Charting the Landscape of Series Seed Investing in North Texas
December 16, 2015 | By Kevin Vela
It’s an exciting time in North Texas for startups. All indications are that we are on the verge, if not already in the midst of, a legitimate startup boom. This is being driven by a good mix of entrepreneurial spirit, a favorable economic climate, and a number of individuals and organizations who have dedicated themselves to driving startups in Dallas. We have the resources and talent right here in the area, and the capital is starting to flow. I truly believe that Dallas is the next startup haven.
Of course, the key ingredient to any startup is investment capital. In the startup world, there are two predominant ways to raise capital: convertible debt (also known as “convertible notes”) and equity.
Convertible debt, while technically a loan, is really a bridge to equity – as the intent is that the loan will convert into equity in the future. The investment is structured as a loan to save on legal costs and to postpone the question of the company’s valuation until a later date (when the company has more of a track record, or the next round investors can help to price the round). The convertible note investor will typically earn interest on the note, and then the principal plus accrued interest will convert into equity at the next equity raise round, usually at a significant discount.
Equity is just like it sounds – it’s a direct investment in exchange for ownership. For example, if a company is valued at $750,000 prior to the investment (or “pre-money”) and an investor invests $250,000, then the investor will own 25% of the company after the investment ($250k/$1M = 25%).
Over the past three years, here at VW we’ve facilitated approximately 150 early stage deals (Series B or earlier). Roughly half of these have been what would traditionally be coined as “Seed” or “Series Seed” deals, meaning that they are pre-Series A, but usually post FFF (“friends, family, and founders”) rounds. To get a better understanding of the startup investment landscape, we took a closer look at our Series Seed deals to see what kind of conclusions we could draw regarding angel investing in North Texas. I think this article will be valuable to anyone who is already or interested in angel investing, as well as to the startups raising money in North Texas in the near future.
We’ve published the results here, and this article will reference those slides. I’d encourage you to take a look before/during your read.
A few notes before I get started.
- We’re defining “Series Seed” as capital raises between $100k and $750k raised in the round. Though the parameters shift depending on the geographic market, and round sizes are increasing in general, I feel comfortable with these bookends for the purposes of this article. We removed small one-off rounds (those are usually FFF), bridge rounds (or combined those with earlier rounds), and Series A/B deals (A and B rounds are typically filled by venture capital/institutional investors and have a different set of standard terms).
- Roughly 80% of the deals we facilitated were when we represented the company, the other 20% were deals where we represented the investor (angels, super-angels, funds, or both VCs and angel networks, though VCs rarely invest in these rounds).
- Most of the docs we use for equity raises are consistent with the SeriesSeed.com docs. Our convertible notes look similar to others that we see, though we do have a few nuances which I discuss below.
- I’m not trying to bore everyone with this article (i.e. get too technical) but there are important thoughts that I want to share. So feel free to ask questions or comment below and I’ll try to clarify if needed.
Okay, on to my thoughts. I’ll start with the convertible debt raises.
First of all, you have to understand how a convertible note conversion cap works. The conversion cap is the max valuation that the convertible note will convert at. It’s true that a conversion cap on a note is not the actual conversion valuation, as that can’t be determined until the next qualified equity round, but most consider the conversion cap to be the implied valuation. The way the conversion cap works is that if the convertible note contained a conversion cap of $5M, and then the company raised money at a $10M valuation, the convertible note investors would convert their principal plus accrued interest at the conversion cap of $5M, even though the company was raising money at $10M. That’s the benefit of a conversion cap, it provides the investor with an incentive to invest in the convertible debt round, rather than waiting for the next equity round. One of these days I’ll chart what percentage of companies convert at the conversion cap, but in my experience, it’s definitely most.
I was not surprised to see that VW facilitated an almost equal number of debt and equity deals over the past three years. I had thought that debt was the preferred mechanism for a few years, but these days I’m seeing more early stage equity raises and at this point in time the ratio has evened-out. I believe that there are three reasons for the shift from convertible notes to equity rounds (also sometimes called “priced rounds”) as the preferred Seed stage investment vehicle: (1) investors in North Texas are becoming more sophisticated, (2) large convertible note rounds are getting out of hand (though I don’t agree with everything Mark writes; “Mark,” as if I know him personally), and (3) document collaboration spearheaded by big law firms has lowered legal fees for equity rounds.
A little more color on (1) – (3) above.
- I think that investors generally prefer equity, because it removes the unknown and gets them on the cap table (“cap table” is short for “capitalization table” and means the company’s ownership chart – usually kept in an excel spreadsheet). By “unknown” I mean that the investor can negotiate the deal terms now, rather than waiting to see what the next round investors do and convert into those terms. A few years ago, I saw angel investors wildly throwing money into seed deals like Vegas newbies wildly throwing chips onto a craps table. They would happily accept convertible notes without ever asking if equity was an option. But angels have become smarter, as a result of a few things, but, IMHO, mainly from the plethora of educational opportunities around town. Between pitch days, online and print content, and angel education seminars, it’s easy to see why angels are getting smarter. And then they are collaborating to share deal intelligence and perform due diligence. So while I’m seeing more angel money in North Texas, it’s definitely smarter money.
