Posts from March 2017

Stocktoberfest East

My friend Howard Lindzon, who I met on this blog something like twelve years ago, runs an annual conference for fintech entrepreneurs and investors called Stocktoberfest.

Yesterday he hit me up on sms and told me they are doing Stocktoberfest East in NYC next week on March 29th and 30th. He asked me if I would do a chat with him. I told him that I’m not that interested in stocks but super interested in digital assets, cryptocurrencies, blockchain, etc. So we are going to do a 30min chat and I’m calling it Cryptoberfest.

My vision for this talk is a completely unprepared and unscripted talk between two old friends about all the amazing things happening in crypto land these days. It should be fun. If you want to attend, you can get a ticket here.

Using Debt Like Growth Equity

If you are in the venture or startup business and don’t read Dan Primack, consider changing that. He’s great.

From his newsletter this morning:

Indebted: Last week we noted that Wal-Mart subsidiary Jet.com had acquired ModCloth, an online retailer of vintage women’s apparel. No financial terms were disclosed, but this didn’t feel like a success for either ModCloth or the venture capitalists who had invested over $70 million into the business since its founding 15 years earlier. Here’s what happened, per sources familiar with the situation:

  • In 2013 ModCloth went out in search of Series C funding, but the process was felled by a back-to-back pair of lousy quarters. So instead it accepted $20 million in unsecured bank debt.
  • ModCloth effectively treated the debt like growth equity, rather than recognizing the time bomb it could become.
  • When the debt first came due in April 2015, existing ModCloth investors pumped in new equity to, in part, kick repayment down the road for two years. This came amid four to five straight quarters of profitability, and just after the company brought in a former Urban Outfitters executive as CEO.
  • Once the income statement returned to the red, ModCloth again tried raising equity ― but prospective investors cited the debt overhang as their reason for passing on a company whose unit economics were otherwise fundable. Insiders could have stepped up but didn’t.
  • Jet.com heard of ModCloth’s debt coming due debt month, and pounced. We’ve been unable to learn the exact amount it paid, except that the amount left over for VCs after repaying the debt (and accounting for receivables) won’t be nearly enough to make them whole.
  • 2 takeaways: (1) Debt is not inherently troublesome for startups, particularly if it’s supplementing equity as opposed to substituting for equity. But startups must recognize that not all cash is created equal. (2) ModCloth was founded in Pittsburgh, but later moved its HQ to San Francisco. It’s impossible to know if things would have worked out differently had the company remained in the Steel City, but some of its quirky retail culture did seem to get commingled with the “grow grow” tech etho

I have lived this story several times in my career and we are seeing this play out again in the market.

It is tempting to use debt instead of equity to finance a high growth company, particularly when you cannot get equity investors to value your company “fairly.” When a company has achieved “escape velocity” and is growing quickly, lenders look at it and say “there is enterprise/takeout value here and we are senior to the equity so the risk to us is pretty low.” And so they will underwrite a loan to the company even though the market hasn’t made up its mind on how to properly value the equity. So the temptation all around the table is to take the debt and kick the can down the road on the equity in the view that more time, more growth, more market validation will fix things.

This can work out well. Our portfolio company Foursquare is an example of where this did work out well. A debt deal in the middle of a business model pivot gave that company the time to re-engineer its business model and validate it. And time also allowed the company to come to terms with how the equity markets would value it and its new business model. Foursquare went on to raise another round of equity capital and refinance its debt and is in a great place now.

But, as the Modcloth story points out, debt can also work against you. If you can’t execute well post raising debt and get to another equity round or some other transaction (an attractive exit being the other obvious option), then you can have your debt called from under you and lose the control over the timing and terms of your exit. I lived through this story with a company I backed in 1999 and which was sold a few years ago in a transaction that was very good for the lenders and good for the management and very bad for the early equity investors.

Dan’s point that substituting debt for growth equity is a risky bet is spot on. That doesn’t mean it shouldn’t be done. But it should be done with care and with eyes wide open.

