Happy Friday everyone! I can feel spring coming and am excited to get out into the woods and start fishing. For now, let’s dive into another week of Fishing in Venture.

Fishing in Venture 🎣

This week I read the State of Private Markets: Q4 and 2023 in review article by Peter Walker and Kevin Dowd on Carta highlights. Carta provides fantastic insights with the quality of data they manage for startups. Today I’m going to share some of my key learnings from the article.

You may ask - What is a down round? A down round is where the valuation of a company is “down” compared to the previous raise. Specifically, the share price has decreased. Like a stock - private shares of a company are subject to fluctuate. Let’s say my startup raised a Series A of $3M dollars last year at a valuation of $10M (post-money). In other words, Series A investors bought 30% of the company at a $10M price tag. Now, I’m raising again, a Series B round. My lead investor has priced the round at $8M (post-money). So now everyone’s shares are technically worth $8M whether you’re a Series A investor or Series B. In my example, if the Series B round was priced at $15M (post-money) and we raised $7.5M then its a down round because your dollar is buying more equity in this round structure.

The prevalence of down rounds, changes the fundraising dynamics for both founders and investors. The report also points out the rising valuation of Seed startups. Remember the first post we discussed the different stages of a startup. The seed stage has grown increasingly popular with the larger marquee funds (Tiger Global, Sequoia, SoftBank) because of the massive losses they incurred during 2022 and 2023. With more money flooding into this stage of the startups lifecycle the valuations have followed suit.

Fish of the Week 🐟

I didn’t catch any “fish” this week. If you are an investor, entrepreneur, innovator or just want to share your story on the newsletter - I’d love to have you on! Click the button below or reply to this post

Ebbs & Flows 🌊

This week I wanted to start the journey on financing rounds and how they’re structured. When it comes to structuring rounds it can get pretty messy quick. So, we are going to chat about Convertible Notes and what they are. I’m going to attempt to make it easy to understand (although I’m still learning a lot!) but there are a ton more complexities to them. Let’s dive in

Understanding Convertible Notes

Convertible notes aren’t new to early-stage investors. They provide a flexible and efficient way inject cash into startups. At its core, a convertible note is a short-term debt instrument that can convert into equity under predetermined conditions. Investors extend these notes to founders in exchange for future equity in the company, with conversion typically triggered by a specified event such as a subsequent fundraising round, maturity date or a liquidity event like an acquisition or IPO. Convertible notes operate as a function of debt until the conversion event occurs, at which point they transition into equity. The conversion price is determined by factors such as valuation cap or discount rate, offering investors favorable terms while delaying valuation negotiations until a later stage.

Let’s look at an example:

A founder secures $500,000 through convertible notes, featuring a valuation cap of $5 million and a 20% discount rate. Two years later, the startup undergoes a Series A funding round, resulting in a pre-money valuation of $10 million. With the convertible notes converting at the discounted rate, investors effectively enter the round at a $8 million valuation ($10 million - 20% discount). Assuming the accrued interest on the notes amounts to $50,000, the total conversion value becomes $550,000. As a result, the convertible note investors receive approximately 6.8% equity stake in the company ($550,000/$8 million)

Key Considerations

For founders, convertible notes offer advantages such as lower upfront costs, simplified negotiations, and quicker access to financing. However, it's crucial to carefully consider factors like potential dilution and the impact of interest payments on cash flow.

Investors, on the other hand, can negotiate favorable conversion terms and benefit from superior liquidation preferences as debtholders. Yet, they must be mindful of the signaling effect associated with convertible note financing at later stages and navigate complexities such as cap table management.

Convertible notes remain a prevalent tool in the early-stage investing landscape, offering flexibility and efficiency for both founders and investors.

A fantastic resource to use is Angellist’s article on Convertible Notes

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