Archive for September 15th, 2012

  • September 13, 2012, 6:45 PM

Investors Weigh In With Convertible Note Caveats for Start-Ups

By Lizette Chapman

Tech entrepreneurs take note: Convertible notes are not free money and, if not structured properly, can prevent you from raising additional financing.

Investors speaking at the TechCrunch Disrupt SF 12 conference in San Francisco this week had this gem and a few other choice observations about early-stage financing for start-ups.

“We’ve had companies come in for their Series A and not realize  that  they’d already given up 25% of their company” in the seed round,” said Sequoia Capital Partner Alfred Lin, referring to the fact that convertible notes are unpriced, but convert to equity stakes when founders go on to raise a priced Series A round. He added: “That you raise money at a higher valuation than your friend? That’s a false milestone for you.”

Another false milestone, according Google Ventures Partner Joe Kraus, is thinking that raising a bigger round is better for the company when a smaller one will do. While Kraus said he “had no bones to pick” with the convertible note structure, he cautioned it can lead to companies over-raising their seed round and then  ending up with a “weird” cap table that makes  backing a  company at the Series A level difficult  for new investors because there’s  not enough equity left to go around.

While none of the investors speaking (Cowboy Ventures Partner Aileen Lee, SV Angel Managing Director David Lee and Greylock Partners Partner James Slavet were also on the panel) mentioned Y Combinator companies specifically, they might as well have.

Many of the 75 companies who graduated from the three-month accelerator program last month have been talking to investors to raise capital on top of the $150,000 offered to all YC graduates by the Start Fund. Along with the note structure, valuation (which sets expectations for the Series A round) has become an unusually public discussion, with YC co-founder Paul Graham last week accusing Google Ventures of lowballing YC companies on valuation and following up on a prediction last spring that valuations may be dropping.

Although the Start Fund (which is backed by Yuri Milner, SV Angel, General Catalyst Partners and Andreessen Horowitz) offers the cash at no cap and no discount, other early seed investors have been unwilling to offer a similar blank check lest their equity gets washed out in a later round.

And, judging from investor comments–Lee said he’s now seeing down valuations in more sectors than previously–the amount and valuations of convertible notes are becoming more disciplined.

“It’s feast or famine,” said Slavet, of start-up  funding. “Seed valuations fluctuate on the ability of seed companies in the previous months to set Series A funding. Seeds, in many ways, are a lagging indicator of Series A valuations.”

Write to Lizette Chapman at lizette.chapman@dowjones.com. Follow her on Twitter @zettewil

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