The Decentralized Startups

If someone were to ask what the most successful startups of this decade are, the answer would likely be Snap (market cap $22bn). Uber and Airbnb might also be on the list although those companies were launched in the prior decade (2009 and 2008 respectively).

But what might be missed is the massive success of the decentralized startups, most notably Bitcoin (BTC) and Ethereum (ETH) this decade.

Look at these charts:

During this decade BTC has gone from essentially zero to about $1000/share which is a market cap of $16.3bn.

If anything, ETH is an even more impressive story. In less than two years (Ethereum was initially released in July 2015), it has gone from zero to a market cap of $3.4bn.

And anyone located anywhere in the world can invest in these decentralized startups and profit from them, unlike the traditional startups.

Obviously, there is no way to know where we go from here. Does ETH go to $100 or $5? Does BTC hard fork and cause the price to crash?

But of course the same is true of Snap, Uber, and Airbnb. Past performance is no guarantee of future success.

And it is also true that using traditional valuation methods (DCF, etc) on these decentralized startups is really hard. One of USV’s investors (LPs in the industry vernacular) asked me how to value a digital asset. It’s a great question and one we are working hard to understand. We don’t know the answer to it yet, to be honest.

But this much I know. There’s a new game in startup land. A new way to do things. And it is working for a lot of people who are playing that game right now.

Audio Of The Week: The Riff

My partner Andy and my friend David are doing an “interview cast” which is “a 24 minute conversation about one topic, with one expert.”

They call it The Riff and their first episode is about the evolving news media landscape with CNN journalist Laurie Segall.

Here it is:

Fun Friday: March Madness

We are on spring break with our son Josh this week in Utah and we caught most of the games yesterday. I am not a huge college basketball fan, I prefer the pro game, but there is something about march madness that is so great, particularly these first two weekends where the games come fast and furious.

So I thought we could have some fun sharing our brackets, or our picks, or whatever.

Here’s mine, sorry about the chickenscratch handwriting. I failed penmanship every grade in school for very good reasons.

I’ve got Villanova, Gonzaga, Kansas, and Kentucky going to the final four and Kentucky taking the trophy.

How about you?

Dronebase API and Dronebase Pilot

I love it when companies quickly get into a market, start delivering a product or service, and then, over time iterate on their products and services to expand the market and their share of it. Contrast that with a company spending years getting something right before shipping their first product. I much prefer the ship quickly, get customers, and iterate and automate approach.

Our portfolio company Dronebase is very much using the iterate and automate playbook. As I posted about here a few months ago, they offered their first commercial drone flight in January 2015 and two years later they did their 10,000th drone flight. All during that time, they were automating much of the workflow for their customers, their pilots, and inside their operations.

Over the past ten days, they have shipped two things that demonstrate how highly automated the drone flight process has become.

On March 9th, Dronebase launched the “Enterprise API” with this blog post. I tweeted out the news:

And today, Dronebase is launching the Dronebase Pilot iOS app, which looks like this on a DJI drone:

As Dronebase cofounder and CTO Eli Tamanaha explains in this post:

The app can now connect to your drone to help you fly. Similar to how you use the DJI Go app, just dock your iPhone or iPad to your drone’s controller, open the app, and launch the drone. You’ll be able to see the 1st person point-of-view from the drone’s camera, shoot photos and videos, and control settings like camera angle.

Our goal, as an engineering team, is to keep drone pilots doing what they love – flying. The more we can streamline the busy work, the administrative stuff like classifying and uploading imagery, the better.

So with the API and the Pilot app, a mission can move from an enterprise customers’ application (like an insurance company’s adjusting workflow application) to a pilot’s phone without any human being touching that mission. And the imagery can flow back from the pilot’s phone back to the enterprise application in the same way.

That’s how you automate something after you’ve figured out what the market wants and how to deliver it. Instead of building all of this stuff before launching, Dronebase starting doing missions and listening to customers and pilots and then went out and built a crack engineering team under the leadership of Eli and started automating the process in the way the market wanted it.

