback regardless of whether good things or bad things happen to the company, while equity results in completely variable payback from \$0 (if the company goes under) to potentially billions of dollars (if the company ends up being worth a lot of money.)

The key functional aspect of these two very different things is that if I’m putting, say \$100,000 into your company as debt, the only thing we need to discuss is the interest rate that you’ll pay me for using my money until you pay it back. But if I’m putting it in as equity, then we need to decide what percentage of the company’s ownership I will end up with in exchange for my investment. To figure that out, we use the following math equation:

[Amount I'm Investing] ÷ [Company Value] = [Percent Ownership]

Therefore, since we can calculate any one of the three terms if we know the remaining two, and we already know how much I’m investing (remember, we said \$100,000), in order to figure out what my ownership percentage will be after the investment, you and I need to agree on a way to figure out what the company valuation is (or will be) at the time I purchase my shares of stock.

So, if I were just going to buy stock in your company today, we would agree on a valuation today, I’d give you the money today, you’d give me the appropriate percentage of the company’s stock, and we’d be all set. But that’s NOT what we’re doing.

Instead, I’m loaning you the money today (for which, as you’ll recall, there is no need to set a valuation on the company). HOWEVER, since I really don’t want only my money back plus a little interest (heck, I can get that just by putting my money in a bank account, instead of into a very risky startup), we agree that at some point in the future I will be able to convert my loan into the equivalent of cash, and use that money to buy stock in the company.

But because that conversion is going to be happening at some point in the future, while I’m giving you the money today, we need to figure out a few things today, before I am willing to give you the money. Specifically, we need to decide (a) when in the future the debt will convert to equity, and (b) how we will decide the valuation of the company at that point in the future.

The answer to both turns out to be the same thing: we will wait until a richer, more experienced investor comes around and agrees to buy equity in the company. At that point we will convert the debt into equity(a) and we will use as the valuation whatever that other investor is using(b). However, the fact is that I was willing to invest in your company at a time when that other big shot investor was not, and you used my investment to make the company a lot more valuable (and therefore got a high valuation from the other investor) so it doesn’t seem fair that I should bear the early stage risk, but get the same reward as a later stage investor, right?

We solve this problem by agreeing that I will get a discount (typically anywhere from 10% to 30%) to whatever the other investor sets the valuation at…which is why we call this a Discounted Convertible Note.

But you know what? Although that sounds fair, it really isn’t  (or at least serious investors don’t think it is.) That’s because the more successful you are at using my original money to increase the value of the company, the higher the valuation the next guy will have to pay…and pretty soon the little discount I’m getting doesn’t seem so fair after all! For instance, if that same big shot investor would have valued your company in the early days at, say \$1 million, but is eventually willing to invest in you at a valuation of, say, \$5 million, that means you were able to increase the company’s value 500% using my original seed money.

But if my convertible note says that it will convert at only a 20% discount to that \$5 million, for example (which, if you do the math, is \$4 million), I would seem to have made a very, very bad deal! Why? Because I end up paying for your stock based on a \$4 million valuation, instead of the \$1 million it was worth in its early days when i was willing to make my risky investment! No fair!

So how do we solve this problem? What we do is say “OK, because I’m investing early, I’ll get the 20% discount on whatever valuation the next guy gives you…BUT just to be sure that things don’t get crazy, we will also say that regardless of whatever crazy valuation HE is willing to give you, in no case will the valuation at which MY debt converts ever be higher than, say, \$1 million.” That figure is known as the “cap”, because it establishes the highest price at which my debt can ever convert to equity.

And that is why we call this form of investment (which these days is used by most angel investors) a Discounted Convertible Note with a Cap.

*original post can be found on Quora @ : http://www.quora.com/David-S-Rose/answers *

# Convertible Debt: Worst Form Of Seed Financing — Except For All The Others

How to finance a new seed-stage startup?  Equity?  Convertible debt?  Convertible equity?

