I’ve given this talk at various Techstars programs quite a few times now, and most recently gave it in L.A. at our awesome Healthcare Accelerator in partnership with Cedars-Sinai. I always do this talk off-the-cuff (no slides) to keep it interactive. You won’t find my talk online anywhere, so I’m excited to share some of the key points for the first time here.
Founders are often given valid but over-simplified advice when it comes to debt financing. Some of the “mostly true” points include; debt rounds cost less from a legal standpoint, that you can negotiate a high conversion cap (implicit next round valuation target) than are priced equity rounds, and you can raise money progressively (one investor at a time).
All of this is often true. Debt rounds can be easier and can also keep costs down for all parties involved. That’s why I’ve often heard it said: “If you don’t know what to do just raise debt”, or “if you don’t want to price your company, just raise debt.” Venture Deals does a great job of discussing these dynamics in more detail.
Don’t get me wrong, I’m not here to say debt rounds are bad news. At all. All I’m saying is avoid raising two (or more!) debt rounds in a row.
Instead, sandwich debt between equity so the debt won’t come back to haunt your company later.
Why Sandwich Your Debt?
Your cap table can end up like a sandwich with too many condiments stacked on top of each other. We all know what happens, and only about ½ the sandwich ends up in your mouth!
Debt rounds become problematic because each round of debt comes with its own discount, it’s own conversion cap, and other rights/terms. It becomes particularly complex if one of the rounds has a low conversion cap and the next has a higher one. The cap table math gets complicated, the founder/common dilution gets significant, and the new money investors end up with less ownership than they are looking for.
All of this has to be sorted out by legal or the VCs, messaged to the existing investors, and managed by the lawyers in papering the round. This causes problems for everyone, and some investors will just walk because the deal becomes complicated.
The early investor sometimes get asked move the cap up, and no one feels good about that move. I often remind founders that $1.00 isn’t actually $1.00 with debt, it’s either a $1.25 (remember the 20% discount & interest) or more like $1.50+ if your next round is well above the cap.
It’s good to go in eyes open and to realize that stacking debt means the discounts, the interest, and the cap all end up driving up the actual dollar leverage to the investor and the company sells more equity in the round but gets no additional net-new capital to spend from it.
When you sandwich your debt between equity rounds you are mitigating the risk of the next equity round toppling over due to complexity or having to do a massive amount of negotiating with both old and new investors and having the dilution get out of control.
Real World Example
One company I worked with had 3 different note rounds with escalating caps and discounts (1M/50%, 2M/20%, 3M/20%). The 1M cap round was the 1st money in and what a deal that was (for the investor)!
The timeframe across all of the 3 notes was ‘too short’; The 1M note was only 6 months from 3M — new investors felt the cap/discounts on the early notes were a ‘deal that never should have been done’ and there was friction from the get-go. Naturally the founders didn’t want to sell any more debt at that 1M/50% level.
Without a restructure of the early debt, it would have amounted to an approximate 5% additional dilution to founders when the priced round closed.
The early note holders were friends and family, but despite that, getting them to agree to changing the debt terms was very challenging. Who wants to give up the better deal they got for taking the early risk?
New investors have a range (ownership model) that keeps founder/early investor/new investor ratios balanced — the successive debt rounds painted the company into a corner where it was almost an impossible equation to solve for. It became messy — and almost killed the deal.
The company ended up renegotiating the 1M cap notes to 2M. This cost the CEO 80 hours of time, the co-founder another 60 hours, and a substantial legal bill. Let that sink in for a moment. The founders lost a good month of productivity on this.
Had they raised the 2nd/3rd round of notes as a priced round, the first round of notes would have been converted in early. The 1M note investors would have gotten a quick 2x on their investment and then owned equity. None of this process and extra dilution would have taken place. The company would have raised that seed round with a pre-money around the same valuation as the later note caps, so they would have also saved the 20% discount.
Avoid this kind of headache, and just eat a debt sandwich instead.
I recently moderated a panel discussion at CES 2016 on how to get from Seed to Series A and it ended up being great in a lot of ways. Topics were broad with some contrarian views on metrics and approaches. A few days later, a Techstars CEO posted a very relevant question on our email list and a great discussion ensued. I chimed in with some of the take-aways from the panel and thought I’d share them here.
A quick note of thanks to my esteemed panelists who provided great input and kept me on my toes! Anjula Acharia-Bath of Trinity Ventures, Nihal Mehta of ENIAC Ventures, Jenny Fielding of Techstars and Adam D’Augelli of True Ventures.
