Angel/Seed Investments Andrew Thornborrow – BlueRun Ventures February 17, 2011
Why Seed? - Supply
Product Build – Consumer internet / mobile startup costs have decreased substantially (Open Source, Cloud-based, Short development cycle).
Customer Acquisition – Enormous distribution channels via search (Google), social (Facebook / Twitter) and mobile (iPhone / Android) platforms.
Result – Tons of new companies being formed. $500K goes a loooong way (at least initially).
Why Seed? - Demand
Incubators / Accelerators
SSE Labs (Stanford)
DreamIT Ventures (Philly)
First Growth Venture Network (NYC)
Individual Angels – AngelList
Super Angels / Seed Investors
Floodgate (Mike Maples)
Felicis Ventures (Aydin Senkut)
500 Startups (Dave McClure)
SofTech VC (Jeff Clavier)
SV Angel (Ron Conway)
Harrison Metal (Michael Dearing)
Lowercase Capital (Chris Sacca)
First Round Capital
Series A Light (Series 1, AA, Seed, A’)
Traditional Series A
“ 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.”
- Paul Graham (Y Combinator), August 2010
“ I have been doing venture capital for 25 years now and have also done many angel investments personally along with my wife. We have never done a convertible debt round…. I don't like convertible debt for a host of reasons. It used to be that convertible debt was a lot easier and cheaper to do legally. But with non-negotiated ‘light series A docs’ from most top venture law firms out there, you can do a Series A Preferred for less than $5000…. I am a sophisticated investor. I do this for a living. I can negotiate a fair price with an entrepreneur in five minutes and have done that for a seed/angel round many times.”
- Fred Wilson (Union Square Ventures), August 2010
“ Have convertible notes really won? And if so is that good for start-ups? Good for investors? I think the answers to these questions are that 1) it’s not at all clear that this trend is as definitive as Graham suggests; 2) it’s a mixed bag for entrepreneurs (more positive in the short run, potentially negative in the long term); and 3) it’s clearly not a positive trend for early-stage investors.”
- Seth Levine (Foundry Group), August 2010
“ Best for seed is convert w/ cap (*need* cap). Gives investors economic rights but not control rights and keeps legal fees down.” “The only advantage of equity over convert w/ cap is investor control, which you don't want/need. Let great people do their thing.”
- Chris Dixon (Hunch; Founder Collective), August 2010
Amount - $50k-$750k
Discounts and valuation caps (converts at lower of X% discount or $Y million valuation – valuation cap may increase for subsequent closings); Warrant coverage
Discount shares as common vs. preferred (liq pref kicker)
Automatic vs. Optional conversion (w/ majority control)
Seniority (no reference vs. senior to all future / no borrowing w/out lender consent)
Maturity – X date vs. closing of next round
If M&A prior to maturity/conversion, repayment multiple (2x-5x) or conversion to common at valuation cap
Participation right for next round (dollar denominated vs. right to get to X% post vs. other)
Interest – 0% to X%
Side Letters – observer rights, inspection / info rights, etc.
Protections against getting squeezed out of rights offered to lead investor in next round (e.g., “Major Investor” definition as tool to deprive noteholders of certain rights following conversion)
How option pool refresh is treated when calculating the valuation cap at time of next round (part of pre-money or post-money)
Series A Light - Just what it sounds like:
No Reg rights
No ROFR/Co-Sale rights (instead, no transfers w/out consent or assignment to investors of Company ROFR)
No Anti-dilution protection
Limited protective provisions
Minimal reps and warranties
No legal opinion
So What’s Better?
Depends (mostly on where you sit)…
Convertible Note :
Allows founder to build valuation / Avoid dilution so not upside down post seed financing, which arguably is bad for founder and future investors alike (valuation caps give investors protection).
Allows founder to delay control issues, which arguably don’t matter to investors at this stage but which are of much discussion currently among entrepreneurs.
“ Q: What’s the biggest mistake entrepreneurs make when they’re raising money? Entrepreneurs focus on valuation when they should be focusing on controlling the company through board control and limited protective provisions . Valuation is temporary, control is forever. For example, the valuation of your company is irrelevant if the board terminates you and you lose your unvested stock.” – Venture Hacks
Relatively less painful to get deal done – minimize back and forth / legal fees – so founders can spend more time on building the product.
Allows founder to work with an investor without being “married” to that investor.
Allows VCs to deploy capital quickly across a number of companies that they can spend time getting to know / developing relationship without Board/fiduciary obligations, etc.
Valuation caps that result in excessive discounts + liq pref kickers if discount shares are preferred -> bad for founder and new investors alike. Does discount go in pre-money? Should discount shares be common instead of preferred?
Lead investor in new round must decide whether should try to modify seed terms.
Result: 3-way negotiation (or 23-way negotiation if lots of seed investors) between founder – seed investor(s) – lead investor.
Signaling Issue – If seeded by VC, what if VC noteholder doesn’t follow?
Fix – Have more than 1 VC invest? What will the dynamics be post-closing? Will they work together or against each other?
Is Series A Light the Answer?
Convertible note structure can be more complicated than Series A Light given the extensive convertible note menu of items and interplay among them.
Convertible note with a valuation cap smells a lot like a priced round.
There is value to a founder (and early-stage investor) in locking in founder-friendly terms now (1x no participation, good vesting/acceleration, near-term/complete Board control, etc.) and then holding the line against new investors going forward.
Extremely competitive environment and many angels / super angels have adopted the convertible note structure (at least for now).
Founders increasingly focused on control (super voting rights, Board control, etc.), especially given lower-dollar M&A valuations and (mis?)perception that there will be misalignment between founders and VCs re acceptable exit values.
No agreement on what are essential Series A Light terms -> multiple forms of Series A Light docs:
TechStars Model Seed Funding Docs (Cooley)
Y Combinator Series AA Equity Financing Docs (WSGR)
Founders Institute Plain Preferred Term Sheet (WSGR)
Series Seed Financing Docs (Fenwick)
Other law firm form docs stripped down
Series A Light docs may not shave meaningful time off the traditional Series A process given terms omitted are often not (heavily / at all) negotiated anyway. Given those terms will need to be added back in Series A, may actually be more practical to just add now (and do a Series A).