If not convertible notes/SAFEs/term loans… then what?
Digital ink has been spilled across the interwebs these past two weeks on the issues with different types of venture financings. To briefly recap:
3/12: Fred Wilson discussed why he dislikes convertible notes and SAFEs, and how priced equity rounds make more sense at the seed level.
3/20: danprimack provided detail on Wal-mart/Jet.com’s acquisition of ModCloth, and how substituting (rather than supplementing) debt for equity can cause problems.
3/20: Fred Wilson again (impressive turnaround time) further elaborated on Dan’s post with the example of Foursquare’s successful usage of debt, while still warning on its use as growth capital.
3/23: Erin Griffith gave the example of Visible Measures’ less successful usage of debt, along with the situations where it does in fact make sense for a startup to raise debt.
The most frustrating answer to almost any question is “it depends”. The question of which instrument should a company fundraise on is unfortunately no different. Priced equity financings make sense as they provide clarity around valuation and ownership dilution, while creating alignment between the investors and founders. However as the above links show, debt is a trickier subject. From the date of its issuance the clock starts, applying constant pressure that can suffocate a company with ever-accruing interest, fixed payment amounts, prepayment penalties, dilutive warrants, or even personal guarantees forced upon the founders (as if they didn’t already have enough skin in the game).
There are solutions that can give founders the best of both worlds though. I point back to Fred Wilson’s blog, specifically a guest post by Andy Sack on revenue based financing. Revenue based financing is a form of debt that comes without the strings that pushed companies like ModCloth into trouble. An investor makes a loan to a company, and the company pays back said loan via revenue share until a pre-determined multiple on the investment is reached. If revenue increases, the payments amounts increase and the loan is repaid sooner. If revenue decreases, the payment amounts decrease and the company has more breathing room in its free cash flows. Founders keep their ownership, and investors are incentivized to help the companies grow. For a company already generating revenue, this type of investment can make a lot of sense.
Additionally, there’s a newer type of investment on the block that deserves mention: the Indie.vc instrument (for a lack of a better name). Indie.vc makes an investment into a company that converts to equity only upon the sale of the company or the raising of additional equity, or gives them the right to begin receiving monthly distributions three years later if no conversion takes place (with distributions capped at three times their investment). Again, founders keep the vast majority of their ownership, and the investors are still incentivized to help the companies grow. This type of investment also makes a lot of sense and comes with this glorious work of art.
Given that the rumors of this venture bubble popping are now several years old, it’s become clear that founders can succeed with different business models. They can grow at all costs and defer the profitability question at their own risk (e.g. Snap), or they can focus on becoming sustainable from inception and grow more organically (e.g. Atlassian). The former just carries more existential risk for the company than the latter. What’s also clear is that founders have many different weapons in their arsenal, with some being more appropriate than others. Which one is most appropriate though? Well, it depends.
