SeedCamp’s hackathon, Seedhack, took place at Google Campus, London, on the 8th to 10th of November. It brought together some of the brightest talent in the startup community from 15 countries with one of the best accelerator programs in the world and mashed it up with awesome content providers like Twitter, Facebook, BSkyB, BBC, Getty, HarperCollins, EyeEm, Nokia Music and Imagga. There were a total of 12 teams working on interesting and exciting projects.
As part of this hackathon, Ali and Will helped me aggregate resources to help founders better understand the process of raising equity and the impact it can have to their founder stakes. We aggregated resources to help entrepreneurs to understand the numbers and implications of raising money and giving out equity. Valuing a company and calculation its impact on your equity is a very complex and confusing for entrepreneurs as well as being far from an exact science, this is the pain point that we wanted to address.
In the words of Seedhack attendee Will Martin (@willpmartin)
“Fundraising is one of the most difficult parts of the startup world, as first time founders this is an even more daunting process. Experience of raising a round and understanding the numbers and implications of that round and the related equity issued to an investor as well as employees in the form of an option pool is vital, but sadly is only fully understood by going through the process for real. Our intention was to give founders the knowledge required by being able to go through the process in a simple and easy way, thus giving the founder the confidence when it happens for real.
Ali and I are first time founders currently actively looking for investment. We know the total value we need in terms of money we want to raise as well the percentage of equity we are comfortable willing to give up to the investor. What we didn’t know and learned through the process is the implications in future rounds as a result of that initial funding round. Having an option pool for employees, advisors, board members etc. is something that complicates the issue and is often a requirement in the terms an investor is offering. This complicates the issue for the founder, so being aware of the impact of their shareholding as a result is vital for a founder as it is them that gets diluted in the first round but also any subsequent round, but it is often overlooked.
The changes to equity positions of the founders, investors, employees etc. is very important to understand as it dictates control and value of a company. Having this knowledge now gives us as founders a huge advantage over other founders we are competing with for funding and bridges the knowledge gap that exists for first time founders.”
In order to read some of the terms on this cap table model, below are some definitions which you might find useful:
Pre & Post Money Valuation –
“The pre-money valuation is the valuation that a company goes into raising a round of financing with. By establishing this valuation, it helps investors understand what amount of equity they will receive in the company in exchange for their capital. Once the financing round has been completed, the post-money valuation is the sum total of the pre-money valuation plus the additional capital raised. So, if the pre-money valuation of a company is $10 million and they raise $2.5 million from investors, their post-money valuation would be $12.5 million. Investors would own 20% of the resulting company.” – Dave Morin, Source Quora
“A PRE-MONEY VALUATION is the valuation of a company or asset BEFORE investment or financing. If an investment adds cash to a company, the company will have different valuations before and after the investment. The pre-money valuation refers to the company’s valuation before the investment.
External investors, such as venture capitalists and angel investors will use a pre-money valuation to determine how much equity to demand in return for their cash injection to an entrepreneur and his or her startup company. This is calculated on a fully diluted basis.
If a company is raising $250,000 in its seed round and willing to give up 20% of their company the pre-money valuation is $1,000,000. (250,000 * 5 -250,000 = 1,000,000)
Formula: Post money valuation – new investment
Source – http://en.wikipedia.org/wiki/Pre-money_valuation
A POST-MONEY VALUATION is the value of a company AFTER an investment has been made. This value is equal to the sum of the pre-money valuation and the amount of new equity.
The Post-money valuation is the sum of the pre-money valuation and the money raised in a given round. At the close of a round of financing, this is what your company is worth (well, at least on paper).
If a company is worth $1 million (pre-money) and an investor makes an investment of $250,000, the new, post-money valuation of the company will be $1.25 million. The investor will now own 20% of the company.
The only reason it’s worth spending time on this term at all is that it “sets the bar” for your future activities. If your post-money after your first round of financing is $4 million, you know that to achieve success, in the eyes of your investors, any future valuations will have to be well-in-excess of that amount.
