When offering convertible debt, the investor accepts the valuation at the next round of investments (in this case series A).
The risk for the convertible debt investor is that this valuation will be very high and the series A can take a long time.
To limit this risk convertible debt investors negotiate valuation caps and discounts.
Cap: The convertible debt gets converted at min=[series A valuation, cap].
Discount: The convertible debt gets converted at series A valuation * (1- discount)
(Obviously, when both cap and discount apply, the valuation for conversion becomes min = [series A valuation * (1 - discount), cap].)
Can somebody give me an advice. We have a two person startup, that is making about 20k/mo and it's growing. I am the founder. The thing is, I do not currently plan to raise VC money. My goal is to achieve revenue of 200k/mo by 2013. It is very realistic, but the problem is that as the service grows, we spend more and more time on operations, since certain things were not timely automated. We need about 300k , so that we can hire a couple of contractors to automate operations, to accelerate product development.
But since I do not plan to raise a VC round, the convertible loan would not work. What is the right mechanism for this investment? I also believe the risk is lower than normal, since we have been making money for a while, and this should be reflected in the terms and in the valuation. Is this the domain of angels to make such an investment?
FYI: Last time I stopped at the bank where I opened business checking account 2+ years ago (Wells Fargo), they sat me down and offered a 100K line of credit (the interest rate was unknown unless I applied, but she said it would be around 7-8%). The service is poorly monetized ( disproportionately high hosting fees + new hardware expenses / revenue). Until recently I was putting all these hosting related expenses on a single US Bank credit card (and paying it off monthly). In response, they raised the credit line to 40k at 8% yearly interest. This is less however than the 300k, that I think is needed. Additionally, I would prefer to use this kind bank debt financing only in an emergency, because I suppose that unlike a savvy investor, Wells Fargo and US Bank would be absolutely inflexible if I say need slightly more time, and would drive the company into default by their blanket policy, regardless of the specific circumstances.
Not unless you're willing to put up (say) your house against it. If I were a bank I wouldn't be willing to take the risk that your business will go under before it ever pays back the $300K.
Basically you need a small-scale VC or large-scale angel investment... or else to continue to bootstrap.
You can still accept a convertible debt investment.
If you don't do a series A the valuation of the sale of the company will be taken. A sale without investments in between would mean a debt investor only gets his money back + interest.
Given your situation, the debt investor might negotiate a time limit for the conversion (and either a cap or a formula for the valuation at that point).
Speaking as someone who's automating a large-ish business right now: 300k will buy you a lot of contracting. It might be possible to do what you want for less, which would expand your options.
Email me, and I'd be happy to discuss your situation and provide pointers where I can. (address is in profile)
I would seek out 2-3 angels who can provide the $300k investment. It's going to be (near) impossible to get a $300k loan on $20k/month gross revenue. Definitely not something any reputable bank will put forth in these times.
You'll likely need to part with 10-20% equity in the business, but the value of the $300k to take you to the next level should make sense. Think of it as - can we get to $200k/m by 2012 if we have $300k/$600k/$1mm. If you can 10x your revenue in a year and give up 20%, you're in a good place.
You may want to look into royalty/revenue based financing. I don't know if your revenue is where it needs to be for that (i.e. revenueloan.com's typical investment makes $1-5MM in revenue), but something to look in to.
Hey, my email is in my profile. I'm obviously unaware of the details but $300k to "tidy up operations" seems to be a pretty large budget. I feel reasonably confident I'd be able to help you out (ie. providing such services) for less than that.
You could try outsourcing and/or hiring students, but I suspect that the quality of outsourcing available to the average individual or startup has decreased as a result of the publishing of books like 4HWW and The World is Flat.
Quick answer - he does get equity at the next funding round. What he gets is the amount of equity that $150,000 would buy at that valuation.
So if someone else invests $250,000 for 25%, that's a valuation of $1m. Yuri would get 15% at that valuation. He'd get 7.5% at a $2m valuation and so forth.
What happens if there is no exit or "liquidity event", but the startup is profitable and never takes additional funding? When does the $150K become equity?
Some notes have automatic conversion at a given valuation (usually the 'floor', which in this case does not exist.) Others have no such clause, presumably under the incorrect assumption that a "liquidity event" will always happen if there is a success. I've dealt with both types of notes before and always insisted on adding an automatic conversion clause.
Might there also be some far-out repayment date — say 10 years — and a small interest rate (even without a discount)? Then, if the company becomes a perpetually profitable independent growing concern the loan is still eventually repaid, though not with the kind of equity conversion and appreciation the investor is really hoping for.