- I’m not a fan of large convertible note rounds. You usually end up with way too many tiny investors, which makes communication for future rounds and voting a PITA, not to mention the conversion very expensive; and I also feel that the dilution gets ignored until it’s too late. What I mean is that because the noteholders don’t necessarily go on the cap table immediately, it’s easy for the founders to ignore the dilutive effect of the conversion. But then a company gets to Series A and is selling a typical 20%, but the noteholders are converting in for another 15%, and suddenly the founders and early shareholders/members are being diluted by nearly a third in total. I love small convertible note rounds – as seed rounds or bridge rounds. But convertible note rounds greater than $500k/$750k don’t make a whole lot of sense to me.
- Years ago, I would often hear that equity rounds were cost prohibitive for a startup and thus convertible debt became the de facto mechanism for seed rounds. But over the last five years or so, there has been a real movement among lawyers, particularly the largest law firms with active venture practices, to share venture templates in an effort to facilitate more deals. Well, it’s definitely working. 75% of the deals I see where we don’t originate the docs still use the SeriesSeed.com templates, and an even higher percentage use the NVCA docs for Series A/B.
Moreover, it was interesting to see that the average equity valuation ($2.88M) is very close to the average convertible note conversion cap ($3.16M). I think that convertible note conversion caps do not get negotiated as closely as equity valuations do, because they are simply a cap and, in theory, the conversion valuation could be lower than the conversion cap. But in truth, they provide a target for the company, and a starting point for the valuation in the next round conversation (even though this shouldn’t necessarily be the case – metrics such as monthly recurring revenue, user acquisition, customer acquisition cost, customer lifetime value and EBITDA/profit are much preferred). Now, it’s important to note that conversion caps are increasing, and this is in line with what we’re seeing on the equity side as well. The companies are better positioned to raise money and the higher caps are justified.
The terms are pretty much what we expected them to be, and are consistent with what we see from deals outside of North Texas. From time to time I’ll see interest rates as low as 2% and as high as 12%. Obviously, when I’m company side, I don’t have any problems with low interest rates. But high interest rates almost seem punitive, especially given the conversion discount to which the convertible note holders are entitled, and may put unnecessary stress on the conversion timeline.
One thing to note about VW convertible notes is that we put a “maturity” cap in place. This is different than most other convertible notes we see. If a company hasn’t raised money by maturity, there is likely something wrong, and the note should not be converting at the same valuation cap as what would be in place for a next round financing. On the flip side, if the company did not need to raise anymore, and that’s why it hit maturity, well good for the company. It should offer to prepay the notes instead of letting them hit maturity, and give the investor the option to accept prepayment or convert at the original agreed upon conversion cap.
Moving on to the Seed equity raises.
On the equity side, the valuations have definitively increased over the past three years. This is due in part to the rise in the number of equity rounds and decreased legal costs. More and more hot startups are choosing to do equity rounds instead of convertible rounds with a high conversion cap, and are justifying valuations near traditional convertible note conversion caps. Great local accelerators and widely available capital are also increasing valuations (it’s as simple as supply and demand – if demand increases and supply stays the same, price has to increase). Again, this is in line with what we’re seeing with the convertible note conversion caps.
A few more notes regarding the equity raises we reviewed.
The overarching theme that I will discuss below is that the deal terms are company friendly. The investors are not too aggressive with their asks, which demonstrates that the investors are excited to invest and want to minimize (a) disruptions to the operations of the company, and (b) the strain on the company’s ability to raise future rounds. Difficult early stage deal terms can inhibit a company’s ability to complete a Series A round.
First of all, our study demonstrates that a board seat is not a standard term in a Seed round deal. Let me explain – usually a company is governed by a board of managers (if it’s an LLC), or a board of directors (if it’s a corporation). Customarily, the investors into an equity round will get a single board seat to represent the investors in board meetings. We’re just not seeing investors in Seed rounds demand a seat. It’s not necessarily that a board seat is not warranted, but rather many seasoned investors who understand the risk inherent in this stage of investing prefer to let the founders be. There’s a reason why the investor thinks the valuation is reasonable and wants to invest, therefore many prefer to let the founders continue to grow the business without interference from or obligation to a Seed investor board member.
The next interesting point is that less than half of the Seed equity investments had a liquidation preference. A liquidation preference puts the investors at the top of the capital stack upon an exit or liquidation (more on this in the next paragraph), and is the hallmark of a preferred class of shares (or units in an LLC). This means that a majority of the Seed round investors are investing into common stock (or common units), which is a company friendly situation.
Continuing, of the Seed equity investments that did have a liquidation preference, almost all were non-participating preferred liquidation preferences instead of participating preferred. Participating preferred liquidation preferences are known as “double dipping” – let me explain. In a 1x non-participating preferred scenario, the investors get the greater of (a) 1x their investment, or (b) their pro-rata ownership. Here’s an example for you – assume that the Seed investors invest $500k for 10% of the company. If the company sells for $10M, the Seed investors would rather take 10%, or $1M, because $1M is greater than the 1x of $500k. If the company sells for $4M, the Seed investors would rather take $500k instead of $400k (10% of $4M). In a participating preferred scenario, the investors get to double dip – they get their $500k back, and then their 10%. Assuming the same 10% Seed investor ownership but this time with a 1x participating preferred scenario, if the company sells for $10,500,000, the first $500,000 goes to the investors, and then the investors get an additional $1M (or 10% of the remaining $10M). We’ve only seen a handful of participating preferred scenarios, which further demonstrates how company friendly most of the deals have been.
In closing, we’ve learned that Seed rounds are increasing in terms of the conversion cap and valuation, almost in step. And there is a lot of investment activity in the area. The terms are generally startup friendly, and this is a great thing for the startup ecosystem across North Texas.