Formula: New Investment * total post investment shares outstanding/shares issued for new investment. “
Source – http://en.wikipedia.org/wiki/Post-money_valuation
Option Pools –
“An option pool is an amount of a startup’s common stock reserved for future issuances to employees, directors, advisors, and consultants.” – from startuplawyer.com
Option pools can also be formed by Restricted Stock Units, but whichever one you use, they are generally still called ‘Option Pools’.
The OPTION POOL is the percentage of your company that you are setting aside for future employees, advisors, consultants, and the like. Employees who get into the startup early will usually receive a greater percentage of the option pool than employees who arrive later.
“The size of the Option Pool as a percentage of the POST-MONEY Valuation and where ALL of it comes from the founder’s equity. This is the least founder-friendly way to present this, but it is also the point at which most early stage investors will start the negotiations. The expectation from traditional venture firms is that this will equal 15%-25% of the company AFTER they make their investment. The Option Pool is one of the most complex and, from the entrepreneur’s perspective, confusing terms in an equity financing scenario.” – source http://www.ownyourventure.com/content/tips/op.html
Round Size –
The investment, or money is how much money is raised in a given round of financing. However, the decisions (and their implications) surrounding this number are among the most important that a founding team makes. It is not just about how much money is raised, it is about the terms that the money is raised on and, maybe most importantly, whose money it is and what they bring to the table in addition to money. – Source http://www.ownyourventure.com/content/tips/inv.html
Link to the Model Cap Table: http://bit.ly/1ayKk8p
NOTE FOR MODEL TO WORK – It needs to run on Excel (Google docs coming soon) and with circular calculations turned on. This can be done by going to (Mac Excel) Preferences -> Calculation -> Iteration -> Click on Limit Iteration
If you are considering using Convertible Notes as part of your round, check out this variant of the cap table with notes on how to convert as well: http://bit.ly/17kHlSA
Additional Equity Calculation Tools (Thanks to Ali Tehrani for finding these – @tehranix) –
This work is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 Unported License.
Watch Carlos Espinal in an episode of Silicon Real. Carlos shares some insights about being part of Seedcamp, and talks about acceleration of startups.
Originally published on Oct 17, 2013 on TNW
by Carlos Eduardo Espinal @cee
A lot of entrepreneurs talk about optimizing their products so they run faster, look better, go viral – but it’s important to remember that none of this can happen unless you are constantly getting feedback from your most valuable asset: Your customers.
During Seedcamp’s recent U.S. trip, we met with many companies like Return Path, Erply, Zemanta, Percolate, OneFineStay, BarkBox, GrabCad, Pinterest, Airbnb, and RunKeeper, to name a few. The consensus from these conversations is that you must continually talk to your customers. Without doing so, you won’t be able to focus on what’s most important: Providing them the value you promised.
In concept, customer communication seems relatively straightforward. But in practice, everyone we spoke with shared that they all experienced varying degrees of difficulty.
Here are the two main reasons why it can be tough to continue listening.
As a startup, you have the pressure of fundraising and needing to articulate to potential investors a “big vision,” which in many ways can be an extension of your original value proposition. However, that can sometimes lead to an over-extension in order to give the appearance of not thinking too small.
The problem is that unless your customers validate your assumptions shortly after your successful fundraise, you may find yourself going down the wrong path to keep up an “appearance” rather than refocusing on what you know to be the real value to your customer. This may, in turn, burn valuable resources along the way.
It’s a tough call to make, but it is one that could literally cost you your startup if made too late.
When you personally believe a product feature or functionality is what will provide value, you may suffer from self-confirmation bias rather than resorting to a real understanding of the needs of the customer. This could result in creating too many features that were requested by your customers (or yourself), thus distracting you from building on the core proposition.
When turning down feature requests from customers, you don’t always have to coldly reject the critique with a big “No.” Rather, as Jason Jacobs, CEO and founder of Boston-based startup Runkeeper suggests, think about whether their comments can be useful in the future, and tell your customers,”Not yet.”