The result will be a much larger available market for drone imagery, or as Dronebase calls it “Air Support For Every Business”. Because if you are a large enterprise with a need for hundreds or thousands of missions, you can programmatically issue (via the API) those missions from your existing workflow and applications and you can get these missions done for somewhere between $50 and $300 per mission. That’s the power of automation and scale at work.  Which will massively expand the market for what enterprises can use drones for. Which will, in turn, mean orders of magnitude more flights for drone pilots to do. A win/win for everyone.

Token Summit

I’ve written a bit here about crypto tokens. How they can be a monetization model for new protocols. How they could be a new monetization model for online media. How they can be a business model for an online “commons.” And why USV invested in a hedge fund that will invest solely in these tokens.

I believe that these crypto-tokens are an important innovation in the world of technology. They allow for the financing and monetization of technology projects that rely on a network of contributors (of software engineers:open source, of contributors:online communities, of computers:p2p systems, etc) to deliver value to the market.

To date, we have mostly seen tokens used as financing vehicles. The last time I looked, over $300mm has been raised in “Initial Coin Offerings” (ICOs) to finance projects like the ones I referenced above. That number continues to rise as more tokens are sold to raise funds to develop these new businesses.

But the longer term implications of tokens have more to do with monetization than financing. And I think its a very elegant and powerful idea that the same “currency” can be used to both finance and monetize a network.

So with that preamble, I am excited that the first ever Token Summit will take place in NYC on May 24th and 25th. This event is being organized by AVC regular William Mougayar and Nick Tomaino, who runs The Control, which I blogged about a few months ago.

William blogged about Token Summit today and says this about the event:

We have identified the following themes that will be debated in a variety of formats, including on-stage interviews and panels.

Token-based Business Models

How do tokens contribute to a business model? When do they make sense? How does an entrepreneur monetize? Where is the real value?

Token Protocols and Platforms

What are the emerging token-based assets? Where/How are we going to trade them? What are the implications for fund managers?

Distribution Mechanics

Lessons and best practices for pre, during and post initial cryptocurrency and token sales, including governance.

Valuation Strategies

How do investors and users value tokens? How does a token transition from a speculative to utilitarian function?

Legal Implications

Legal, regulatory and ethical practices for token creations.

I plan to attend this event and I encourage everyone working in or around this space to attend. It will be an interesting and lively discussion.

If you want to attend the event, you can register here.

From Healthcare to Wealthcare

There is no doubt that the healthcare system in the US could use some work. We spend way too much and the quality of the healthcare that many receive is not where it could or should be. We allocate too much of our healthcare spending in the last few months of a person’s life and not nearly enough on preventive care throughout our lives. We are not leveraging the power of technology enough to help treat diseases and other conditions early when the treatments are more effective. So I am all for modifications to our health care system that will allow for more innovation, more preventive and wellness care, and more engagement with the system.

What I am not for is a total and complete dismantling of the Affordable Care Act and a return to a time when many US citizens did not have a means to pay for the healthcare they need (ie insurance). The Congressional Budget Office predicts that the Republican plan that has been put forth will cause 15mm US citizens to lose their insurance in the near term and up to 24mm over the longer term (by 2026).

This would just take us back to the time when a large percentage of our population had no other option but to defer healthcare until they got really sick and then show up in hospital emergency rooms and stick the “system” (ie those with insurance) with the bill. This is not a good way to run our healthcare system. Sure it might enable the government to remove the mandate that everyone have insurance, which sticks in the craw of conservatives and libertarians, but the cost of doing so means less preventive care, less outpatient care, and more costly end of life care.

I believe citizens of the US should have healthcare insurance. If they can afford it, they should pay for it. If they can’t afford it, society should pay for it. But one way or another, everyone should have the ability to see a doctor regularly, get preventive care, find diseases early on and treat them, and not defer their medical needs until they become acute.

The Republican plan seems hastily drawn up, largely a political reaction to the Affordable Care Act, and a return to a time when the wealthy can afford healthcare and many others cannot. I would encourage the President, his team, and the Republican members of Congress to go back to the drawing board and come up with something that moves us forward, not takes us back.

