Editor’s note: Jonathan Friedman is a Partner at LionBird, an early-stage fund investing in digital health, commerce, and enterprise software. He blogs at Venture Capital Point of View.
It’s become increasingly common for early-stage entrepreneurs to “lead their own rounds” via the use of convertible notes. In cases where they set financing terms themselves, they often set a high valuation cap and sign initial angel investors onto those terms rather than waiting for VCs to join.
While this sounds like it’s good for founders, it can actually harm their fundraising efforts down the line. This is because most VCs aim to establish significant ownership percentage and pro-rata rights in startups they invest in, which high cap convertible notes often don’t allow for.
So what can you do if you already have an existing convertible note and want to make it attractive for a VC to invest in you now before your next round?
“Common Plus” Shares
There are some very rare cases when, as a VC, I meet a team and know that it’s highly likely they will have no trouble raising significant future financing, usually because of a combination of founder pedigree and connections, reachable significant milestones, and other investors already clamoring to get in.
In these cases where the team is amazing but the note is unworkable, investing in “common plus“ shares could be an option. These are common shares that include side letters for pro-rata rights and for a board seat, which provides visibility and governance.
Before the VCs reading this burn me at the stake, let’s look at the benefits of these so called common plus shares from the startup and VC POVs:
For the Early-Stage VC
Whether you are a micro VC or a multi-stage larger VC with a seed program, your primary goal with early-stage investments is the same: establish significant ownership percentage with the right to double down on your best portfolio companies. Liquidation preference is of course important as well, but only comes into play when things go south and the exit price is lower than the liquidation waterfall hurdle rate.
In a company that meets expectations, liquidity preference on early stage shares is less important down the line, as it’s junior to the millions of dollars that come after. In fact, hitting one dragon that you fully participated in due to pro-rata and ownership percentage more than makes up for any losses incurred by owning common shares instead of preferred. So while this is risky versus investing in a convertible note with a high cap, it can represent far superior upside.
For the Startup
Having a VC invest in you via common plus stock comes with many advantages, including potential support for dreaded but often necessary seed extension rounds and a strongly aligned partner that may set a precedent for keeping a clean cap table.
Regardless, the bottom line is if you are talking to a VC you believe can help make your company more valuable and that you want to work with, offering common plus stock at a lower valuation than the convertible note cap provides a means of getting them in without going through a perceived “down round.”
Preferably, this investment can be structured in a way that does not trigger a conversion of the issued convertible notes, as most angels prefer to wait for a proper “institutional” qualified financing round that includes senior rights.
A Good Calculated Risk?
Don’t get me wrong, this doesn’t mean LionBird will start making a habit of investing in common shares, and I suspect many VCs would refuse to invest in common plus shares no matter what. But in very selective use cases where there is a fast-growing company and a VC wants to grab a significant share, this may be a way of doing so.
Given the often binary nature of VC, one large win acquired via this strategy would more than make up for any losses due to forgoing preferred shares.