Continuing to listen is only half the battle. The first half is identifying who your customers are and knowing how to speak to them effectively.
Rob Fitzpatrick’s new book, “The Mom Test,” does a nice job highlighting the methodical process which you can use to avoid the typical pitfalls of customer conversations. This could include confirmation bias and looking for compliments rather than actual feedback. You may think your product is the best thing out there, but be prepared to hear otherwise from the people who matter.
Secondly, it’s important to know who your customers are in the first place. In typical B2C companies, that might be more straightforward, but for non-B2C companies, it can take a little bit more work.
Take B2B2C models for example. These cases pose a unique challenge because it can be tempting to stop short of talking to the end customer and primarily focus on the immediate buyer, partner, or distributor. Don’t forget that the “C” stands for consumer, therefore, it is crucial that the customer that derives most value from your proposition in your marketplace.
In the example of a B2B2C business, you will want to have a relationship with the end customer if you want to keep control of your brand and what it stands for. Your marketing message will likely still have to be targeted to them and you will have to invest in those efforts to reach them, even if there is an intermediary step of the ultimate “buyer.”
Customer conversations should involve understanding the dynamics of both the end user and the B2B side of things. With customers, you must communicate with them to position your product vis-a-vis the competitors. You can do this better than your distributors or partners may be able to, even if they are helping you reach them.
Focusing too much on partners may leave you with a product that the end customer doesn’t care about or is wrongly adapted to their needs because you spent too much time caring about distributors.
Another form of customer conversation that needs to be done in tandem is one that is part of a two-sided marketplace. Yes, it will be twice as much work, but it is necessary in order to make sure you aren’t building an “unbalanced” customer acquisition process and product development. Below are some of the articles that thoughtfully discusses the topic.
The most complex situation is when the customer is not various individuals, but many people disguised as a single figure. This usually happens in situations where the end user is not empowered to actually make the decision to buy. Rather, there is a series of people within an organization that jointly make a purchasing decision.
In slides 49 to 51, Michael J. Skok has a good break down of what he calls the Decision Making Unit (DMU). He discusses the potential constituents of a DMU, and encourages you to think of them as a unit. This means “speaking to your customer” equates to speaking to all of them as they jointly make the decision. Not all organizations have all the components of Skok’s full DMU list, so it’s just about finding the ones that are required to make a decision – and think of those as the DMU.
After hearing many founders share their stories, it is clear that you need to constantly keep in touch with your customers as you continue to evolve your proposition and maintaining focus on what delivers value. The further you are from the reference customer, the more you need to be mindful of not losing touch with your users and their needs, for that can be fatal in an early stage business.
A big thank you to Bretton Putter of the Forsyth group for Feedback and Editorial Input – http://www.forsythgroup.com/about/the-team/
By Carlos Eduardo Espinal Twitter: @cee
This post is not about how to hire or how to fire someone. It is about highlighting the potential reasons why employees relationships can fall apart and lead to a dismissal down the road. Hopefully this is post provides with your the necessary information for you to consider on how you can prevent this from happening by setting up an appropriate hiring process and cultivating an environment where employees are not set up for failure within their defined roles.
As you likely already know, hiring and firing are probably two of the most difficult things to do in a company. That’s why usually, for key hires, a company’s leadership is directly involved in the selection and interview process. Ideally, if done right, you never find yourself in a position where you have to lay someone off, but what if you do? Was it entirely the employee’s fault, or could you have done something to prevent it from happening?
Let’s start with looking at your hiring process and mistakes that can lead to an employee relationship breaking down:
After the Fact Mistakes Analysis – These are mistakes you might have committed unknowingly that led to a dismissal
So, some final things to consider –
As I mentioned before, when you see a problem that’s brewing, deal with it quickly. If you need to let someone go, let them go, but don’t be blind that it’s entirely their fault, review your company’s internal circumstances to see if they contributed towards the problem.
