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Convertible and SAFE notes

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Re: Convertible and SAFE notes

#21
post #10

I really really dislike when VCs make a pro-investor claim and try to hide it in founder-friendly terms. Priced rounds are great for VCs because they remove all their risk. But they don't remove any founder risk. Do a down-round after a priced round and you'll wish you were just taking more dilution from a SAFE. > "1. They defer the issue of dilution until a later date". When the company is doing well, notes allow fo…

Also the biggest issue - it defers the question of valuation. That is a huge thing in pre-product/pre-traction stages when valuation is what you believe in.

99% of first time entrepreneurs have a simple question - "how do you value an idea, an early stage startup": It completely eliminates this question.

Re: Convertible and SAFE notes

#22
post #16

> They defer the issue of valuation and, more importantly, dilution That's what the cap if for. If the founder is 19 years old, fine, read a book on it (I recommend this: https://www.amazon.com/Funded-Entrepreneurs-Guide-Raising-Fi... but basically any will do) but angel investors that don't know what caps are are dumb angels. > They obfuscate the amount of dilution the founder(s) is taking. Also what a cap is for. U…

> The first convertible or SAFE note issued in a company should have a cap on the total amount of notes than can be issued. A number like $1mm or max $2mm sounds right to me. By "cap" in this context, I believe he's referring to the aggregate amount of convertible notes.

Ah, nice catch. In that case I generally agree with him.

Re: Convertible and SAFE notes

#23
post #6

It's really not that hard to understand how these notes convert and how much you are diluting if you spend just a few minutes modeling it out with https://angelcalc.com Of course it's still possible to get more dilution than expected if you raise at unrealistically high caps (or uncapped!) and convert at a lower valuation down the road, but even that is probably less painful than a conventional down round.

Agreed. We walked all our angels through a 3 scenario (low, goal, home-run) Series A pre-money valuation analysis using a calculator. Bit overwhelming for some but everyone appreciated the effort. The biggest benefits of the note structure to us were a) Rolling close b) Not wasting time debating "valuation" when neither us nor the angels were capable of estimating a number with limited to no data.

How does a safe prevent you from debating valuation? It seems like a safe note with no discount is rarely a good deal unless you hit the valuation cap (why not just wait until A otherwise?), and if you do hit the cap it's essentially equivalent to investing in a round priced at the cap (a little worse due to preference caps).

In what way is the cap not a "valuation"?

Re: Convertible and SAFE notes

#24

Earlier quoted context omitted.

Agreed. We walked all our angels through a 3 scenario (low, goal, home-run) Series A pre-money valuation analysis using a calculator. Bit overwhelming for some but everyone appreciated the effort. The biggest benefits of the note structure to us were a) Rolling close b) Not wasting time debating "valuation" when neither us nor the angels were capable of estimating a number with limited to no data.

How does a safe prevent you from debating valuation? It seems like a safe note with no discount is rarely a good deal unless you hit the valuation cap (why not just wait until A otherwise?), and if you do hit the cap it's essentially equivalent to investing in a round priced at the cap (a little worse due to preference caps). In what way is the cap not a "valuation"?

So we raised on a convertible note with a cap and a discount. We're from the east coast and our accessible angel pool balked at SAFEs. An argument for a different thread :-).

I'd defer to Paul's point that choosing a too high (or non-existent) cap makes no sense. We did have to negotiate our cap and we set it so that we had a realistic shot of hitting 2-3x that in Series A pre money which in my mind is why an angel should be investing. I'd personally consider it a disappointing outcome if I raised at my cap and I'd hope my investors would as well.

A cap is not a valuation and I agree that everyone thinking it is, is a problem.

Re: Convertible and SAFE notes

#25

Earlier quoted context omitted.

Agreed. We walked all our angels through a 3 scenario (low, goal, home-run) Series A pre-money valuation analysis using a calculator. Bit overwhelming for some but everyone appreciated the effort. The biggest benefits of the note structure to us were a) Rolling close b) Not wasting time debating "valuation" when neither us nor the angels were capable of estimating a number with limited to no data.

