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The danger with convertible notes - YouTube
Channel: Slidebean
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over the last few months our advisors
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and our legal team have been working
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tirelessly
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to solve a terrible starter predicament
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that nobody plans for
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growth slow growth and notice that how
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for
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any other company growth means success
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but not for a venture funded company
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this is a fundamental concept you have
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to understand if you intend to pursue
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venture capital
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let's draw a line between a startup
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success and a startup failure in the
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eyes of a venture capital investor
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in the eyes of silicon valley on this
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side we have failure
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the company goes out of business
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slightly better than this is when the
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company's
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scraps get aqua hired which probably
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doesn't pay investors back but at least
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it saves the tech and gives part of the
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team a job on the other side of the
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spectrum we have unicorn status
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starter gets funded and within a few
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years it reaches a billion dollar
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valuation
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raising money is not the definition of
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success mind you but a billion dollar
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company must be doing something right
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for the most part now this unicorn
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started up success
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multiple rounds of funding story
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probably means that the company has been
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able to scale
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revenue by around 300 percent year on
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year that's not a typo it's
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3x annual growth that's what investors
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expect and then to get to that unicorn
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status companies
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often raise multiple rounds of funding
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it's usually impossible to grow that
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fast
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without some external capital and these
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rounds are called seed series a series b
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series c and so on now the first round
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of funding starters race
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is often structured as a convertible
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mode and we have a full video about them
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if you want to understand
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the instrument of a convertible known a
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lot better but in a nutshell
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money is raised as convertible debt the
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company commits to converting the
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investment into shares
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but delays the decision until a new
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round of funding happens
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so that the convertible node investors
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follow the same terms as the new
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investors
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throughout this time the money invested
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is not converted into stock
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but it is considered dead on paper it
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sounds great and convertible notes have
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their advantages
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they're a very cheap instrument legal
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fees are small you can close investors
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at different times
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and get money in your bank account
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faster than with any other fundraising
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approach
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the problem is convertible notes or
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bridge rounds as they are often called
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are designed for these two startup
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stories
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and there are many stories in the middle
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where convertible notes can become
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a hassle we are one of those stories and
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in this video we're going to tell you
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all about it so here's
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the danger with convertible notes
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[Music]
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all right so so we can get on the same
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page here are some of the rules defined
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in a usual convertible node term sheet
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an amount of course
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a valuation cap since the convertible
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node will transform into stock at a
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future valuation which is defined by the
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valuation that future investors give the
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company
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many nodes have a cap a maximum
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valuation and which the nodes will
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convert this is to protect investors in
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case the company values skyrockets
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then there's an interest rate again
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since the money is dead a standard five
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percent interest rate is often
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used then there's a maturity date a
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maximum date at which the notes are to
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execute if a new round of funding isn't
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achieved by then
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investors have the right to execute the
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notes meaning
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requesting a repayment or converting
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them or
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some other term defined in the term
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sheet but once again the terms in this
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document
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are usually built on the premise of a
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future round of funding
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that should happen if the company is
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growing fast if the company meets that
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expectation
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then the process is very simple the
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nodes convert using the terms defined
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by the new round of investors on the
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other hand if the company is
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struggling investors may force the
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founders to liquidate it and to
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distribute the company assets which
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probably wouldn't pay them back
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their entire investment and certainly
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wouldn't make them any money but at
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least it gives them something
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however requesting a repayment is often
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regarded as a douche move and for the
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most part
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investors avoid asking for repayment it
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does give them a tool to pressure
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founders
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to look for an exit if the company isn't
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going as expected however both of these
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scenarios relate to the extremes
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in this diagram but what about a middle
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scenario we could have a scenario around
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this area
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where the company is growing slowly and
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has managed to stay profitable
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maybe it generates a couple of million
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dollars for revenue per year and maybe
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some profits
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it's a business after all and nobody
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would want to kill it
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but it's not a unicorn story it's not
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going to grow three times a year and
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year
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and therefore it doesn't really have
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access to another round of funding it
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doesn't have access to more venture
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capital
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and this scenario was us slide bean in
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2017 by the way and i'll go back to that
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story in a second
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in a better scenario we could have a
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company around this area of the diagram
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where
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we could have a fast growing business
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say 30
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50 maybe even 100 year-on-year it's
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found
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profitability and therefore it doesn't
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really need to raise more money
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that's slide bean in 2020 and that is a
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successful company
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by most measures but the convertible no
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terms don't really apply
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to it it's not going to raise more
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capital at least in the near future
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it doesn't need to paying investors back
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is certainly a possibility however
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the business would need to get into
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profitability or cash cow mode
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to get that capital out quickly to
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investors which will inevitably
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cause the company to slow down perhaps
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that would open
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an opportunity for another competitor to
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come in and take advantage