"Startup fails" is the reason why these companies have the so-called "limited liability". They file for bankruptcy, founders get on with their lifes, investors see nothing. This is, in fact the vast majority of the cases, and the reason investing is called "high-risk, high reward".
The $150k offer reminds me of a rumor about the way in which Subway selected franchise locations back in the 1980's.
Subway wouldn't do extensive market research or study traffic counts. Instead, they would see where there was a McDonalds franchise and then open a franchise in the same catchment area. At least that was the rumor (not to compare YC to McDonalds or Hamburger University).
I thought Starbucks had simply reversed the process. They appear to open a coffee shop on every corner (sometimes several on the same corner) and just close the ones that don't do well.
I heard the rumor about Burger King (combined with the idea that McDonalds would do the extensive market research and study traffic counts and so forth.)
Does anyone else see that this offer will drastically change the tone and success rate of YC startups?
Constraints (in the form of funding and time) were a large part of YC. Entrants got a low (but livable) amount of money and 3 months to come up with something great. That something would either sink or swim on demo day.(for more on how constraints help creativity: http://ecorner.stanford.edu/authorMaterialInfo.html?mid=1530) Within those constraints, past YC classes did pretty well, and came up with amazing companies. Those that didn't failed quickly, and could go on to bigger and better things. But YC is now throwing those constraints away.
Because the $150k offer is guaranteed runway, it fundamentally changes the behavioral economics behind startups participating in YC. Products no longer have to be demoable by demo day, and startups won't have to think about profitability/funding, in the short term. This means that we should expect YC startups to dream -and fail- bigger in the future.
I was thinking this as well, but for a different reason. I, for one, would never enter the YC program. $15,000 (especially for that much equity) just doesn't work for most people. The only demographic that can really make that work are 20ish year olds coming right out of school. They haven't started real life yet, and have minimal obligations. Anyone else competent/qualified is probably quitting a job and has various bills and debts, and if they made the decision to do a startup, they already have some bootstrap money or a bit of revenue from a side gig, so that $15k isn't going to make or break them. For 150k however, this changes things entirely. YC can now attract a far more diverse pool of aspiring startups.
I was curious about the potential for returns so I considered a scenario: the successful YC companies take series A investment at an average $10 mm pre-money valuation (which is reasonable for a YC company starting off with $150k), and no series B is ever needed before exit. This gives the original investors a 1.5% stake at the time of exit.
In order to return the $6 mm there needs to be $400 mm of exits.
But I don't think it's reasonable to assume that the successful companies wouldn't take additional funding past series A. More likely, any successful company would also take series B funding. Then we'd need to see ~$500 mm - $800 mm to break even.
My guess is that these investments aren't really intended to be profitable. I would guess that they're instead a gateway into future deals that will be profitable.
I think your logic is generally right, but I'd say in addition to being a gateway into future deals, it's also a guarantee that they'll be in for any truly huge wins.
There's a solid chance that the next Google or Facebook-level company will come through YC, and this deal means they'll get a piece of it.
Going off on a tangent, one of the comments on the TC article seemed really odd - even by TC's standards for terrible comments.
Am I the only one who finds Y combinator predatory? It preys on 20 year old kids who think they're building the next google. Am I crazy?
On the actual subject of the article - if any of the four startups that haven't (yet) signed the paperwork don't end up accepting the offer, I hope they share their reasonings (either now or sometime in the future).
And on a pedantic note: 39/43 rounds to 91% rather than 90%.
Some people believe that in every economic transaction, at least one party must be exploited, no matter how wildly beneficial the deal is to both sides. It's actually a natural implication of the idea that wealth is never created, only reallocated. Unfortunate to see that view among TechCrunch readers, who have evidence to the contrary presented to them every day.
I wouldn't mind hearing the view that YC is exploiting founders (though I wouldn't agree with it), but the idea of YC exploiting them in such a way that YC would lose money is fairly dumb.
Maybe that commenter is being a bit harsh, but I certainly also get that vibe. At the very least the whole thing has a "dotcom bubble, version 2.0" feel.
Seems to me that the people who get accepted by YC (and, most likely, the majority of the people who apply to YC) are the kind of people who would be doing their stuff with or without the help of YC.
As to a bubble - without getting into that debate now, even if it later turns out that we're in a massive bubble right now, YC are investing money/time with the purpose of making money, so they're in the same situation as the founders themselves, in that they don't want the bubble to burst, and they don't want to see their startups fail.
Nobody ever wants to see a bubble fail, that's part of what makes them so dangerous. People go to extraordinary lengths to ignore warning signs of events they don't want to happen. That's what happened the first time around, and I fear that's what will happen this time.