As of August 2010, Paul Graham famously proclaimed, “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”  Yet in my little corner of Wonksville, Founder Institute CEO Adeo Ressi and Yoichiro “Yokum” Taku, a partner at my “alma mater” law firm Wilson Sonsini Goodrich & Rosati, created quite a stir this past week by announcing a new set of template deal documents dubbed “Convertible Equity.”  Ressi in particular seems to be passionate about removing the “debt” component from convertible debt seed financing transactions.  For a good summary with links to the documents, see Leena Rao’s post at TechCrunch.  The whole episode has reopened a broader discussion about the virtues and vices of each variety of seed financing, as exemplified by Mark Suster’s most recent post on the subject. Read more

September 5th, 2012

# For a Startup, Two Heads are Always Better Than One

Sergey Bin and Larry Page image via Wikipedia for Google

If you are a first-time entrepreneur, I recommend that you team with a co-founder with experiences, connections, and a skill set that complements, but doesn’t duplicate yours. Even experienced entrepreneurs need a partner to back up each other and improve fundability. The question is how to find that elusive perfect-fit partner.

First, I will admit there is no magic formula here, just like in real life when trying to find a relationship partner. But from my own experience, and input from others, there are useful approaches that will improve your odds of success: Read more

September 2nd, 2012

# What do investors consider the most important aspect of a potential deal?

Characteristics of the Entrepreneur
Integrity, Passion, Startup Experience, Domain Expertise, Functional Skills, Leadership, Commitment, Vision, Pragmatism, Flexibility, Personality

Characteristics of the Venture
Team, Business Model, Traction, Customer Acquisition, Scalability, Defensibiity, Capital Efficiency, Churn, Time to Breakeven, Exit Strategy

Characteristics of the Market
Size, Growth, Concentration, Geography, Demographics, Competition, Channels, Regulatory Environment, Technological Developments, Adjacent Markets,

Characteristics of the Deal
Valuation, Size of Raise, Amount of Investment, Form of Investment, Liquidation Waterfall, Option Pool, Board Composition, Anti-Dilution Rights, Protective Provisions, Founder Vesting,

*original post can be found on Quora @ : http://www.quora.com/David-S-Rose/answers *

# 3 Essentials for Selling Your Marketing Plan to Investors

Somebody asked me in email what investors look for in the marketing portion of a business plan and/or business pitch. What works? What’s credible? What are investors looking for?

Caveat: generalizations are dangerous. And I’m generalizing here from what I’ve seen in the three dozen or so pitches and plans I’m exposed to in a year, plus my discussions with other angel investors in my group, and investors I meet as fellow judges in business plan competitions.

I see three essentials:

1. The market-defining story

The market defining story explains the need, or want, or why-to-buy factor, defines the target customer, leads to credible market numbers, generates the marketing messages, and communicates a market to investors, so that they can visualize it, and sense it’s potential, in their own imagination. I have a commented example here. It’s a story that makes product-market fit come alive. Investors don’t want to be force fed large numbers for potential market; they want to be able to imagine the numbers for themselves.

2. Believable  paths, triggers, and channels

If and only if that potential market seems to come alive, it needs credible plans to move from ideas and messages into media and concrete marketing programs with some backbone and metrics to them.

Nobody buys the hand waving at “online marketing” and “we’re going to be big in social media” anymore. For online marketing, as a common example, you should be able to talk realistically about your search engine budget, pay-per-click budget, social media experts on staff or available as contractors and budgeted into the plan, targets for page views, unique visitors, and conversions. You should be able to explain your Facebook, Twitter, and/or LinkedIn, and/or Pinterest or other social media plans in terms of numbers such as follows and followers, tweets and retweets, topics, engagements, likes, and so forth.

For physical products supposedly moving through channels, you need to show that you understand the margins through channels, the difficulty in getting through distributors with new products if that’s relevant, the process for getting accepted, and what it takes in push or pull marketing to get sell-through in channels.

For business-to-business and direct selling, be able to show that you understand the expenses involved and the sales cycle selling to large organizations.

Not all of these details need to go into the pitch with slides; but they should be in your plan, and you should be able to pull them up in an instant when asked, during a pitch, for more detail.

3. Defensibility

Investors will be thinking, as they watch your pitch or read your plan, about how easily some future competitor can jump into your marketing plans, co-opt your tag lines, jump on your topics, pre-empt your channels, and use your own marketing against you. Don’t trust trademark or copyright to defend you by themselves. A brilliant marketing plan that others can easily jump on isn’t as interesting as a good marketing plan that’s exclusive and defensible.

Conclusion: These are necessary but not sufficient conditions. Looking good on all three doesn’t guarantee anything, but looking less than good on any one of them is going to hurt your prospects to attract investors.