How does a safe prevent you from debating valuation? It seems like a safe note with no discount is rarely a good deal unless you hit the valuation cap (why not just wait until A otherwise?), and if you do hit the cap it's essentially equivalent to investing in a round priced at the cap (a little worse due to preference caps). In what way is the cap not a "valuation"?

The argument for a seed investor to invest in a SAFE note with no discount and no cap is that the Series A round will be priced by a VC or superangel, and the seed investor will not otherwise have the opportunity to invest at that later point. That is, the seed investor is trading the opportunity to participate in an investment at all for control over the exact terms. But since neither the entrepreneur nor the seed investor have any idea what a pre-revenue company is worth, they're often fine delaying the valuation question.

Re: Convertible and SAFE notes

#26

Earlier quoted context omitted.

Agreed. We walked all our angels through a 3 scenario (low, goal, home-run) Series A pre-money valuation analysis using a calculator. Bit overwhelming for some but everyone appreciated the effort. The biggest benefits of the note structure to us were a) Rolling close b) Not wasting time debating "valuation" when neither us nor the angels were capable of estimating a number with limited to no data.

How does a safe prevent you from debating valuation? It seems like a safe note with no discount is rarely a good deal unless you hit the valuation cap (why not just wait until A otherwise?), and if you do hit the cap it's essentially equivalent to investing in a round priced at the cap (a little worse due to preference caps). In what way is the cap not a "valuation"?

>> why not just wait until A otherwise

1) For a VC: more performance info / better access to the A.

2) For an angel: most angels won't have access to the A, so seed rounds are their chance to invest early in a potentially VC track company.

Re: Convertible and SAFE notes

#27
post #3

This article assumes naive founders and doesn't mention the many situations wherein convertible notes and (especially) SAFEs are very advantageous to the founders. I wonder which situation is more common?

It's even funnier: SAFE notes are very advantageous to naive founders as well...

Re: Convertible and SAFE notes

#28
Maybe these endless rounds of financing even when the company is selling product aren't such a good idea. The result is often a chicken run for the bankruptcy cliff. Can you buy dominant market share before the investment money runs out?

Looking at you, Uber.

Re: Convertible and SAFE notes

#29
post #10

I really really dislike when VCs make a pro-investor claim and try to hide it in founder-friendly terms. Priced rounds are great for VCs because they remove all their risk. But they don't remove any founder risk. Do a down-round after a priced round and you'll wish you were just taking more dilution from a SAFE. > "1. They defer the issue of dilution until a later date". When the company is doing well, notes allow fo…

Also the biggest issue - it defers the question of valuation. That is a huge thing in pre-product/pre-traction stages when valuation is what you believe in. 99% of first time entrepreneurs have a simple question - "how do you value an idea, an early stage startup": It completely eliminates this question.

There should be better ways to know how to "value an idea.". I believe that there are better ways, that the VC-startup world does poorly there with biggie costs on the both sides of the table, that there are some good examples of the ways, and that, really, we are awash in both how to do this and examples.

First, we start with evaluating ideas. Gee, guys, the research community does that many times daily. A researcher who pursues dumb ideas in a few years is known as a poor researcher. So, good researchers know how to evaluate ideas.

The researcher's superiors, the proposal reviewers, and the funding agencies also all know how to evaluate ideas and where here the ideas are just research directions with the ideas not really formed yet.

Moreover, for publication in peer reviewed journals of original research, the standard criteria for evaluating the ideas in a paper are "new, correct, and significant", and these criteria get applied with good accuracy.

Moreover, for a Ph.D., one way to evaluate the work is "an original contribution to knowledge worth of publication." And, before a Ph.D. student starts their research, they and usually also their faculty advisers have to evaluate the research direction, even before a solid idea.

The US NSF, NIH, DARPA, ONR, etc. are also quite good at evaluating research directions well before a finished idea.

