4 Reasons Investors Shouldn’t Do Convertible Notes

Over the last week the topic of convertible notes came up in two different conversations. Convertible notes are essentially a loan to a startup that converts to equity on a certain date or if the startup raises a certain amount of capital. Convertible notes (and subsequently the safe) became popular several years ago as investors wanted to move fast, keep initial legal costs down, and defer the valuation topic to the next investor. Basically, a much simpler transaction. Only, it put convertible note holders in a poor position.

Here are four reasons investors shouldn’t do convertible notes:

  1. Misalignment on Valuation – Convertible notes often have a cap which represents a maximum valuation for the investor (e.g. a cap of $3 million such that if the startup raises money at a $4 million valuation, the investors’ debt converts at the lower of the two valuations). Only, the convertible note investor is incentivized for the startup to raise money at a lower valuation so that they’ll get more equity for their money (assuming everything else about the terms is equal). Entrepreneurs want to raise money on good terms and good valuations, but that isn’t aligned with the convertible note holders as they have negative benefit with a higher valuation.
  2. Limited Initial Upside – Most convertible notes have a discount of 20% to the next round of financing (e.g. if the round is at a $5 million valuation, the convertible note holders get their equity at a $4 million valuation as that’s 20% less). Yet, raising convertible debt doesn’t guarantee a subsequent round of financing happens quickly. If the financing round takes 6-12 months (or more), the investor is only getting a paper return of 20% for taking on outsized risk. Investors typically want to see their portfolio companies raise money each round at a minimum of twice the last valuation.
  3. Lack of Future Qualified Financing Event – Most convertible notes only convert at a qualified financing event (some have a conversion date far in the future). If the startup doesn’t raise more money, or can’t raise more money, the investor is essentially stuck with a low interest loan in a high risk investment.
  4. No Governance – Convertible notes are simple debt with limited covenants and no governance rights. Ideally, the startup will raise a “normal” round and have the governance that comes from a board and a lead investor in the future, but there’s no definitive timeline. Without governance, the entrepreneurs can do what they please with the money with limited recourse.

Investors would do well to understand the pros and cons of convertible debt. Personally, I require equity and don’t invest via convertible debt.

What else? What are some more reasons why convertible debt can be worse off for investors?

4 Quick Ways to Evaluate a Startup Idea as an Investor

Earlier this week an entrepreneur casually threw out an idea he had on the side that wasn’t related to his startup. My recommendation: don’t judge an entrepreneur’s idea. Push them to do customer discovery and let the market plus their internal motivation decide if the idea makes sense or not.

Now, as an investor, once you get past the common requirements of a great team and market, there are four quick ways I like to evaluate an idea:

  1. Must-Have vs Nice-to-Have – If the app is taken away from customers tomorrow, how much do they complain? How replaceable is the app if they just went back to email and spreadsheets?
  2. In the Path of Revenue – Where the app in the path of revenue? How clear is it that the app helps the company make more money?
  3. System of Record vs Utility – What functional category does the app fall in? Do people live in the app most of the day? Once a week? Set it and forget it?
  4. Timing – Where’s the market in the adoption lifecycle? Is it too early? Too late? Timing is 10x more important than people realize.

Evaluating an idea is hard. These four quick ways help me develop a mental model of a startup idea to see if I should pursue it further.

What else? What are some other quick ways to evaluate a startup ideas as an investor?

Startup Funding and Optionality

One of the challenges entrepreneurs face after achieving a repeatable customer acquisition process with great metrics in a big market is just how much money to raise. Initial thinking might be to raise as much as possible at the highest valuation possible. Only, investors have an expectation to make at least three times their money at the later stages and many more times that at the earlier stages. Couple this with the fact that only 2 out of every 100 venture-backed startups ever sell for $100 million or more, and raising substantial amounts of money greatly reduces the potential chance of a “successful” outcome.

Here are a few thoughts on startup funding and optionality:

  • Discuss this topic with potential investors before raising money to understand expectations and see if there is a fit
  • Ensure the founders, management, and board are aligned around desired outcomes
  • Recognize that not all outcomes are to sell the entire business as high growth tech companies are staying private longer and have more access to secondary liquidity
  • Sometimes raising money at a valuation lower than what’s possible makes sense to get the startup to the next milestone and keep more options open

The next time an entrepreneur wants to raise more money at all costs, explain how startup funding affects optionality. Raising too much money has made many acquisition offers not feasible due to the underlying motivations.

What else? What are some more thoughts on startup funding and optionality?

Notes from the AppDynamics S-1 IPO Filing

AppDynamics, a fast-growing application performance management software company, just filed their S-1 IPO filing to go public. AppDynamics has raised a huge amount of money ($300+ million) and is growing super fast (>50%), making it one of the higher profile B2B software companies to file recently.

Here are a few notes from the S-1:

  • The integrated suite of applications monitors the performance of software applications and IT infrastructures, down to the underlying code, and automatically correlates them into logical “business transactions,” such as booking a flight in a web browser, transferring money on a mobile device, getting directions through a car’s navigation system or locating physical goods in an inventory system. (pg. 1)
  • 1,975 customers (pg. 2)
  • Revenues (pg. 2):
    • 2014 – $23.6 million
    • 2015 – $81.9 million
    • 2016 – $150.6 million
  • Net losses (pg. 2):
    • 2014 – $68.3 million
    • 2015 – $94.2 million
    • 2016 – $134.1 million
  • Industry Background (pg. 2):
    • Enterprises are Undergoing Digital Transformations
    • IT Investments are Moving to Customer-Facing Software Applications
    • Velocity is Critical
    • Accelerating IT Complexity
  • Internally estimate that the total addressable market for the solution is approximately $12 billion (pg. 4)
  • Revenues nine months ended October 31, 2016 (pg. 12):
    • Subscription $110 million
    • License $32.6 million
    • Professional services $15.7 million
    • Total: $158.4 million
  • Accumulated deficit of $476.8 million as of October 31, 2016 (pg. 16)
  • Mix of time-based licenses, SaaS subscriptions and perpetual licenses and the mix of applications sold (pg. 23)
  • Competition for people in our industry, especially in the San Francisco Bay Area is intense and often leads to increased compensation and other personnel costs. (pg. 29)
  • Federal, state and foreign net operating loss carryforwards (NOLs) of $182.1 million, $199.8 million and $94.7 million (pg. 42)
  • Cash, cash equivalents and marketable securities of $142 million (pg. 57)
  • SaaS subscriptions and time-based licenses are typically one or three years in duration, and are bundled with software updates and customer support services (pg. 67)
  • As of October 31, 2016, we had more than 165 customers with a life-to-date total contract value greater than $1 million, an increase from just over 20 such customers as of January 31, 2014 (pg. 70)
  • We have increased our sales and marketing headcount from 157, as of January 31, 2014, to 485, as of October 31, 2016 (pg. 70)
  • 2016 dollar-based net retention rate of 123% (pg. 71)
  • In the fiscal year ended January 31, 2015, we recognized the settlement costs of $10.0 million related to our litigation with CA, Inc. (pg. 75)
  • Founder/Chairman equity: 14.2% (pg. 153)

I think AppDynamics has the scale and growth to have a well received IPO but I think the heavy losses and high percentage of license and services revenue relative to subscription revenue will make it less desirable compared to equivalent SaaS companies.

Congratulations to the entire team at AppDynamics for building a large, fast-growing company.

What else? What are some more thoughts on the AppDynamics S-1 IPO filing?

SaaS Funding Valuations Based on a Forward Multiple

Continuing with last week’s post on 3 Quick Ideas When Thinking about SaaS Valuations, there’s another common way to determine a SaaS valuation for funding purposes based on a multiple of what the revenue or run-rate will be in 12 months. This approach is known as a “forward multiple”, and because the valuation is based on an expected amount in the future, it effectively takes into account the current growth rate, which is one of the largest, if not the largest, drivers of valuation, everything else being constant.

Long term, SaaS companies will likely trade at 4-6x revenue based on strong recurring revenue, great gross margins, and excellent economies of scale. As a simple example, if a SaaS company was put into harvest mode, it could generate 60-80% profit margins and get an EBITDA multiple of 6 – 10x, resulting in the same value as 4-6x revenue.

So, if a startup is doubling year over year, and expects to double again next year, a funding valuation could be 4-6x the expected run-rate in twelve months. If a startup is at $5 million today, and will clearly be at $10 million in 12 months, asking for a pre-money valuation of $40 – $60 million might get funded, assuming a great team and market. Investors would be willing to “pay up” for a fast-growing startup as they believe it’ll continuing growing fast and has the opportunity to be a large, meaningful business.

For entrepreneurs raising money, use the idea of a forward multiple when discussing valuation.

What else? What are some more thoughts on SaaS funding valuations based on a forward multiple?

3 Reasons Founders Might Not Make Any Money After Raising Venture Capital

Yesterday’s post on Most Founders that Raise Venture Capital Don’t Make Any Money prompted a number of comments and questions. One of the popular questions was “why?” If a startup raises millions of dollars of institutional capital, why would a founder not make any money? Here are three reasons:

  1. Stacked Preferences – Most venture investments are either participating or non-participating preferred equity such that investors get their money back first in the event of a sale. For example, if the startup raises $25 million in capital and ends up exiting for $20 million, the $20 million would go to the investors and the founders wouldn’t make anything (unless there was a carve out or incentive plan to join the new company). The more money the startup raises, the higher the bar to sell where everyone is happy.
  2. Down Round – If a startup raises a round at a valuation lower than the previous round, a variety of anti-dilution clauses kick in that “true up” the previous investors’ quantity of shares to reflect their previous investment in the context of the new, lower valuation. Depending on how much lower the valuation, these anti-dilution measures can completely wipe out the common shareholders including the founders.
  3. Bankruptcy – Not all venture-backed startups succeed, and a small percentage go bankrupt even after raising institutional capital. With a bankruptcy, shareholders are wiped out, including the founders.

A general rule is that if the startup sells for 3x the amount of money raised, things are usually OK for the founders. If the startup sells for 10x the amount of money raised, things are great for the founders.

Most founders don’t make any money after raising a venture round and these are a few reasons why.

What else? What are some more reasons founders might not make any money after raising venture capital?

Most Founders that Raise Venture Capital Don’t Make Any Money

TechCrunch has a great article up titled A longtime VC on the virtues of not swinging for the fences where the author interviews Jodi Sherman Jahic. Jodi’s fund, Aligned VC, focuses on capital efficient B2B startups where the entrepreneurs aren’t trying to build the next unicorn. From the post:

The majority of the time — something like 75 percent of the time, according to [the benchmarking company] Sand Hill Econometrics — founders who take venture money get not a dime.

Think about that for a minute: with all the focus and hype around raising venture money, the majority of founders that go that route don’t make any money at all. Of course, entrepreneurs choose to raise institutional capital for a variety of reasons, primarily to grow faster and build a large, valuable business. Only, the majority of entrepreneurs that go down this path don’t make a dime when the company sells.

The next time an entrepreneur says they want to raise venture capital, let them know that the majority of entrepreneurs that do so don’t make any money.

What else? What are some more thoughts on the idea that most entrepreneurs that raise venture capital don’t make any money?