August 29th, 2012

# The Unwritten Secrets for Choosing a Startup Mentor

Every first-time entrepreneur, or even an experienced founder stepping into a new business area, needs a mentor. Nothing you have ever done raises so many questions, or has the potential to be so fulfilling, or so risky, as starting a new business for the first time. A mentor is a confidant who has been there and done that, and is willing to guide your steps.

In case you think mentors are only for “wimps,” you should know that most great entrepreneurs are quick to give credit to their mentors. Bill Gates always revered the early guidance he received from Dr. Ed Roberts, creator of the Altair 8800. Later, the great Warren Buffet became his mentor on many corporate matters.

In a reverse fashion, most of the recognized business gurus always found time to be a mentor. For a fortunate, surprisingly large club of CEOs, the late Peter F. Drucker was the single most lucid, eloquent, and encouraging force in their lives. With experts like this willing to help for free, why should you be the one to go it alone?

The best mentor candidates are the most experienced professionals you admire, and from whom you can learn, to accelerate your progress and avoid the deep potholes in the road ahead. Martin Yate, in his recent book “Knock ‘em Dead – Secrets and Strategies for Success in an Uncertain World” succinctly outlines the key criteria for choosing mentors:

• Mentoring is not a group activity. Mentors are not like lovers. You can have more than one at a time. But my advice is to start with one, or certainly no more than one in an area of expertise. It could make sense to have a business mentor, as well as a technology mentor, but a committee of your friends won’t work.
• The best mentors are older than you. Although age and wisdom don’t always go together, it is better to find a mentor older than you, because they will have skills you don’t and the wisdom of greater experience. You need both.
• Let the relationship develop naturally, over time. Mentor relationships, like any other human relationship, don’t happen overnight, and need to be nurtured on a person-to-person basis, rather than remotely or anonymously. The best mentors will even introduce you to their support network, which can multiply the value.
• The mentor should not have a direct reporting relationship with the protégé. The protégé should be able to feel free to speak about issues which may be plaguing him without fear of repercussions from a major board member, investor or boss.
• The mentor must be committed to being a mentor. Mentoring is an incredibly important responsibility. If the mentor does not want this responsibility, he will view the time spent mentoring as a nuisance. Being committed means being available, listening well, and able to keep confidences.
• Find someone who will tell it straight. Telling it straight means having direct discussions that are constructive, respectful, and specific. Both sides need the courage to stop if the relationship isn’t working. Life is too short to waste their time or yours. In this context, it’s also important to find someone who matches your values.

Remember that a good mentor doesn’t relieve you of any responsibility in running your business. Be aggressive and take charge of your own decisions. Don’t expect the mentor to do the work for you, or even the research required to get a job done. In other words, don’t abuse the mentor, by asking them to be your boss, or respond to every thought that pops into your head.

In business as in life, the smartest people are the ones who know they don’t know it all. But smart people learn quickly. Not far down the road, you will be ready to mentor entrepreneurs who are where you were only a year or two ago. You then become a contributor to business leadership in the same way your mentor was to you. That’s value squared.

August 26th, 2012

# Is it common for startups to have a president? Why or why not?

Startups usually begin with one or two founders who play many roles. The lead founder is likely to wear the hats of Founder, Chairman, CEO, President, CFO, CRO and CMO, while a co-founder may well be CTO, Chief Product Officer, and Programming Team Lead.

As the company grows and brings on more people, even in cases where everyone wants to keep the organization ‘flat’, it simply becomes too unwieldy for the CEO to have more than six or so direct reports, or for the CTO to both code everything personally AND design/plan the product line AND be involved at the larger, strategic level. So as more skills are needed, the founder(s) tend to spread out the responsibilities, pushing responsibility down the chain to newly hired CFOs, CMOs, etc.

The “President” role would typically not appear as an independent title until sometime post-Series A, when the CEO may be supervising a team of four to six CXOs while at the same time being the primary ‘outside’ person speaking for the company, dealing with investors and handling long-term strategy. At that point, it would not be at all unusual for the CEO and the board to agree that it makes sense to bring on a President (often with the added title of “Chief Operating Officer”) to handle most or all of the direct reports internally, while the CEO focuses on the Big Vision, the outward-facing relationships, and the company culture.

In virtually all cases of which I am aware, the President reports to the CEO, who in turn reports to the board. It would not be at all unusual, however, for the President to have his/her own seat on the Board as well.

*original post can be found on Quora @ : http://www.quora.com/David-S-Rose/answers *