Of course we can evaluate ideas, especially ideas already polished and ready for publication and also finished, polished ideas already implemented in solid, running code.

Then, sure, that evaluation does not necessarily lead to business success, that is, traction, revenue, earnings, money in the bank, an a good ROI and exit for investors. Right.

But, wait, there's more!

Second, here's a severe way to evaluate such a polished idea ready or nearly so to go for first traction: Or, with the running software, can see that it works. Now the severe question is, "Is that software a must have solution with enough users/customers and revenue per each to make the big bucks or is that software just a nice to have and/or for just a niche?" And we will want to know about barriers to entry, scalability, etc. Doing well on these criteria should be darned good signs.

Apparently instead the VC community wants to judge based almost entirely on traction and rate of growth in traction. Yes, that's hard headed; it's also dumb headed, ignoring important information.

Some businesses do quite well with new ideas:

Xerox did well with the research direction of electro-static photocopying -- from just the research direction through creating a major company.

At each smaller step in line width, Intel does well. Who would have believed 1 billion transistors on a postage stamp with line width 14 nm?

The pharmaceutical companies that do original research make their money on picking good research directions and then doing good research.

And may I have the envelope, please [drum roll]! The all-time, unchallenged, unique world-class, grand champion of going from mere research directions to world changing results is the US DoD. Second and third places are occupied by the NSF and NIH. Intel, some of the pharmaceutical companies, and more are also on the award stage. VCs need to start learning up from those examples.

The VC approach would have been, "You build and test the first one, and we will chip in for the gasoline for the Enola Gay."

Instead, IIRC from books of Richard Rhodes, the Manhattan Project cost ballpark $3 billion in 1940's dollars.

Okay, big, expensive waste just from war time, right? Maybe not: Let's divide $3 billion by one million -- right, even without a super-computer, that's $1000.

And the relevance? The estimates were that a US invasion of the home islands of Japan would cost the US 1 million casualties. Given the experience at Okinawa, Iwo Jima, etc., the 1 million was believable. So, the Manhattan Project saved expected 1 million casualties at, right, from the arithmetic, $3000 per casualty. Grand bargain just from the money alone! If your father, son, brother, uncle, etc. were one of those casualties, then you would have regarded the $3000 as a grand bargain.

And the Manhattan project spent money like it was worthless -- cost no object or concern. Good ideas are like that.

Re: Convertible and SAFE notes

#30
(I'm a seed-stage VC, but as a caveat I'm not an expert when it comes to cap tables.)

He's an example of where having many notes can hurt founders:

- Raise $2m at an $8m cap, 15% discount.

- Raise $2m at an $18m cap, 15% discount.

- Raise $2m at a $28m cap, 15% discount.

- Sell 20% of company for $X in the Series A.

Caps are "sort of" like pre-money valuations, so the founder might expect that their dilution from the 3 notes is approximately 2/10 + 2/20 + 2/30 = 36.7%

Here's what actually happens in 4 different scenarios:

1) Raise $10m at a $40m pre. Dilution from the notes is 20.0 + 8.9 + 5.7 = 34.6%

2) Raise $7.5m at a $30m pre. Dilution from the notes is 20.0 + 8.9 + 6.3 = 35.2%

3) Raise $5.0m at a $20m pre. Dilution from the notes is 20.0 + 9.4 + 9.4 = 38.8%

4) Raise $4.0m at a $16m pre. Dilution from the notes is 20.0 + 11.8 + 11.8 = 43.6%

For the founder, #1 and #2 are better than expected, #3 and #4 are worse. It's not hard to get into situation #3 or #4 if you raise money from strategic investors or angels at high caps, and then Series A investors drive your price down below your most recent caps because that's where the market is. The 9% dilution difference between the first and last scenarios is fairly dramatic. When you combine that with the 20% dilution from the Series A, it's the difference between founders and employees having ~45% of the company vs ~36% of the company.

(Source of calculations: https://captable.io/company/8/convertible-notes/calculator)

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