I love Mark Suster. He's relentless. He's been blogging and talking to entrepreneurs about the dangers of convertible notes and other traps in fundraising. His frustration in getting entrepreneurs to listen to him is clear.
A Small Deal, A Convertible Note & A Friend From Business School
I'm one of those entrepreneurs who ignored Mr. Suster's advice. Two years ago, I was in a rush to pull some seed money together. I reached out to Todd Newnam, one of my business school friends. Todd did pretty well as a private equity guy at The Carlyle Group. I don't know how much he's worth, but he was retired by our 15-year HBS reunion.
I've created six startups and five were bootstrapped to profitability. I don't have any experience making money for investors because I've never had one. When I started my journey, I was testing myself to see if I was good enough to create a business from scratch with no money. It was always about the journey of self-improvement for me.
In this context, I run very lean. I like to keep my burn rate ridiculously low and get to profitability quickly so I can be self-sustaining. Then, I don't need to answer to anyone. This is a nice way to do it, but it's difficult to build a really big company using this approach. With my current startup, I was open to getting someone else involved.
I had just closed a new customer deal using our enterprise SaaS MVP (minimum viable product). I needed about $25K to build the vaporware that I just sold. I was already $150K invested in personal cash into the venture which went to our previous business model before the pivot to LegitLead. The idea of throwing another $25K in wasn't all that appealing to me at the time. I wanted of offload some risk.
I sent Todd an email.
"Hey Todd. It's been a while. I'm working on an enterprise SaaS startup and we just closed our first deal with DeVry University. I need $25K to complete the product build so I can delivery the features I just sold to them. Can you help?" I wondered if he would respond. We haven't talked in years.
If memory serves, I sent similar emails to 3 other HBS friends. 33% response rate.
"Hey Dave, great to hear from you. Give me a call tomorrow," he replied.
I told him the story and after about 45 seconds he said, "I'm in. I don't really understand much of what you just said, but I like you and I always have. Give me a 50% discount and I'll put in $50K to give you more runway."
50% discount rate! "That's fucking outrageous. Some friend," I thought to myself. Aren't typical discount rates 20-25%? Fucking private equity asshole! Thanks buddy.
Then I thought a little more about it. We're only talking about $50K so who gives a shit. If you do the math on the discount, we're not talking about a lot of money here. Plus, Todd is the first money in after mine, so I'm ok with rewarding him more than anyone who comes in later. It felt like the right thing to do. So, I agreed.
The only person that would be happier than Todd to get a good return would be me. I think there's a lot of value in building a good track record of returning something-positive-X to investors. At the moment we agreed on terms, I committed myself to busting my ass to get Todd's money back, plus a good return.
Here's the convertible note agreement we signed.
My attorney, at the time, was Michael Gray from Neal, Gerber & Eisenberg. I met Michael about 14 years prior, although we've never really worked together. I saw him recently during his free presentation to entrepreneurs at 1871. The meeting was timely, so I asked for his help to close a deal with Todd.
Neal, Gerber & Eisenberg is one of those old-economy firms in Chicago that startup Founders hate. In fact, I never signed their agreement because it was basically a blank check for them and a bunch of one-sided bullshit. I just ignored the agreement and moved forward with Michael to get the deal done. I paid Michael what I agreed to verbally but I never signed the bullshit engagement agreement. As you may have guessed, I'm not working with them anymore. I wouldn't recommend them to any other Founders. Maybe they are great for bigger companies; I don't know.
Michael added this section to the convertible note agreement. Incredibly, it was not something Todd was asking for.
(d) Change of Control. If the Borrower shall consummate a Change of Control prior to the Maturity Date, then each Investor shall receive an amount (the "Change of Control Amount") equal to the product of (X) its pro rata share of the then outstanding principal and accrued and unpaid interest on this Note, determined in accordance with the amount of outstanding principal and accrued and unpaid interest with respect to such Investor's Loan, and (Y) the Multiplier (as defined below) within thirty (30) days after receipt by the Borrower or the Borrower's holders of membership interests/Economic Interests (and their respective Percentage Interests) of proceeds from the Change of Control; provided, however, that to the extent such proceeds are all or partially in kind (and not all in cash), then each Investor shall receive, to the same extent, the Change of Control Amount in securities and cash. The "Multiplier" shall equal, for a Change of Control consummated: 2 times (e.g. if the principal and interest is $50,752, the payment for a Change of Control Amount will be $101,504.)
The logic of this provision is to reward the investor if there is a quick exit. If the discount is only 20-25%, this makes sense. An early-stage investor should get more than 20% return for taking this level of risk. When you make the discount rate 50%, this provision makes less sense. As we were sending redlines back and forth, the discount rate changed from 25% to 50% and the liquidation preference was just left in. Fuck me.