Verse yourself well with what the legal requirements are in your company’s jurisdiction. Don’t get yourself into a big mess by not going through the appropriate process, which typically requires warning before dismissing someone. You don’t want to find yourself in a lawsuit for wrongful dismissal.
In conclusion, when you hire, consider whether your hiring process is exhaustive, but also take stake and review your company’s situation so that you can prevent things from going wrong for your new team members once they are hired.
by Carlos Eduardo Espinal @cee
A big thank you to Christoph Janz of Point Nine Capital and Juan Cartagena of Traity for feedback and editorial review.
Just as driving with your eyes closed is dangerous to your health, so is acquiring customers without knowing what it costs you to acquire them. Both can lead to disastrous outcomes.
Whilst acquiring new customers is always something to be happy about, it doesn’t mean, however, that you should throw out common sense in how you account for your time and human resource efforts in acquiring them, typically referred to as your CAC (customer acquisition cost). Most startups understand that if they pay Google for advertising, that should be included in my CAC costs, but many other items add up as part of the CAC that are less obvious.
In tldr format: Companies typically under-account for time costs in acquiring a customer; don’t forget to include your staff’s time in your CAC.
Before going any further, I should caveat that this does not mean you need to go nuts on excel getting this perfect to the nth degree. In a pre-product market fit company, you will likely be experimenting on how to sell quite a bit. The point here is to approach things with a rational sense for what can scale and what cannot and doing a back-of-the-envelope calculation on how this might affect your CAC down the road.
Ideally, everything you did in order to get that shiny new customer would be accounted for if you want to get a true snapshot of what that new customer cost you, how much need to charge to cover your costs, and what it might cost to get, say 100 more or 1000+ more similar customers. One tool that we can borrow from the accounting world to help you visualise this, is what is called Activity Based Costing. In the words of Wikipedia: Activity-based costing (ABC) is a costing methodology that identifies activities in an organization and assigns the cost of each activity with resources to all products and services according to the actual consumption by each. This model assigns more indirect costs (overhead) into direct costs compared to conventional costing methods. For more reading on ABC click here.
You might feel you have ‘acquired’ your new customer for ‘free’ but when you account the time that it took and some of the additional efforts, you might find that your new user is costing you more to acquire than you are charging them and thus, you are accidentally creating an imbalance in your company’s cashflow and experimenting with a non-scaleable method for customer acquisition.
To help illustrate, let’s walk through a few examples:
A customer that wants to buy your product says they only will pay if you help to integrate your product into their current systems and help them migrate their data from their old systems onto your new one. Because you are a hot-shot coder, you oblige and bang out the necessary code changes quite quickly and import their data into your system’s formatting. Within 6 weeks, you have finalised onboarding this new customer and you are happy as your first pay check comes in… was this truly a ‘free’ customer acquisition process if this is something you plan on implementing as an ongoing way of acquiring customers? How should you account for that time you spent integrating systems and migrating data?
You have a team of 5 people who are in charge of communicating with the outside world via social media and provide them with lots of ideas and communications about your company and its products, because of this, your product gets lots of mentions on the inter webs for a great customer experience. Is this truly a ‘free’ customer acquisition process or do these people act like a quasi-PR / sales team?
If we take an activity based costing mindset when assigning costs to your customer acquisition model, what you will find is that it takes more than just a website and some Google Ads to convert customers into paying customers. It requires the time of people, initially you, but later perhaps sales people or sales engineers to get the deal over the line.
The time you spent helping someone use your software or installing it or deploying it within their network or employees is part of that cost because you will not be the one doing this for the rest of your company’s life. You will likely have to hire someone to do this later.
As a starting point to kickstart your thinking, the following list includes time and/or other items that you may be ignoring as part of your acquisition costs:
As I mentioned before, these time based costs need to be considered for inclusion onto the more ‘traditional ones’ such as paid Ads & PR which startups usually associate with CAC calculations. Once you have determined what your rough aggregate CAC is, then you can figure out if it works for you vis-a-vis how you plan on monetizing your proposition.
