When venture capital first became institutionalized in the late 1950s, the most prominent instrument was the subordinated convertible loan with detachable warrants — “Convertibles”. The key reason to use it was the financing structure of the early VC world. Many of the early institutionalized VCs were small business investment companies (SBICs) that were licensees of the Small Business Administration and were allowed to leverage their own equity with government loans. Except bank-owned SBICs, most SBICs were financed by equity and loans from the SBA. These SBICs needed regular repayments from the ventures they financed, and they used Convertibles because:
· Convertibles had preference over common and preferred stockholders
· Convertibles had liquidity (if the venture could afford to repay or refinance the loans)
· Convertibles charged interest that allowed the SBICs to repay their own interest owed to the SBA
· Convertibles could convert to common stock for upside if the venture had an attractive exit event.
The negative aspect of Convertibles was that the ventures had to pay interest and repay principal, although they could delay both for a while. But the overhang meant that the venture could not spend like the proverbial sailor and often had to restrict growth to have positive cash flow. After the venture’s potential was evident, it could refinance with equity instruments, including IPOs.
The second stage of VC evolution, in the late 1970s, was the legislation that allowed the formation of VC limited partnerships (LPs) with funding from pension funds, causing one of the most profound changes in VC:
· VC LPs used preferred stock to gain an edge over SBICs. Preferred stock had less onerous dividend payments and principal repayment requirements so the venture could grow faster
· With VC LPs offering financing at various stages, ventures could get growth financing in successive rounds to fully reach their potential
· Without SBA constraints, VC LPs were more attractive to early-stage, high-growth ventures
The Silicon Valley VC LPs were in the best position among VCs at the time since the semiconductor industry had attracted leading technology-skilled entrepreneurs who went on to dominate successive emerging industries such as PCs and the Internet, and they have not relinquished their dominance.
The third stage in this evolution was the development of the Simple Agreement for Future Equity (SAFE), which was developed in Silicon Valley. In this agreement, angels mainly invested in companies and valued their equity on the basis of a future round of VC funding. It basically allowed investors to convert their investment to equity, but without a price being set at the time of the investment. SAFEs are promoted as simpler and shorter and with “fewer complications” but the investors could be stuck in the venture if there is no attractive exit via a strategic sale or IPO, and/or no VC funding that makes valuation and an attractive exit possible.
Given that VC has worked mainly in Silicon Valley and that SAFEs need VC, except in some industries such as medical devices, is it time to bring convertibles back?
That is exactly what one financially sophisticated entrepreneur has done. Alex Ehrlich, who was with some of the most famous names on Wall Street, tried to get his startup, “nonracist,” financial-services company (PerCapita) funded with the Silicon Valley method. It did not work (Bloomberg BusinessWeek, 3/21/22, page 62). After being rejected by many investors, Ehrlich used convertible notes. Investors liked the greater protection and the potential upside. Ehrlich got his money.
But Convertibles may need updating to Unicorn-Convertibles (UC) in order to compete and build unicorns in the world of SAFE and VC, and especially outside Silicon Valley for the 99.9% who will not get VC and the 80% who will fail with it. UC21 can be used as a medium-term convertible debt instrument with lifetime detachable callable warrants, and a put option with teeth for investors to make sure that entrepreneurs don’t take advantage of the crowds and angels who invest in UC:
· UC can be more balanced to protect investors, and attract more financing outside Silicon Valley
· UC will require entrepreneurs to use finance-smart strategies to grow more with less before Aha, as was done by 99% of unicorn-entrepreneurs, because the capital will have a real cost
· By making the warrants into lifetime warrants with puts and calls, investors will have teeth to protect their rights.
MY TAKE: The “Simple” in SAFE may be great for a few, mainly in Silicon Valley. But there may be value in complexity outside Silicon Valley. Unicorn-Convertibles can serve this need by not blindly following Silicon Valley but by developing the right “complex” financial instrument that is designed for entrepreneurs who want to grow more with less. It also helps angels who don’t want to be shortchanged by entrepreneurs and VCs.