From The Archives: Convertible Debt

I wrote this in July 2011, as a part of an MBA Mondays series on financing structures:

————————————————————-

MBA Mondays are back after a one week hiatus. Today we are going to talk about convertible debt. Convertible debt can also be called convertible loans or convertible notes. For the purposes of this post, these three terms will be interchangeable.

Convertible debt is when a company borrows money from an investor or a group of investors and the intention of both the investors and the company is to convert the debt to equity at some later date. Typically the way the debt will be converted into equity is specified at the time the loan is made. Sometimes there is compensation in the form of a discount or a warrant. Other times there is not. Sometimes there is a cap on the valuation at which the debt will convert. Other times there is not.

There are a number of reasons why the investors and/or the company would prefer to issue debt instead of equity and convert the debt to equity at a later date. For the company, the reasons are clearer. If the company believes its equity will be worth more at a later date, then it will dilute less by issuing debt and converting it later. It is also true that the transaction costs, mostly legal fees, are usually less when issuing debt vs equity.

For investors, the preference for debt vs equity is less clear. Sometimes investors are so eager to get the opportunity to invest in a company that they will put their money into a convertible note and let the next round investors set the price. They believe that if they insisted on setting a price now, the company would simply not take their money. Sometimes investors believe that the compensation, in the form of a warrant or a discount, is sufficiently valuable that it offsets the value of taking debt vs equity. Finally, debt is senior to equity in a liquidation so there is some additional security in taking a debt position in a company vs an equity position. For early stage startups, however, this is not particularly valuable. If a startup fails, there is often little or no liquidation value.

Friends and family rounds, which we discussed earlier in this series, are often done via convertible debt. It makes sense that friends and family would not want to enter into a hardball negotiation with a founder and would prefer to let the price discussion happen when professional investors enter the equation.

The typical forms of compensation for making a convertible loan are warrants or a discount.

Warrants are another form of an option. They are very similar to options. In the typical convertible note, the Warrant will be an option for whatever security is sold in the next round. The Warrant is most often expressed in terms of “warrant coverage percentage.” For example “20% warrant coverage” means you take the size of the convertible note, say $1mm, multiply it by 20%, which gets you to $200,000, and the Warrant will be for $200,000 of additional securities in the next round. Just to complete this example, let’s say the next round is for $4mm. Then the total size of the next round will be $5.2mm ($4mm of new money plus $1mm of the convertible note plus a Warrant for another $200k). The total cost of the convertible loan is $1.2mm of dilution at the next round price for $1mm of cash.

A discount is simpler to understand but often more complicated to execute. A discount will also be expressed in terms of a percentage. The most common discounts are 20% and 25%. The discount is the amount of reduction in price the convertible loan holders will get when they convert in the next round. Let’s use the same example as before and use a 20% discount. The company raised $4mm of new cash and the convertible loan holders will get $1.25mm of equity in the round for converting their $1mm loan ($1mm divided by .8 equals $1.25mm). Said another way $1mm is a 20% discount to $1.25mm.

Convertible notes also typically have some cap on the valuation they can convert at. That cap is anywhere from the current valuation (not very common) to a multiple of the current valuation. Recently we are starting to see uncapped convertible notes. These notes have no cap on the valuation they can convert at.

Startups typically think about raising capital via convertible debt early on in the life of a startup. They want to move fast, keep transaction costs low, and they are often dealing with a syndicate of angel investors and it is easier to get the round done with a convertible note than a seed or series A round. While these are all good reasons to consider convertible debt, I am not a big fan of it at this stage in a company’s life. I believe it is good practice to set the value of the equity early on and start the process of increasing it round after round after round. I also do not like to purchase or own convertible debt myself. I want to know how much of a company I’ve purchased and I do not like taking equity risk and getting debt returns.

