VC Myth 03: Dilution

Myth: The issue is about how much external financing the founders should raise, and when. It also reflects on who and how the company is being controlled, an issue near and dear to the hearts of all entrepreneurs across the globe. This myth exists in many variations, all centering on two themes: control and dilution. This might be stated in diverse ways, with the same underlying belief - if you raise money, you should raise as little money as possible, because then you will give up less of the company now.

The amount of financing a company should raise is often a controversial (internally) issue. Entrepreneurs sometimes intentionally choose to raise lower amounts of funding to minimize dilution or to remain attractive for the quick flip in the unlikely situation (at times it is intended and planned too) sale of the company, but most of the time, that decision is later regretted. The entrepreneur should raise the amount of funding that will enable accomplishment, with some cushion, of the key milestone that will justify a significant increase in valuation. Valuations of early-stage companies do not increase in a linear fashion over time, but instead in a "stair-stepping" fashion, jumping upon a key accomplishment such as a product release, a certain level of customer traction, a big deal, or a technical milestone and then more or less flattening again until the next milestone. Taking an illustration, a INR 5L seed investment to be able to raise "Series A" at a higher valuation makes sense, but only if that key milestone can be reached with the IINR 5L funding.

Very few entrepreneurs have ever regretted taking additional funding when it is offered. At the end of the day, start-up businesses fail for one reason: because they run out of money. Raising money opportunistically helps to weather the storm caused by external factors such as market or economic conditions.

VC Myth 02: Board of Control

Myth: While it is imperative from a fund-raising perspective and can be considered as one of the ten important pillars of early-stage fundraising activities, there is some deep-diving and understanding required of it. Entrepreneurs who are overly concerned about control will need to find a path to success other than venture capital. A glance at the typical ownership percentages as understood previously shows that even after a single round of financing, the founders no longer have "control," while also the VCs would have special veto rights over key matters such as acquisitions, the next round of financing, et all.

The terms of venture capital financings are structured around alignment of incentives, and not control, which is unlike many other routes of corporate financing methodologies. VCs appreciate the fact that the founders must have a sufficient incentive and bandwidth to create value for the benefit of all. Hence, the terms of a typical venture capital financing provide that, after a return of capital invested, the investors do not profit unless and until the management does. Likewise, management does not profit unless and until the investors do. This circular dependency and co-habitation create a mutually beneficial and conducive corporate structure.

VC Myth 01: Valuation of the Idea

Myth: Most entrepreneurs tend to focus extensively on the value of their enterprise, creating elaborate storyboards, extrapolated discounted cash flow models to demonstrate the net present value of their future projected revenues.

In early-stage venture capital financing, the concept of valuation is simply a surrogate - it is more about the percentages and ratios. The typical post-financing value share for a company's initial venture capital financing breaks down as - 

• Main (Lead) VC: typically insist on owning close to 20-25% of all early-stage portfolio companies
• Co-Investor VC: Most VCs prefer to invest alongside a co-investor, which is favorable to both the investors and the company. Here too, a typical 20-25% must be given off, here as well
• Option Pool: negotiating the size of the option pool is a surprisingly effective back-door way of negotiating valuation, as part of the "pre-money" valuation equation, which constitutes 15-20% share of the company
• Founders: taking into perspective and consideration the above dilutions, the founder entrepreneurs are left with almost 35-40% of the company

Unlike valuations of later-stage companies, valuations of early-stage companies do not fluctuate with the financial markets, but economic downturns do have an impact in the number of early-stage companies getting financed, and those who brave the winters and autumns, succeed in smaller funding amounts than would have been otherwise.

Convertible Notes

There has been a lot of noise about how most seed stage deals are being done through convertible notes. The convertible note was really intended as an instrument for a “bridge financing” — when an equity round was imminent, and likely to occur, but the company needed some money in the interim. In such a scenario, it made complete sense to have a debt instrument, where the investor converts them into equity when the financing occurs. As the debt-based investment is made close to an equity round, there is no need to have a valuation-based factor in the note. In a worst-case scenario, where the intended equity-based fund raise fails, the very nature of the instrument being debt-based insures and guarantees that the bridge investor would get priority in case of a liquidation of the company’s assets.

However, somewhere along the way, the usage of a convertible note changed. This primarily happened due to the higher fees and cumbersome process associated with doing an equity round. The convertible note hence came to be perceived as the easier, cheaper, and faster option. Today, the convertible note is no longer a bridge, but has all too often become a pier.

