The danger with convertible notes

by birtanpublished on October 27, 2020

This video was brought to you by Slidebean Founder's Edition. Get help from our team in your pitch deck, your financial models, and your fundraising. Sign up with the link in the description. Over the last few months, our advisors and  our legal team have been working tirelessly   to solve a terrible startup predicament  that nobody plans for: growth. Slow growth. And notice how, for any other  company, 'growth' means success,   but not for a venture-funded company:  this is a fundamental concept you have   to understand if you intend  to pursue venture capital. Let's draw a line between  startup success and startup   failure in the eyes of a venture capital  investor, in the eyes of Silicon Valley. On this side, we have failure. The company  goes out of business. Slightly better is   when the company's scraps get acqui-hired,  which probably doesn't pay investors back,   but at least it saves the tech  and gives part of the team a job. On this side, we have unicorn status: a  startup gets funded, and within a few years,   it reaches a billion-dollar valuation.  Raising money is not the definition of   success, mind you, but a billion-dollar  company must be doing something right,  

For the most part. In most cases, this means that  the company has been able to scale   revenue by around 300% YoY. That's  not a typo; it's 3x annual growth. To get to that Unicorn status, companies   often raise multiple funding rounds:  it's impossible to grow that fast   without external capital. Those rounds are often  called Seed, Series A, Series B, Series C, etc. Now, the first round startups raise, is  often structured as a convertible note.   We have a full video about them if you want  to understand the instrument a lot better. In a nutshell, money is raised as convertible  debt: the company commits to converting   the investment into shares; but delays the  decision until a new round of funding happens   so that the convertible note investors  follow the same terms as the new investors. On paper, it sounds great, and convertible  notes certainly have their advantages:   they are a cheap instrument. You can  close investors at different times   and get money in your bank account  faster than any other approach. The problem is convertible notes (or  bridge rounds as they are often called)  

Are designed for these startup stories,   and there are many stories in the middle  where convertible notes can become a hassle. We are one of them, and in this  video, we'll tell you all about it.  Here's the danger with convertible notes. So here are some of the rules  defined in a convertible note:  An amount, of course. A valuation cap: since the   convertible note will transform into stock at a  future valuation, defined by future investors,   notes have a cap: a maximum valuation at which  the money will convert. This is to protect   investors in case company valuation skyrockets. An interest rate: again, since this money is debt,   a standard 5% interest rate is often used. A maturity date: a maximum date at which the   notes will execute. If a new round of  funding isn't achieved, investors have   the right to execute the notes, meaning,  requesting a repayment, or converting them. Again, the terms here are built on the  premise of a future round of funding,   that should happen if the company is growing fast. If that happens, the process is simple:  

The notes convert using the terms  defined by the new round of investors. On the other hand, if the company is struggling,   investors may force the founders to liquidate  it and distribute the company assets,   which probably wouldn't pay them back their entire  investment, but at least it gives them something. By the way, requesting repayments is often  regarded as a douche move, and for the most part,   investors avoid asking for them. It does give them  a tool to pressure founders to look for an exit. However, both of these  options relate to the extremes   in this diagram. But what  about the middle scenario? We could have a scenario around this area where  the company is growing slowly and has managed   to stay profitable. Maybe it generates  a couple of million dollars in revenue   per year and some profits. It's a business,  after all, and nobody would want to kill it;   but it's not a unicorn story, it's  not going to grow 3x Year on year,   and therefore it doesn't have  access to more venture capital. This scenario was us, Slidebean, in 2017, by  the way, and I'll get back to this in a second. In a better scenario, we could have a fast-growing  company: say 30% to 50% or 100% year on year.  