However, later on in a company’s life convertible debt can make a lot of sense. A few years ago, we had a portfolio company that was planning on an exit in a year to two years and needed one last round of financing to get there. They went out and talked to VCs and figured out how much dilution they would take for a $7mm to $10mm raise. Then they went to Silicon Valley Bank and talked to the venture debt group. In the end, they raised something like $7.5mm of venture debt, issued SVB some Warrants as compensation for making the loan, and built the company for another year, sold it and did much better in the end because they avoided the dilution of the last round. This is an example of where convertible debt is really useful in the financing plan of a startup.

My guess is we will see the use of convertible debt, particularly with no compensation and no cap on valuation, wane as the current financing gold rush fizzles out. It will remain an important but less common form of early stage startup financing and will be particularly valuable in things like friends and family rounds where all parties want to defer the price negotiation. But I expect that we will see it used more commonly as companies grow and develop more sophisticated financing needs. It is a good structure when the compensation for making the loan is fair and balanced and when the debt vs equity tradeoff is useful for both the borrower and lender.

Convertible and SAFE Notes

Angel/seed rounds used to be done via priced equity securities, either common or preferred. Then, starting about ten years ago, we started to see convertible debt being used in the angel and seed rounds. By 2010 this was the norm and Paul Graham tweeted this in Aug 2010:

Which led me to write this blog post here on AVC. I was not a fan of convertible notes then and I am not a fan of them now. USV has done a number of convertible and SAFE notes since then. I would guess that we have done a dozen or more of them in seed and angel rounds we have participated in. We are not opposed to convertible and SAFE notes and will not let the form of security the founder wants to use get between us and investing in a company that we like.

But I continue to think that convertible and SAFE notes are not in the best interests of the founder(s).

Here is why:

  1. They defer the issue of valuation and, more importantly, dilution, until a later date. I think dilution is way too important of an issue to defer, for even a second.
  2. They obfuscate the amount of dilution the founder(s) is taking. I think many investors actually like this. I do not. I believe a founding team should know exactly how much of the company they own at every second of the journey. Notes hide this from them, particularly the less sophisticated founders.
  3. They can build up, like a house of cards, on top of each other and then come crashing down on the founder(s) at some point when a priced round actually happens. This is the worst thing about notes and doing more than one is almost always a problem in the making.
  4. They put the founder in the difficult position of promising an amount of ownership to an angel/seed investor that they cannot actually deliver down the round when the notes convert. I cannot tell you how many angry pissed off angel investors I have had to talk off the ledge when we are leading a priced round and they see the cap table and they own a LOT less than they thought they did. And they blame the founder(s) or us for it and it is honestly not anyone’s fault other than the harebrained structure (notes) they used to finance their company.

The Series A focused VC firms that often lead the first priced rounds get to see this nightmare fold out all the time. The company has been around for a few years and has financed itself along the way with all sorts of various notes at various caps (or no cap) and finally the whole fucking mess is resolved and nobody owns anywhere near as much as they had thought. Sometimes we get blamed for leading such a dilutive round, but I don’t care so much about that, I care about the fact that we are allowing these young companies to finance themselves in a way that allows such a thing to happen.

Here are some suggestions for the entire angel/seed sector (founders, angel investors, seed investors, lawyers):

  1. Do priced equity rounds instead of notes. As I wrote seven years ago, the cost of doing a simple seed equity deal has come way down. It can easily be done for less than $5k in a few days and we do that quite often.
  2. 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.
  3. Don’t do multiple rounds of notes with multiple caps. It always ends badly for everyone, including the founder.
  4. Founders should insist that their lawyers publish, to them and the angel/seed investors, a “pro-forma” cap table at the closing of the note that shows how much of the company each of them would own if the note converted immediately at different prices. This “pro-forma” cap table should be updated each and every time another note is isssued. Most importantly, we cannot and should not continue to allow founders to issue notes to investors and not understand how much dilution they are taking on each time they do it. This is WRONG.

Honestly, I wish the whole scourge of notes would go away and we could go back to the way things were done for the first twenty years I was in the venture capital business. I think it would be a better thing for everyone. But if we can’t put the genie back in the bottle, we can at least bottle it up a bit better. Because it is causing a lot of problems for everyone.