Basically, the liquidation preference means if I sell the company, Todd gets a 2 times his money before any other investors get anything. The "X" includes both principal and interest. That makes the interest rate effectively 20%. The interest rate on my credit card is 18%, which seems like a deal in comparison. Liquidation preference also means Todd gets paid before I do.
Thanks Michael Gray! You've really represented me well in this matter! Douchebag.
This is totally my fault. I understand that. Still, it's always fun to blame the attorneys.
"I love hitmen. No matter what you do to them, you don't feel bad." - Marv, Sin City
But I digress.
It's incredible but I could only think of one situation where I would have a change of control -- if the company was doing really, really well. That seemed to make sense at the time. After all, if the company was struggling, who would want to buy it? I think that's how a lot of entrepreneurs think.
It turns out that assumption was completely wrong.
I'm a bootstrap guy and I've built profitable businesses for myself, without help from investors. I simply didn't have enough experience selling startups to know that there is another potential outcome. You're doing ok, not well, yet someone wants to buy your company anyway. It turns out that's pretty common. I pretty sure it's more common that a big exit. At the time I did the deal, all I could envision was a huge exit! Perhaps that's why I am an entrepreneur in the first place. Now, I know it's a blind spot for me.
So, as this story unfolded for my startup, Acquisition Science (A16E.com), formerly LegitLead.com, it became clear our best exit was to sell our platform to a strategic buyer. I found one that was interested and we are trying to close the deal right now.
My company has been struggling. We lost a big customer at the end of last year. We ran the experiment and here's what we learned - this is an interesting, high-margin business but I don't think it is as scalable as I thought it would be. There are too many issues with missing customer data and too many hurdles around CRM integration issues. Building this business is going to be a slow and painful slog.
We need to pivot, and I know where to go. But I'm out of juice. I've lost my passion for the project and I want to do something else. After thoughtful consideration, I decided that I want out.
The proposed terms are $225K cash, a lot of earn out and stock in the acquiring company. The total value is around $1MM, but most of that is conditional so I'll have to report back in two years or so to see if I've realized anything on the back end. It's not a great deal, but I'm ok with it given where we are right now with business performance. If I can provide good a return to my sole investor, I'll do it.
In addition to Todd's 2x liquidation preference, he also has a 10% coupon, which means he's earning simple interest on his investment, just like a conventional loan. We started at 8% and I don't remember exactly how we got to 10%. Clearly, Todd has done this more than I have :-).
Here's how the cash would be distributed at closing if the deal goes through as it is now.
- $117K to Todd, our sole investor who came in on the convertible note
- $52K to my personal credit card
- $37K to a business line of credit with my personal guarantee
That leaves a whopping $19K for me and the IRS. Keep in mind, whatever the government doesn't take, I get to split with my soon-to-be ex-wife 50/50. Yay! I'm hitting the beach baby! I'm going to Disney World!
Realistically, I think I'll be working for a few more years...
If I Could Do This Deal Differently
Now let's rewind two years to March 2013. This is what I should have done, if I could turn back the clock.
Instead of a note, let's say we did a priced round at $500K pre-money. That's a low valuation considering we had a product, a bigco customer and revenue, but let's see how it plays out.
After Todd's $50K, the post-money valuation would have been $550K. Todd would own 50/550 or 9.09%. In hindsight, I should have made sure my personal debt was in the company ahead of all equity. This can be done in the agreement or by creating an official loan between owner and company. I didn't do that because I thought "It's all my money anyway." That's only true if you don't have an investor. Duh.
Assume the same thing happens with the business and the sale and we now distribute the cash. The debt comes out first and the cash would have been distributed this way.
- $52K to pay the loan to owner (me), which is my personal card that I "lent" to the company
- $37K to business line of credit
= $136K cash to equity.
Todd owns 9.09% and I own the rest.
- $12.4K to Todd. He reports a loss of $37.6K on his investment
- $123.6K to me. I put in $150K so my loss is $26.4K.
But at least I $123.6K of my $150K back. And if you think about it, that's the way it should be, right? I put my money in on day one and spent it during our first year. Todd came in two years later. So, it follows he should get less out than I do. I think pricing the round would have made this so much more clear.
But with a convertible note liquidation preference, that's not how it worked out. Instead, Todd gets a 2.3X on his money after two years and I get to fight with my ex wife over $5k.
Well, at least I have a good track record with one investor now who made a descent return in two years. I guess that's something that may pay off later.
Ouch. Lesson learned.
This isn't the startup outcome I envisioned when I started LegitLead. Startups are a high risk game. Most of the time, it just doesn't work out.
We usually hear about home runs, and how brilliant the entrepreneurs and investors were in the process. But I think there is value for all of us in learning from examples that weren't home runs. I think we learn more in failure and disappointment than we do in success. I think it's because failure is so painful, the lessons learned imprint themselves more deeply than they would otherwise. That's why I'm sharing my story with you. So you can avoid my mistakes.