I'd be interested to hear you elaborate on that. I keep hearing comparisons to the tech bubble (particularly around LinkedIn's IPO), but I'm having trouble seeing the parallels.
I think everyone can agree that it's booming, in much the same way that the housing market was booming. Tech is sexy again, and that's driving investment and throwing money into the ecosystem that otherwise wouldn't be there. That said, the only real test of bubbledom is whether the valuations are sustainable, and whether startups generate profit commensurate with the money being sunk into them.
Google, Apple, and facebook aren't going to continue making $65MM talent acquisitions indefinitely, so at some point the penny will drop. When it does, the question of whether we'll have a popped bubble or an adjustment will be decided on the individual financial condition of the startups in question.
Could the current ecosystem be sustained if Google, Facebook, Apple, and AOL acquisitions were no longer a reality? No. Too many people are investing in features, not companies. Those startups can't survive on their own if there isn't a real possibility of a big exit through acquisition.
Nevertheless, it isn't 1999. Groupon is IPOing with at least some real revenue and exponential growth, and LinkedIn has a solid, if not expansive, userbase. If there is a bubble, it should only affect the startup world, and even then only the companies that can't survive on their own.
If those big companies continue to grow though there is no reason why they won't continue to make the acquisition's. For all the small acquisition's though your also generating new big companies that will be acquiring companies in the future.
A few years back there was no big social gaming company, now you have zynga cashed up and acquiring companies. Same thing could happen in the mobile space, a company that gets really big and then is able to acquire some of the many small new mobile development companies.
I guess I could see Rovio go on an acquisition spree. Still, I think any market predicated upon acquisition rather than growth and profitability is inherently unstable. That instability allows for rapid growth, but it also allows for rapid and catastrophic failure, as we saw in the Banking industry.
Well for acquisition's to happen their still needs to be growth and profitability somewhere, I guess the acquisition's are a way to gaining great efficiency in the market, if each need startup stays independent there is a lot of duplication in activities that support the main business operations.
Everyone starting startups, joining startups, or wanting to do one of those. The majority of people working for peanuts, in hopes of future riches, spurred on by stories of a few people making it big, obscenely big. Businesses with vague business plans, and sales pitches full of jargon intermixed with good ideas but for the most boiling down to "we're on the internet!". Investors getting excited about an industry they don't understand. All of this fueled by long nights pulled by young kids who's bodies can take the caffeine abuse for a while.
Now, I sure as hell hope this time it turns out differently, and even it working out the same it would be pretty slick (I wasn't quite in industry yet the first time around, so it almost seems like harmless fun to me), but I definitely can see some parallels. Also, I'm talking about the industry in general right now, not just YC.
All of this fueled by long nights pulled by young kids who's bodies can take the caffeine abuse for a while.
Don't doubt for a minute that some of us old farts are staying up late, downing obscene amounts of coffee, Red Bull, Monster drinks, etc., trying to get in on things. Hell, if anything, when you start getting older, and you look around and realize "I haven't done anything yet" a certain sense of, hmmm... I won't quite say desperation, but something like that, sets in. I've even spent a lot of time lately debating the merits of going ahead and ordering some black market "smart drugs" just to get a little extra edge. I haven't pulled the trigger yet, but it's awfully damn tempting.
For whatever its worth, plenty of people in this gig don't abuse caffeine and often don't have any at all. I rarely have more than one coffee a day, and often have none. I don't drink energy drinks or soda (except perhaps when out to eat). Francisco doesn't drink any coffee. Tom, on the other hand, has a bit of a red bull addiction. I'd guess anecdotally that most of my friends in startups behave more like me than like Tom or Francisco.
Sure, it's just a stereotype, although I freely admit that I, for one, do kinda help perpetuate the old saw about how "a programmer is a biological machine for turning sugar and caffeine into code."
Or, to look at it another way.... "The four food groups for programmers are salt, sugar, fat and caffeine."
All joking aside, my diet has it's good days and it's bad days. But I do like my coffee, that's for sure.
Better to fuel your mind with the right foods, supplements, etc. B-complex, good quality sea salt, the right fats -- all good for the brain. And it isn't followed by a crash because it builds capacity rather than squeezing existing resources to get more out of them.
Yeah, I take fish-oil, a b-complex, a regular multi-vitamin, ginko-biloba and a couple of other supplements, and eat moderately healthy and least part of the time. I try not not totally fall into the programmer stereotype when it comes to diet, but the bit about late nights fueled by caffeine and sugar, well... what can I say?
Trying not to belabor the point, but you didn't mention "good quality sea salt". I really think that does important things for the brain and nervous system.
