Why I tend to prefer equity rounds over notes

Why I are inclined to favor fairness rounds over notes

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This visitor submit is authored by Mark Bivens. Mark is a Silicon Valley native and former entrepreneur, having began three firms earlier than “turning to the darkish facet of VC.”

He’s a enterprise capitalist that travels between Paris and Tokyo (aka the RudeVC). He’s the Managing Companion of Shizen Capital (previously referred to as Tachi.ai Ventures) in Japan. You’ll be able to learn extra on his weblog at http://impolite.vc or observe him @markbivens. The Japanese translation of this text is out there right here.

alignment transparency
Modified from a Pixabay picture

All however two of my final 10 investments have taken the type of straight fairness. Moreover, all the offers by which Shizen Capital was lead investor over the previous two years have additionally been for fairness rounds. On this submit I’ll lay out the explanations that I favor fairness rounds to convertible notes or SAFE notes in early stage enterprise investments.

For simplicity right here, I’ll use the generic time period be aware to embody any sort of non-equity instrument that’s convertible right into a startup’s fairness sooner or later based mostly on sure circumstances. This consists of due to this fact traditional convertible notes in addition to SAFE and JKISS notes. [Note: there are some key distinctions in the implementation; notably, SAFE and JKISS notes generally behave more like warrants than debt, in that they typically do not carry an interest rate nor a maturity date).

My preference for investing with equity rather than a note center on two of the guiding principles we hold dear at Shizen Capital when partnering with founders: alignment and transparency.

First, let’s revisit why notes can seem more alluring than a priced equity round

  1. they are less costly and more expedient to implement from a legal perspective
  2. they sidestep a difficult negotiation over valuation
  3. they can surmount a conflict of interest for investors during an internal round
  4. they grant investors additional optionality and seniority in the financing of the company

Now let’s discuss these characteristics one by one:

True, a note agreement is simply a contract between two parties: the investor (as note-holder) and the startup. At a future point, the note converts into equity or is reimbursed, based on conditions defined in the agreement.

Since no equity is being issued at the time of a note financing, corporate formalities and legal filings are unnecessary. There is no need to update the articles of association, draft a shareholders agreement, or make any formal filings. The investor could even dispense with hiring a lawyer entirely for such a transaction, thus saving fees (the founders could do so as well, though I personally recommend founders seek at least some minimum level of legal counsel). However, once the future hoped-for equity round materializes, all of these aforementioned legal formalities will become necessary.

SAFE notes can be fast but only if the investor moves fast

In theory, transactions with notes (again, including SAFE’s and JKISS’s here) are faster to implement then equity rounds. In theory. If handled deftly, a straightforward equity investment should take a few weeks to implement. A note, in contrast, can be implemented within a few days (especially a SAFE or JKISS, which are based on a standard template). However, I find it cringe-worthy all too often to hear founders lament to me about how their fundraising efforts via a note are dragging out for weeks or months. I admittedly have not performed a scientific analysis on this, but anecdotally my observations are that weeks or months of note discussions are not uncommon in many regions outside of Silicon Valley.

Postponing uncomfortable conversations

Sidestepping a difficult negotiation on valuation can also be an appealing feature of financing via a note, which does not place a price on the equity of the company at the time of the transaction. If a founder and investor cannot agree on valuation at the time of the fundraising, a note postpones this uncomfortable conversation on price.

The distinction between convertible notes and SAFE notes becomes relevant here. While a convertible note often eliminates any reference to valuation, a SAFE note by its very construction usually contains a valuation cap. This valuation cap does not represent the valuation of the company at the time, but it does require some negotiated consensus between the parties, and it also lays the groundwork for future signaling to the market.


Furthermore, this is where the principle of transparency comes in. Postponing the uncomfortable valuation conversation is simply kicking the can down the road. Eventually this conversation has to take place, and the stakes will likely be much higher in the future than today. Moreover, numerous other unexpected consequences can arise from this approach. Because I’ve seen this play out across a vast number of companies over the years, often to the detriment of founders, I feel that in the spirit of transparency I have an obligation to alert founders to what I’ve witnessed. [Note: I’ve raised the alarm in detail on this issue here. And here is the Japanese version of the same piece]

Inside rounds

For {most professional} VC funds, inside rounds can increase compliance points if not executed correctly. For avoidance of doubt, by inside spherical I imply a future financing spherical of a startup the place no vital exterior events put money into the corporate. A VC fund refinancing one among its present portfolio firms with out an exterior market participant can be required to justify the next valuation if the brand new spherical is priced in fairness, reflecting an inherent battle of curiosity. Using a convertible be aware (usually structured as a convertible bridge mortgage in these cases) can surmount this problem

Danger of misalignment

Lastly, financing by way of a be aware naturally grants the investor an extra diploma of optionality and doubtlessly even seniority within the fundraising.

Let’s begin with the notion of seniority (extra flagrant in convertible notes than in SAFE or JKISS notes). From an investor’s perspective, sitting senior to all of the shareholders in an organization affords the very best of each worlds: if issues go nicely, convert and reap the upside; if issues don’t go nicely, redeem to your a refund plus curiosity, even when it throws the corporate into monetary misery. Accordingly, the phrases of a convertible be aware doc matter. Founders must evaluation the nice print earlier than coming into into one.

The notion of optionality is a little more nuanced. As a VC, I welcome optionality; in reality I actively search it out for sound portfolio administration. Nevertheless, I would like the founders into whom I make investments to totally perceive the implications of it within the case of notes. Let’s illustrate with a easy instance: the VC invests 50 million yen in a seed spherical by way of a SAFE be aware that comprises a 20% low cost and a 400 million yen valuation cap. When it’s time for the Collection A, the respective pursuits of the investor and founder diverge resulting from a slight misalignment. The founder’s proximate incentive is to spice up the valuation of the collection A better, and ideally excessive sufficient to neutralize the low cost, i.e. above 500M¥. In distinction, the investor’s incentive favors a decrease valuation, as a result of the decrease the valuation of the Collection A, the larger the variety of shares into which the investor’s be aware will convert. Had the seed spherical been raised as a priced fairness spherical relatively than by way of a be aware, each founder and investor can be aligned within the dilution they’d face from the long run Collection A.

I’m not ideologically against investing notes. Right here at Shizen Capital we method each potential funding as a long-term relationship. Accordingly, we consider that the higher we will align incentives and act with transparency with the founders we again, the more healthy and extra fruitful our collective partnership will likely be.

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