So How Did I Let This Happen?
I consider myself to have above average intelligence. I realize this is a highly-disputable fact to anyone who is still reading this post.
Here's how I think this happened:
1. I didn't listen to Mark Suster.
2. I didn't consider all possible outcomes. I only considered one outcome - that my startup is going to be wildly successful. I don't think I was capable of holding any other thought in my mind at the time. A lot of entrepreneurs are like me in this way.
3. I had the wrong guy representing me. Sorry Michael, but it's true. It's 100% my fault.
4. I was focused on customers & product. I didn't have enough psychic energy for deal structure. I didn't put enough energy into structuring the right deal. At the time, my biggest concern was getting some quick cash so I could deliver our incomplete software to our first customer. A note deal that won't play out for a few years didn't seem all that important at the time.
5. Shit happens. I don't have a fucking crystal ball. I never would have guessed in a million years that this startup would have ended up this way.
If you told me on March 2013 what was about to happen, I wouldn't have believed you. The company got off to a good start, landed a big enterprise customer, built a great product, achieved profitability quickly. That part I would have believed. It was going well.
Then, the roof caved in. The for-profit education market crashed. Student demand fell 15-20% in all top 20 schools and across the entire market. We couldn't leverage the DeVry deal across the industry because CMO's were getting fired left and right. Almost all schools were fined or under investigation by the Department of Education for "predatory" marketing, increasing our national burden of at-risk student debt loans, guaranteed by US taxpayers. Our off-shore development team, who was based in the Ukraine, was invaded by Russia! That's right, they were invaded by the Russians! We couldn't get any money to them with sanctions in place. That wasn't a disclosed risk in my prospectus!
Last, but certainly not least, my wife and I mutually agreed to divorce. Then, she hired an attorney to go on the offensive and fuck up my shit in court. This included suing me for half of the equity in my startup, which made it impossible to raise additional money for the company. Who wants to invest in a startup currently engaged in litigation over equity ownership? If you do, please call me asap.
My mom said there would be days like this. She didn't say there would be a year like this.
A lot of shit can happen on the way to building a billion dollar startup.
I'm pretty hard on myself in general. When it comes to being all knowing and omnipotent, I'm going to cut myself some slack.
All anyone can do in this situation is keep blocking the punches and keep punching back. Work your way out of the corner and get in position where you can land your big right hand. Sometimes you can fight your way back, and sometimes you just get knocked on your ass. This was one of those times when I got my ass kicked.
This reminds me of a great quote.
"Good judgement is the result of experience and experience the result of bad judgement."
- Mark Twain
I hope this example is an illustration of what not to do if you are an entrepreneur. Forget convertible debt. Just price the damn company already. You will be better off and you will know what your company is worth at the time you put yourself on the hook with investors.
It also gives you a valuation number as a baseline that you can build on. What are we doing to increase our valuation today? Are we working on the right things? What are the things that acquirers would value in our business? Are we making progress? These are really important questions for us as entrepreneurs. Putting a number to where you are now is both helpful and powerful.
With a priced round, the terms are more clear and much less is implied that can bite you in the ass later.
Listen to Mark Suster. He's done more deals than you and me combined.
Next time I take money from someone, I'm going to look at the terms and run three sets of numbers:
1. What happens if we are kicking ass in two years?
2. What happens if this goes sideways, and someone buys us on the cheap?
3. What happens if this totally fucking flames out, we burn all our money and have nothing?
Run those scenarios, especially #2, and see where the money flows to both debt and equity according to the terms on the table. I think that's the best way to get clarity on what the deal is, and how it works in a variety of different outcomes.
Calm down for a minute. Forget about your product deadlines and your customers, just for a few minutes. Think this through. It's important.
Thinking through all three scenarios seems like the smart thing to do. Hindsight is 20/20. Please learn from my mistakes.
Mr. Suster says you'll use convertible debt anyway, in spite of his warnings. All it took was one convertible note deal for me to learn my lesson.
Feel free to follow our advice, or ignore it. Either way, you will eventually learn the truth about how your deal works. The only question is how much pain you will experience in the process.
Finally, please don't pity me. I'm doing just fine. Considering everything that happened, I'm pretty happy to give a good return to my investor and friend. This experience as brought us closer together. Todd is one of the most supportive people I know and he's a great guy.
I'm incredibly grateful I learned these lessons on a relatively small deal. Add a few zeros to the numbers above and it gets a lot more painful! Fortunately, I rarely make the same mistake twice.
I'm already recovered from this experience and I'm ready to start my next company, this time more intelligently.
Apollo: You know, Stallion? It's too bad we gotta get old.
Rocky: Just keep punching Apollo. Wanna ring the bell?
Apollo: All right. Ding, ding.