The question from the CEO was:
“In your experience, what ARR is required before approaching investors for a Series A? I’ve received a few suggestions, but most suggestions come from our existing investors (with bias).”
The email responses included some of the market-standard metrics like $100K MRR and double digit monthly growth as common targets.
Our panel went in a different direction on what it takes to get from Seed to Series A. Part of the framing for the panel and the room was:
“In Q4 the venture market started to shift (I hate to use the loaded term “correction”) and the volatility we’ve already seen in January suggests this trend will continue.”
While getting rounds done isn’t going to get any easier in 2016, there is a lot you can do before going out to raise to improve your chances. As a group, we could not agree there was set number, or even one set of criteria that made any Series A round a given…
- One of the themes that came out of the panel was that Series A is still about the overall story. Metrics do play a part, but the investors have to share the vision and the long term potential about a huge return at this stage.
- Related to the point above, make sure you know who you are talking to and and how they like to make investments. For example, if you are talking to Bessemer, a prolific Cloud/SaaS investor, make sure your metrics are tight and you know their portfolio. If you are approaching True Ventures, know that they like to lead/co-lead the 1st institutional round.
- One of my panelists thought that investor feedback of, “ your metrics aren’t quite there for a Series A” truly means “we just aren’t that excited but don’t want to say no yet.” A lot of VCs like to hold onto optionality by not saying no, but not saying yes either. In my experience a “no decision” is often a no and rarely changes. For what it’s worth, I got a lot of this with Filtrbox in 2009 when I was raising the A. I was at $70-80k MRR and growing just around 10% per month and was told, “if you were over $100k MRR this would be an easy round to do.” I think I heard this over a dozen times. We would have been at over 100k by the time the round closed. At the time this was super frustrating because investors were using it as a smokescreen and that option value. Had I been growing 20-30% M/M for 6 months, I think it would have been different. Note that 2009 was a very hard time to raise money, but the market is turning in that direction more than where we were in 1H 2015.
- Growth and solid G2M metrics are a bit of a proxy for gross MRR, but you have to have enough runtime with those numbers for investors to be comfortable they are real and will stick around. Two to three months of high growth might get the meeting, but everyone is going to want to see another chapter or two unless they fall in love with the business on the spot or have FOMO.
- The Series A crunch is real in that there are many seed-funded companies but not a commensurate growth in Series A funds out there — what this means is that rounds are going to be harder to get done and truly based on fit between the fund and the company. Do your VC research deeply and make sure they are a fit on paper so you don’t waste time.
- I heard anything from $50k MRR to $250k MRR for Series A on the panel. Not super helpful given the range but illustrates the dynamic a bit.
- Every investor will tell you to, “Have eighteen months of runway, be able to run at break-even, and it’s about survival if the market gets really bad,” – pretty vanilla and predictable advice, but the reason for it is investor risk-mitigation. If I fund a company’s A round and the sh*t hits the fan, I want to know we can batten down the hatches and ride it out without having to put in more money.
- “Build relationships, not pitches,” was discussed as well. The panel debated whether this was true for seed rounds vs. Series A. The gist of the debate was that many Series A round investment decisions can happen when the investor is in “advice mode” and the light bulb goes off.
Check out a recording of the full panel below:
If this is helpful and/or you have more questions about raising your Series A – let me know in the comments.
One of the challenges we face as Techstars continues to grow is maintaining an intimate network of relationships and fostering connections between our alums, mentors, sponsors, and investors. To be sure that we’re making the most of all opportunities, the Techstars alumni and staff come together at #FounderCon every year. Two weeks ago we had 300+ alumni founders in Chicago for our gathering, our biggest and best yet. We’re already heads down working on the agenda for next year.
#FounderCon 2013’s theme? Scaling Up. It was an incredible three days packed with networking, two tracks of lectures to attend in different rooms (business and technical), business development introductions to major brands like Bing, LG Electronics, Barclays, Motorola, Target, and more. Special guests included Jason Calacanis, Jason Fried, Tim Sanders, David Grove, Jamie Cooper, and many others . We announced a partnership with CareerBuilder for a new talent network to help our portfolio companies hire faster.
Here’s a sneak peek at what went down in the Windy City. A huge thanks to Megan Sweeney, our talented videographer, for making sure we gathered all the evidence.