I've been involved in several discussions lately on convertible debt financing for startups. First, I should reference some good posts out there. My former advisor, Brad Feld (Managing Director at Foundry Group), has a good post here ("What’s The Best Structure For A Pre-VC Investment?"). The Venture Hacks guys have a good overview here, "What are the benefits of debt in a seed round?"
Pretty much everyone is in agreement that convertible debt is ideal for entrepreneurs during their company's seed round. You don't give up equity at this point and the valuation of the convertible debt is pegged to the next round of financing, which should be your Series A.
Other entrepreneurs might need convertible debt in the form of a bridge loan to your next round of financing. A common situation for 2009 might be a startup needing a $1 million bridge loan as they try to close their Series B financing since they want to avoid shutting down their operations.
Prior to the economic meltdown, I would tell entrepreneurs for any seed investment under $1 million you have to push for convertible debt. Since $1 million is the new $10 million under today's environment, I would probably say negotiate this for only deals under $500,000. Maybe even $300,000 depending on what region or country you live in.
Also the standard terms have changed. From my experience and speaking with a couple attorneys at Wilson Sonsini, which is considered the top Silicon Valley law firm, a standard convertible debt deal would provide the investor 6% to 7% interest, 20% warrant coverage, and 2 to 3 year maturity date. After the economic meltdown, it seems more investors are asking for 8% interest, 20% to 40% warrant coverage, and a backstop provision.
The last item is the one to avoid. Some aggressive investors (conservative in selection but aggressive on terms), which are becoming more frequent in today's climate, are asking for backstop provisions. This sets a deadline for you to close your next round of financing. If you don't close, the debt provided will convert to equity based on your current round or an agreed upon valuation.
Your startup might already have seed capital or a Series A at a set valuation. The standard term for a backstop provision is one year. Let's say if you have $1 million in convertible debt, your company is valued at $3 million, and you don't close within the year time, then that $1 million is converted to equity at the $3 million valuation. You've given up a third of your company. Crap!
Some investors might even try to negotiate for a shorter duration, such as 6 months. Don't fall into this trap especially if you're already in discussions with your next round investors. Financing rounds take longer than you think. Sure if you're in the top 3% of all tech startups, then you can close within a month. Most rounds take 3 to 9 months. Today I would say it takes 6 months to over a year.
Just say "NO" to any backstop provision less than a year. I would suggest to negotiate the opposite if an investor insists on having a backstop provision. Push for 2 years due to the current financial environment, or just avoid the backstop provision all together.
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