Category Archives: equity

Convertible Notes vs. Equity

Over at AsktheVC someone asked:

“Should Entrepreneurs Be Worried About Convertible Notes as a First Financing Event?”

Jason provided a pretty good answer to the entrepreneur’s specific question and I commented about the broader question of VC vs. Angel comfort with convertible notes. It’s worth a read for anyone facing this question. I’ve copied my comment below:

“It can differ by geography, but I’d say that convertible notes are the exception for institutional rounds; whereas they are quite common for angel rounds.

Unless deal speed is critical or there is a huge gap in valuation expectations, VCs aren’t interested in their dollars converting into a valuation their dollars helped create. Unless the VC goes there, I wouldn’t spend too many cycles trying to go debt instead of equity. You want everyone aligned and equity does that best.

Angels can differ widely, however, and if they will accept convertible debt it might be worthwhile. It avoids the valuation dance with an angel and the risk that such a dance results in a valuation that will create problems for the next round. Of course, they may have the same concern as VCs (e.g. their dollars working against their conversion valuation), but not as often.

If it’s a close call, I’d err toward solutions that keep everyone aligned…”

Splitting the Pie: Looking Forward or Back

A common issue every entrepreneur faces is how to split the equity pie early-on. A recent founder discussion reminded me of my first company and the pie-splitting process — it wasn’t pretty. Our process incorporated elements of:

  • who created the founding idea
  • who had seed funds to invest
  • who had time/effort to invest
  • who had networks/relationships to invest
  • what are expected ongoing roles (e.g. CEO, silent founder etc.)

The result was a roughly equal split among 5 co-founders (surprise!), with some minor re-allocations as everyone’s contribution became clearer in those first few months. Although it worked mathematically, the process could have been better and some of those early decisions were a sore-spot for years to come.

This topic could support multiple posts on the various trade-offs, but for now I wanted to share how investors and founders often differ in their focus. Specifically, founders place greater weight on past contribution and investors place greater weight on future contribution. Having been on both sides of the table, I understand why this happens, but it still surprises me when it comes up.

Why do entrepreneurs place so much weight on past contribution?
Because they are the ones who have invested their whole life into the business. They want to be rewarded for that investment. They see clearly that the business wouldn’t be where it is — poised to create more value — but for their early commitment. Past contributions are also already in the record books, not some uncertain measure of future value.

Why do investors place so much weight on future contribution?
Because investors are measured/rewarded only on creating future value. As such, every decision about stock/option grants etc. is measured against whether the shareholder value created will exceed the dilution of that grant. Of course, investors have to acknowledge past contribution to maintain harmony and ongoing commitment, but that isn’t the driver of their equity decisions. Investors also see a difference between number of shares and value of shares — whereby, the growing value of shares rewards past contributions instead of the need for additional shares.

Who is right?
They both are to a degree. In fact, the entrepreneur carriers a bit of both viewpoints because they are both founder and shareholder. I can make the argument for both sides, but the important part is just understanding the different perspectives. Doing so will help with investor discussions, but could also help with early founder pie-splitting.

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