In conclusion, the concept of accounting for your actual customer acquisition costs isn’t a difficult one to grasp, however, avoid getting caught not thinking through the impact of your time and other efforts in getting that customer! Driving while not looking is dangerous!
If you want a good starting point to start getting a better feel for how to model and visualise a SAAS KPI funnel and its related costs, refer to Christoph Janz SAAS KPI Dashboard on Google Docs (http://christophjanz.blogspot.co.uk/2013/04/a-kpi-dashboard-for-early-stage-saas.html ) Keep in mind, however, that his model is meant to be just that, a starting point; you will likely need to adapt it for the particular circumstances of your business.
Also, for more on customer acquisition costs vis-a-vis the lifetime value of your customers, David Skok’s blog post on the subject: http://www.forentrepreneurs.com/startup-killer/
Article originally published here: http://netocratic.com/real-customer-acquisition-cost-1546
By Carlos Eduardo Espinal @cee
Accelerators come in all different shapes and sizes. With many new Accelerators coming into existence within the last few years, the job of selecting one to join and getting the most out of your chosen accelerator program isn’t always obvious. Some programs, like Seedcamp, cater to high ambition & high growth companies spread across various industries, whereas others focus on specific verticals such as clean energy or healthcare to name a few.
We all have different approaches, but with over 90 companies forming the Seedcamp family we’ve had a chance to see many different industries and what it takes to get those companies to the next level.
Below are Seedcamp’s top tips for succeeding before you enter a accelerator programme:
1) Asses Program Fit – Research what an accelerator’s deal is regarding investment and terms before applying. perhaps your company isn’t ready yet or is too mature for the program you are considering.
2) Do your Due Diligence – Get in touch with founders or mentors that are part of the program, read blog posts from the Accelerator’s team to see what is important for them. This will help you get a better feel for the program but also how the program leaders think.
3) Rehearse your Pitch and prepare to answer questions – Be transparent, confident, and open. If your pitch isn’t ready or you are defensive in your approach, it’ll be a huge red flag.
Once you enter the program:
4) Be Proactive – Don’t wait for the Accelerator’s team to chase after you, you should chase after them and if you can, be as physically close to the team as possible..
5) Understand your startup is more than just tech – Finding Product-Market-Fit is crucial at this stage of the game. Don’t focus entirely on tech, embark on a mission to learn and master all the commercial aspects of your startup as well.
6) Attend as many of the curriculum events as possible – They are there to help you. Don’t skip valuable content.
7) Network as much as possible – email all the people you meet and get to know as many of the Accelerator’s mentor base as possible.
8) Build a board of advisors from your networking efforts early. They will be of incredible value
9) Start developing your fundraising strategy after the first week of being in the program
10) Lastly, don’t be afraid to experiment and ask questions – You will have lots of people supporting you. Your mantra should be ‘test test test’ – and that applies to all aspects of your company.
Article originally published here:
Written by Carlos Eduardo Espinal [@cee] & Special thanks to Dale Huxford from Orrick, Herrington & Sutcliffe LLP for edits and additional legal review.
UPDATED (Nov 11, 2013) – Notes added on: Conversion Triggers section & attached Cap Table in folder updated to v2 to fix some bugs.
The “Convertible Note” gets lots of attention in the blog-o-sphere as an alternative to traditional equity financings; some of this attention is good and some of it bad. Some investors refuse to use them, while others love them as a quick way of getting a company the capital it needs.
Convertible notes are sometimes viewed as a “best of both worlds” compromise from both a company perspective as well as from an investor’s perspective: on the one hand, a note is a loan, so the investor enjoys more downside protection than would an equity holder in the event the company is forced to wind up or dissolve for whatever reason; on the other hand, if the company eventually raises money by selling shares to later investors in a typical early stage financing round, then rather than pay back the outstanding amount in cash, the principal and interest are “converted” into shares of stock in the company (usually at some sort of discount off the price offered to new investors – I’ll discuss that below). In other words, the investor enjoys the downside protection typically associated with debt lenders, but is also positioned to enjoy the upside opportunity typically enjoyed by equity holders.