It's found profitability, and therefore it  hasn't seen the need to raise more money yet. This is Slidebean in 2020. That's a successful company by most measures,  but the convertible note terms don't really apply   to it. It's not going to raise  more capital: it doesn't need to. Paying investors back is certainly a possibility;  however, the business would need to get into   profitability or cash cow mode to get that  capital out quickly, which will inevitably   cause the company to slow down. Perhaps another  competitor could come in and take advantage. So once again, neither of the convertible note   alternatives seems to be a solution  for this business. What to do? I don't know the right answer to this  question. I just know what we did. The 2017 decision  Between 2015 and 2016, we closed  around $800,000 in venture funding. We used it to expand aggressively,  expanded our team, our office,   and our growth budget. And it kind of worked,  but not well enough. Check out our video on that. The point is, the runway was short,  

And we realized we were not going  to get to the metrics we needed. Founders choose one of two routes here: one  is the full-speed-ahead round. Continue the   aggresive spending while trying to raise more  money to continue fueling it. They may get lucky   and raise some bridge cash, but they might not.  The problem with this approach, in my opinion,   is that you depend on other people to keep the  company running: you depend on other investments. We took the profitabilty route. Painfully, we  scaled down the budget, and that also meant our   team, and got ourselves into profitability.  We cut our monthly expenses from $110K/mo   to around $70K, which was more or  less the revenue we were making. We survived! Sacrificed our growth and our  potential for future funding, but we survived.   What happened next was up to us and nobody else,  well- except for the convertible note investors. I went back to them, explained the situation,  and offered them to extend the convertible   notes' maturity date. We had a few ideas that  would put us back on a unicorn growth path,   and I asked them for time to try them out. We extended the notes for two years,  which delayed this conversion and   allowed us to re-focus on the company:  on very different terms this time.

The 2020 decision We did many things between 2017 and 2020,   added artificial intelligence to our pitch  deck builder, launched our consulting branch-   Slidebean Agency, our Financial Model  services, and began working on Monthly. The fantastic advantage of running a profitable  operation is that the company can choose to   pursue these projects, these experiments, these  new-startups without raising additional capital. Some of these bets paid off: you are  watching this Youtube video after all. In 2020 the conversation was very different:  we were growing faster, we had the ability to   repay some of the notes without causing  a financial struggle for the company.   The valuation in the Cap was more justified  now, because our revenue was a lot more. So I came to our investors with a sincere pitch:   I laid out the progress we had  made while capital-constrained,   our ideas for what Slidebean could become in  the future, and asked them what they preferred.   I offered to repay the convertible notes if they  didn't believe in what the company could be come,   and I offered the to convert them at the cap  if they wanted to stay on board the ship. The convertible note terms allowed  each of them to pick, individually,  

What to do with their money. The vast  majority of investors chose to convert,   and the ones who didn't were bought out by  some of the existing investors that were   bullish on Slidebean. The rest of the money,  the company paid back from our cash reserves. This is, I believe, a fantastic outcome: we ended  up with only the investors that wanted to stay,   the company retained some of the stock  that we didn't end up issuing while keeping   a nice budget to continue investing in R&D. But here's the problem with all of  this: it's so far from the standard. Nobody takes about what happens in the  middle ground of a convertible note.   Nobody tells you that not raising  more venture capital is an option,   and by many measures, we are  not a startup unicorn success. I still want the $100MM ARR business that we set  out to create. I still think we can become that,   but the path is not the straight  line that you read in the press-   and this alternative path is one  that nobody wants to talk about. Make sure that you prepare for it. If you raise  money, by all means, use our pitch deck tools to   do it, but remember that raising capital is just  a means to an end. The end goal is to build a  

Successful business, but success can come in many  ways, not only with a Series F round or an IPO.  So what's the solution to this? Be prepared  mentally for that middle scenario. Don't   assume that you are going to be this company or  this company. Be prepared for being a company   in the middle. Make sure that your investors are  prepared for that and most importantly make sure   that your legal documents are prepared for  that. Hopefully, that story shed some light   into how to manage these things and this stage in  a business like ours. Let me know if you have any   questions in the comments or if you would have  approached it differently. See you next week.

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