Not really trying to butt in. I've just seen my quality of life go up so much and it's hard to resist sharing my enthusiasm.
EDIT: Oh, and I meant better to feed your brain better than to try "smart drugs". I consume caffeine like it's going out of style. So I didn't mean that.
Interesting... I've never really thought about "sea salt" as being something to seek out specifically. I do consume some, because I eat a lot of nuts (cashews, pecans, almonds, etc.) that are often salted with sea-salt. I have no idea whether or not that constitutes "good quality sea salt" though.
I'll have to do some research, thanks for the pointer.
And on a pedantic note: 39/43 rounds to 91% rather than 90%
Maybe they were going for one sigfig. This comment doesn't really add anything, so next time you find yourself typing "And on a pedantic note" press delete 22 times.
And to be really pedantic — only in the service of further demonstrating that the original pedantry was silly, I promise! — when the real percentage is 90.6something, it is also true that "90%" (and "80%", and "22%", etc.) "have already accepted", but it is not yet true that "91%" have.
Na i'd take that money any day. First it's good to have Yuri Milner and Ron Conway on your team.
43 startups @ 150k is only 6.45million, which is typical funding for one venture capital company. Except it's diversified into 43 of them, so that if one of them advances to a series C, they can probably get it all back.
I guess the only problem would be if you try to get a Series A from DST, then you might possibly not get an ultra high valuation, but then again, DST seems to be throwing money at startups after their lustful experiences with Zynga/Groupon/Facebook
This just toughens up the next round of YC applications, which is a bummer. But i'm really interested to see how this will work out.
150K x 43 = 6,450,000.
I'm guessing that there is a fair chance that at least one of the 43 companies alone will allow them to break even on their investment. They should end up doing extremely well on the deal.
Numbers missing: what is the typical valuation at Series A for a company coming out of YC? If it's $2 million then he'll wind up with (on average) 7.5% of each company (similar to what YC itself gets for about eight times less money), so to break even on one exit it'll have to be a $100+ million exit, which would be bigger than any YC exit so far as far as I know.
They'd be crazy not to, it basically boosts whatever runway they had by a considerably amount. What's more interesting than those that took it is those who didn't and if in the end there will be any that won't take it at all and what their reasons are. Likely the number will be '0'.
I would assume the conversion is calculated at the value of the acquisition or IPO (which is really just a type of investment round). [edit: as it says, no discount so forget this part] Typically there's a conversion percentage kicker, so it might be 110% of the value (ie the early investor gets more for the risk)
Seriously? I don't think you grok quite how disruptive this is. This is a better deal than any YC company has gotten... probably ever. The only way someone could top it is to pay founders to let them invest. Add to that the fact that YC almost certainly had piles of legal analysis done to protect the founders' interests.
Convertible debt paperwork is really only a few pages... Heck, they might've used YC's boilerplate docs to simplify things.
I don't understand. They aren't diluting shares, they aren't liable if the company fails to reach Series A, and by all accounts there do not seem to be any strings attached with regard to oversight (ie. the founders don't need to "answer to" the investor in any way). All they are doing is giving a portion of their future shares to that investor now, at the same value as they would later. It's a no-brainer - what is the downside in your opinion?
What people are pointing out is that nobody outside of this batch in Y Combinator has seen the paperwork, so nobody can actually verify that there isn't something hidden or sketchy present.
I trust Paul implicitly, and I suspect most YC Founders do, and that probably has a lot to do with the acceptance rate. I wasn't in the meeting obviously, so I can't know how I would have reacted to the specifics, but I can say knowing only what I know now I probably would have at least taken the weekend to do my homework.
That makes sense. After re-thinking my previous comment, I suppose another potential downside might have to do with somehow missing out on the numerous copycat offers that I imagine will arise. At any rate, although I'm surprised that everyone has signed on so quickly it does seem like a really good deal for all involved.
Probably not. But I imagine that when it comes to the details some angels might be a better fit than others for certain companies due to their networks, etc. Also, if I had a company that needed about $200k and I had one offer for $150k from Yuri and one for $200k from another similar investor I might only take the $200k instead of both - it would represent a (hopefully small) difference in available shares once it was time for Series A. This is all speculation though - while it seems like fun, I haven't yet been on either side of the investor equation.
(Or he might die of a heart attack, or the Russian government might seize his assets, or any number of other unlikely scenarios might make him unable to close the deal.)
I understand what a debt is, so how is "no cap and no discount debt" different from a regular debt?
Also why would you as a startup would want to take a debt?
Another question - what's the point of Yuri giving the debt, it seems he's not even asking for equity in return?