#28- The convertibles I like have four wheels and a roaring engine!
Why convertible rounds do not make sense to me!
Should entrepreneurs go for convertible rounds?
There is no rationale behind the valuation of any seed, angel, or Series A round companies based on any financial metrics. Put simply, there isn't enough historical evidence of the company's performance, or its business model to justify a 'right' number. At this point in the company's life, the business model itself is unstable or immature to project the terminal value.
How does one come up with the 'right' number?
It is simple to the point of being illogical. The entrepreneur decides the amount of capital they require to take the company from point A to point B (which is the usually the next stop before raising another round), they arbitrarily decide what is the kind of dilution they will be happy with, and negotiate with the investor to come up to a number that everyone is largely alright with. Fair enough.
But we have had real conversations with quite a few people who are very uncomfortable agreeing to a number upfront.
And here comes the trap of Convertible Notes!
We are not big fans of convertible notes. This is a fantastic way of prolonging the pain of negotiations to a later date when everyone is on-board, but might not be on the same page.
How?
Say, for example, you raise 1 cr from F&F at a 20% discount to the next round. And you raise your next round at 150 cr valuation - very good for you. But your F&F will be seriously pissed when they find out how much they'll end up owning despite backing you when nobody did.
So now, you raise 1 cr in convertible from an angel with a cap of 25 cr. The 25 cr is just a cap, your floor price is largely undetermined. There is also a possibility of converting the round at 10 cr. Good for them, catastrophic for you!
Alright, a smarter entrepreneur will now say "I will also specify a floor of 15 cr in the above." But, my friend, if you can come up with a cap and a floor, and you can largely determine a band. Why not just put a number and get it done with?
What is the problem with a convertible?
Many people who are ardent believers of a convertible tend to be super early-stage investors and accelerators. Some of whom have never had the privilege of leading a round. The key reasonings that we get are:
It's faster
It's easier
It's cheaper
Probe a bit further, and you come to the bottom of the reasoning.
"It is a good thing because we do not have to negotiate the terms today, we can always do it later! In the future, we will have a better performance to negotiate better terms for ourselves."
What a great way to begin a relationship with the most important stakeholder that fuels your business, by not being aware or aligned with their expectations? Isn't it possible that you might still not agree to a number in the future for when you actually negotiate?
"The best part of a convertible is that I do not need a lead investor."
It is true. But what is also true is that a lead investor will usually set the terms, and bring in co-investors from his network, or by their reputation so you do not have to worry about doing the groundwork yourself. Not having a lead means you will be fighting most of the battles on your own when you actually start negotiating the terms.
The convertibles that I prefer have four wheels and a roaring engine!
But when are convertibles actually a good option?
When you put money in tranches.
We (at Malpani Ventures) recently agreed to terms with an entrepreneur wherein we put in half the money at a certain valuation and offered a good upside kicker to the entrepreneur for the rest of the cash at a higher valuation upon meeting certain pre-determined milestones.
And even then, the agreement has to be with utmost clarity, pre-determined milestones, and the measurement of success, pre-determined valuation in the future, and pre-determined upside. Thus, leaving no chance for ambiguity in the future.
There has to be a meeting of the minds before a relationship starts. We can't half-ass relationships, and prolong important issues. After all, if you are looking to marry someone, you also need to know whether you both want kids or not. The same goes for a funder-founder relationship.
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