An uncapped convertible note misaligns the incentives between the founders and the investors. Although both the founders and the investors have the common objective of getting the company funded, there is a basic misalignment of incentives when it comes to valuation. While the interest of the founders is to maximize the valuation of the company at the time of a follow-on financing (thereby minimizing equity dilution), the investors' motivation is to minimize the valuation of the company so that the investment committed as part of their note convert in to as large a piece of the company as possible. This concern can be addressed by putting a cap in the note for the pre-money price for conversion, which is the genesis of the term "capped notes". Although entrepreneurs prefer the notes as they defer the process of a valuation to the company, once a cap is put in a note, it effectively prices the company.

Although notes have fewer rights associated with them, they come with one big caveat. Legally, the note is a debt instrument and can be called upon maturity. It is in essence equivalent to being a liquidation preference that is typically seen in a preferred equity. In a lot of ways, the note is not as strong a commitment from investors as equity investors, as they still have the option to pull their money out. By contrast, when investors buy equity, they are fully committed, and usually do not have an option to get their money back before a milestone and their only choice is to help the company succeed or end up losing their money 

Notes have some interesting ramifications for investors as well. When an investor buys equity in a priced round, the capital gains clock on that stock starts as of the date of investment. However, in the case of a note, and especially with long maturity dates, the capital gains clock does not start ticking till the note converts. The intensity is felt at the seed and angel level where a lot of startups make exits. Let us say a company liquidates with a positive outcome. In the case of equity holders, there would be long-term capital gains and they must pay 15% on the gains. However, for a note holder, since there is a chance that either they have not converted yet, or if it had converted, it may not have been 1 year since the conversion. In this case, the note holder would end up paying 35% on short-term capital gains.

My purpose in writing this post is to incite a bigger discussion on this topic and to solicit more opinions and feedback. I would love to hear from founders and from investors on their view on convertible notes.

Preferred Stocks as an Investment Option

We come across the terms - Preferred Stock, or Preference Shares, interchangeably which, by definition, is a kind of corporate ownership that combines features of both bonds and common stock/ordinary shares. A preferred stock (we will carry forward the discussion, taking this term as the representative to understand the topic), is a class of stock that typically has a higher priority and a greater claim on the distribution of the company’s assets and earnings as compared to ordinary stock. Preferred stock has distinct characteristics that make it an attractive investment option. However, understanding the advantages vis-à-vis its disadvantages can help investors make better informed decisions and diversify their investment portfolios.

Types of Preferred Stock

1. Cumulative: guarantees that if a company does not pay dividends over a specific period, the unpaid dividends will accumulate and must be paid before any dividends are granted to common shareholders.
2. Non-Cumulative: does not allow unpaid dividends to accumulate. If the company fails to pay dividends during a given period, non-cumulative preferred shareholders do not have a claim to unpaid dividends in the future.
3. Convertible: allows shareholders to exchange their preferred stocks for a set number of common shares. This feature allows preferred shareholders to profit from capital growth in the company’s common stock.
4. Participating: entitled to additional dividends over and above the predetermined dividend rate.
5. Callable: right to repurchase the shares at a specific price after a predetermined time. This gives the company the flexibility to buy back preferred shares from shareholders, typically when interest rates have dropped, or the company needs to restructure its capital.
6. Adjustable Rate: also known as floating-rate preferred stock, has a dividend rate that changes based on a predetermined benchmark or index. This ensures that the dividend payout reflects the current state of the market, including any changes in interest rates.

Advantages

• Fixed Income: frequently pay a fixed dividend, providing investors with a steady income stream
• Tax Benefits: Dividends may be tax deductible, which helps lower the overall cost of ownership
• Priority Payouts: In case of bankruptcy, the investors are assured a priority in receiving funds
• Call Feature: as it grants the issuing corporation the ability to repurchase shares of preferred stock at a predetermined price, if the market price of the stock surpasses the call price, there is an opportunity to investors, potentially resulting in higher returns
• Conversion Feature: a conversion provision enables shareholders to convert their preferred shares into common shares. Investors who anticipate better performance from the common shares in the future may find this feature advantageous, as it allows them to participate in potential gains

Disadvantages

• Growth Potential: often does not increase in value as much as common stock
• Risk of Default: it is common as it functions as a debt instrument. If the issuing firm fails to fulfil its obligations, preferred investors may not receive their expected dividends.
• Limited Voting Rights: investors often lack voting rights; hence they do not influence how the corporation is governed