As with any tool, before you use it effectively, its best to understand the pros and cons of each of its features and how they can be used for your individual circumstances. Fortunately, convertible notes typically have fewer moving pieces than do equity instruments (which explains, in part, why they’re sometimes favoured by early stage companies and investors – the negotiation and documentation for a convertible note round is likely to be far less time-consuming and costly than for an equity round), but before we proceed any further in dissecting this tool, let’s look at the headline basics of a convertible note:
1) Total Amount Raised by the Note – This amount does have a natural limit. Think about it this way… you have an amount ‘outstanding on your cap table’, that will be part of an upcoming round. If a new round in the future isn’t particularly big, having too much money outstanding can create a problem with your convertible note holders taking up too large a portion of that round. Example: a 300K convertible which converts as part of a total 600K seed round would loosely mean that the convertible note holders would have 50% of the round. If the round was supposed to be for 20% of your equity, that means your new investor will only get 10%, an amount that may not excite him that much… and also you only get 50% new money in the door. To limit the extreme cases of this being done, investors usually create a ‘qualified round’ definition within the Note’s terms for conversion (see bullet #5 below) which reduces the likelihood of this amount being disproportionally larger than a new investors amount as part of a new round.
2) Discount Percentage – Simply put, if shares are worth $1 a 20% discount percentage would mean that an investor would get the shares for 80 cents. For cases where the next round’s valuation is below your convertible note holder’s cap as set in point #3 below, a discount factor will yield the convertible note holder a marginally cheaper price for having taken a risk on you. Typically this discount percentage is likely to be between around 15-25%. Another Example: a round closes at 3M. Your cap is at 5m. Your convertible note holders have a 20% discount, so they get to convert into the next round at a valuation of 2.4M.
3) Limit On Company Valuation At Conversion (the so-called “Valuation Cap”) – In order to calculate the number of shares into which the outstanding balance on a convertible note will convert, you must know the price at which the next round’s equity securities are being sold. Price per share, as you may or may not know, is calculated by taking the company’s pre-money valuation (negotiated at the time of the equity financing between the company and the investors) and dividing that number by the total number of outstanding shares in the company (the company’s “fully diluted capital”). Recall, however, that convertible notes are typically entered into in anticipation of an equity financing round – thus, at the time a convertible note is issued, no one knows what the negotiated pre-money valuation will be if/when the company undertakes an equity financing. Consequently, no one knows exactly what the price per share will be at the time the notes are issued. This creates uncertainty and is a cause for some investor anxiety, particularly for those investors concerned that that the number of shares into which their note may convert may be insignificant relative to the other shareholders, particularly in the event the pre-money valuation at the time of conversion is especially high.
The valuation ‘cap’ is intended to ease investor concerns by placing a maximum pre-money valuation on the company at the time of conversion. with the use of a cap, an investor can effectively set the minimum amount of equity an investor is willing to own as part of having participated in your convertible note round. For example, if you have a 200K note on a valuation 5m cap, then the worst case scenario for that convertible note holder, would be 4% equity after the new round is over. A typical valuation cap for very early-stage companies will be around $4m – $6m, with most companies at the Series A level settling on $10m valuation caps or more. For more statistics on caps and other components of a convertible note, I have included a link at the bottom of this post to an article with additional stats.
One thing to note, is that in the USA, there is a rising prevalence of uncapped notes. Clearly this is a founder friendly outcome, and if possible, always nice to get. The flip-side, is that for the investor, the may feel a bit ‘unprotected’ in the case of where the company does exceedingly well and thus their amount converts to a much smaller percentage than originally hoped.
4) The Interest Rate on a Note – A convertible note is a form of debt, or loan. As such, it usually accumulates interest, usually between 4-8% between the point when you sign it and when it converts. This amount is usually converted as part of overall amount at the next round. For example, if you have an annual interest rate of 8% and you have a Loan Note of 100, then you’d convert 108 after a year.