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so once again neither of the convertible
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node routes
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or alternatives seems to be a solution
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for this business but the business is
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making money
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so what to do i don't know the right
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answer to this question
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i can just tell you what we did the 2017
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decision
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between 2015 and 2016 we closed around
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800 thousand dollars in venture capital
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we used that to expand aggressively we
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expanded our team
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our office and our growth budget and it
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kind of worked but
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not well enough we have a full video on
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that the point is
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the runway ended up shortening and we
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realized that we were not going to get
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to the metrics that we needed to raise
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that next round of funding
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and founders at this stage choose one of
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two routes
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one is the full speed ahead round
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continue that aggressive spending while
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trying to raise more money to continue
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fueling that
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and they may get lucky and raise a
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bridge round maybe a post seed
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investment
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but they might not the problem with this
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approach in my opinion is that
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you depend on other people to keep the
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company running
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you depend on other investments so we
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took another route we took the
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profitability route
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painfully we scaled down the budget and
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that also meant cutting down part of our
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team
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but we got ourselves into profitability
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we cut our monthly expenses from 110k a
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month
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to around 70k per month which was more
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or less the revenue that we were making
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at the time
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and we survived we sacrificed our growth
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we sacrificed our potential for future
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funding at least at that time
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but we survived what happened next was
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up to us
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and nobody else except for the
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convertible node investors
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so i went back to them explained the
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situation i've always been very
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transparent about our metrics and they i
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sent them monthly updates and whatnot
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but i offered them the possibility to
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extend the convertible node's maturity
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date
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we had a few ideas that could put us
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back on that unicorn growth path
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so i asked them for time to try them out
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so we ended up extending the maturity
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date for the notes
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which delayed this conversion or this
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decision event
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and allowed us to refocus on the company
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and on very different terms this time
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the 2020 decision so we did a lot of
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things between 2017 and 2020.
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we added artificial intelligence to our
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pitch tech builder we launched our
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consulting branch sliding agency
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we launched our financial model service
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and began working
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on our new platform monthly the
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fantastic advantage of running a
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profitable
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operation is that the company can choose
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to pursue these projects these
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experiments
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these new startups within a startup
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without raising additional capital
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and some of these bets paid off you are
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watching this youtube video after all
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in 2020 the conversation ended up being
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very different
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we were growing faster we had the
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ability to repay some of the notes
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without causing a financial struggle for
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the company
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the valuation in the cap was more
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justified now because
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our revenue was a lot more so i came to
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our investors with a very sincere pitch
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i laid out the progress that the company
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had made while being capital constrained
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i laid out our ideas for what sliding
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could become in the future and i asked
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them
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what they preferred i offered them to
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repay the convertible notes
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if they didn't believe in what the
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company could become and kind of
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enforce the fact that we were able to do
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that and that it wouldn't constrain the
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company and i offer them
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also the option to convert at the cap if
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they wanted to stay on board
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this ship that had changed from what the
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company
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that they originally invested in so the
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convertible node terms allowed each
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investor to pick individually what they
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wanted to do
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and the vast majority of them chose to
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convert and the ones who didn't were
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actually bought out by some of the
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existing investors
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that were very bullish on slide bean and
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what we were planning on doing
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the rest of the money the company paid
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back from our cash reserves
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so i think this was a fantastic outcome
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we ended
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up with only the investors that really
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wanted to stay that really believed in
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our vision the company retained some of
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the stock that we didn't end up issuing
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because we bought some of that back
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and we still have a nice budget and a
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nice cushion to continue investing
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in r d but here's the problem with all
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of this it's
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so far from the standard nobody talks
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about what happens
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in the middle ground of this convertible
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node nobody tells you that
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not raising more venture capital is an
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option
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and even though we are not a startup
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unicorn's success we are still
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a profitable multi-million dollar
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company i still want the 100 million
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dollars arr
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business that we set out to create a few
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years ago i still think that we can
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become that
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but the path is not the straight line
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that you read in the press
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and this alternative path is one that
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once again i think
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nobody wants to talk about so make sure
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that you prepare for it
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if you raise money by all means use our
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pit tools to do it but remember that
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raising capital is just a means
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to an end the end goal is to build a
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successful business
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but success can come in many ways not
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only with a serious
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f round or an ipo so what's the solution
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to this
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just be prepared mentally for that mill
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scenario don't assume that you're going
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to be this company
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or this company be prepared for being
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the company in the middle
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and make sure that your investors are
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prepared for that and most importantly
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make sure that your legal documents
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are prepared for that so hopefully that
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story sheds some light into how to
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manage these things
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at this stage in a business like ours
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let me know if you have any questions in
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the comments or if you would have
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approached it
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differently see you next week
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you
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