Note: In the US, it’s highly advisable to include an interest rate, even if it’s simply a nominal amount equal to the applicable federal rate (most recently at less than 1%), b/c if not, then any amount that could have been earned via interest is taxed to the company as gain. So it’s not really an option to exclude it in the USA. In the UK, you don’t necessarily need to include it should you wish to omit it.
5) Conversion Triggers – The point of a convertible note is for it to convert at some point in the future, not for it to stay outstanding indefinitely. As such, it will likely have a series of triggers for conversion. One I mentioned earlier is the next ‘qualified round’. Basically this means that the round is big enough to accommodate the amount in the note (without washing out new investors) and also is the type of round that is typical for the next step in the company’s growth and will give the note holders the types of rights they’d expect for their shares once converted from loan to equity. Another conversion trigger is an expiration maturity date, whereby the note holder typically can either ask for their money back (although this rarely happens) or basically seek to convert the outstanding amount at that point. There are more types of conversion triggers that note-makers can add to a note, but these are the basic ones. Update: upon a change of control event in the future and before the convertible is converted, investors can sometimes ask for a multiple of their loan back as payment in lieu of converting to ordinary shares prior to the completion of the change of control event. You can see some examples of this in the wording of the attached examples later in this post.
Again, these are the headline terms of a convertible note, and not representative of all the terms. However, for early discussions with potential investors, you’ll rarely have to talk about anything more than 1-4. Beyond that, you usually start having to involve lawyers (or experienced deal drafters) to help you finalise the document.
Now that we’ve reviewed the basics of a Convertible Note, take a look at a recent report that has statistics of what common terms have been given to Valley based companies. If you are not in the Valley, you will likely have a different set of averages, so be mindful of that.
Now, let’s look at the headline pros and cons of using a convertible note.
Now let’s explore a few more core concepts in detail.
Seniority – A convertible note is a form of debt or loan. Although its not too common to hear about investors asking for their money back, they in fact, do have that right… additionally, one of the privileges that having the Note act like debt is that it acts senior to equity in the case of a liquidation. What this means in practice, is that Loan holders will get their money back first.
Subscription Rights – Some investors like to have more equity than their invested amount would likely yield them upon conversion. So one thing to look out for is how much they want to take up of the next round as part of having been in the convertible note. Example: An investor gives you 50K, which converts at your next round of 1m on 2m Pre at 1.6% -> next to nothing for the convertible investor. However, that investor had a Subscription Right for up to 30% of the new round, so that allows him to participate on the 1m round with up to 300K thus affording him a larger ‘seat at the table’ in excess of the 1.6% he would just have without this right.
To conclude and to provide you with some practical examples, in the following Google Drive Folder I have added an excel sheet with an example cap table as well as UK & USA termsheet templates from Orrick* that are uberly simple, for review purposes only (they may not be fit for what you need, but give you an idea). A comment on the example cap table – it isn’t designed to be ‘fully realistic’ per se, as in, your cap table will likely not look like this in terms of founders and shareholders and number of rounds before a convertible comes in, but it serves well for you to play with the variables that make up a convertible note so you can see how they affect your fully-diluted stake after a round.
I hope this helps you decide what the best options may be for you. As usual, please feel free to leave feedback on all these materials as with software, there are likely bugs somewhere!! Thanks in advance!
*Regarding the Convertible Note Documents, a disclaimer from Orrick: The linked documents have been prepared for informational purposes, and are not intended to (a) constitute legal advice (b) create an attorney-client relationship, or (c) be advertising or a solicitation of any type. Each situation is highly fact specific and requires a knowledge of both state and federal laws, and anyone electing to use some or all of the forms should, prior to doing so, seek legal advice from a licensed attorney in the relevant jurisdictions with respect to their specific circumstances. Orrick expressly disclaims any and all liability with respect to actions or omissions based on the forms linked to or referenced in this post, and assumes no responsibility for any consequences of use or misuse of the documents.
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