CrunchBase recently published a new case study on early-stage funding including the different types of deal structures, priced (equity) and unpriced (convertible notes or SAFES). The post was a useful, if very high level, overview of the early-stage funding process. However, due to this simplicity, the article painted a naive picture of how unpriced rounds often work in practice. While notes and SAFES have become the norm in recent years, it doesn't mean they should be, especially in underserved ecosystems like Texas, Pittsburgh, or Atlanta.
In these metros, early-stage capital is scarce, thus increasing an investor's negotiating leverage. Given that context, fundraising is often an extremely difficult hurdle to navigate for local entrepreneurs. Ultimately, unpriced rounds making up the majority of early-stage deals in emerging ecosystems can be shortsighted. Over the long term, it can limit a startup's ability to raise future rounds and hinders the ecosystem as a whole by sometimes forcing great entrepreneurs to start companies in more favorable markets where investors are accustomed to optimizing for the company’s long term success.
It’s easy to forget that, just 130 miles outside Chicago, is the University of Illinois’s main campus. “Remember, Marc Andreessen was building Mosaic at U of I, and Max Levchin,” probably best known as the founder of PayPal, “was down there too.” Carter relayed the story of how Levchin came to Chicago to raise money for his first startup, he was spooked by the terms put forth by the independent investors he spoke with. He probably left for the Valley because we [Chicago investors] couldn’t structure a deal,” - Jeffery Carter, Hyde Park Angels
Convertable notes and SAFES only make the process more confusing by putting off the valuation and thus hiding the potential ownership (i.e possible dilution) at the time of conversion especially in cases where the startup has raised more than one note on varying terms. I believe some investors do like this opacity.
Entrepreneurs are not the only ones put at risk by unpriced rounds of fundraising, the investor hasn't actually put themselves on the cap table which leaves open the possibility of issues such as the renegotiation of their terms by the next lead investor. This puts the seed investor in the awkward position of getting the terms they believe they negotiated or being the “bad guy” who could potentially spoil the next round.
The goal of any aspiring startup ecosystem should be collectively working to eliminate onerous term-sheets to better incentivize founder upside for the ENTIRE lifecycle of a company, not maximizing the “paper” upside of one investor for one round. This perspective enhances the goodwill between investors and entrepreneurs while encouraging both sides to continuously participate in the scaling of great companies. We achieve this by taking four simple steps:
Anyone who has discussed venture investing with me knows I passionately dislike unpriced rounds though that doesn't mean I won't do them. The ultimate goal for us has, and will always be, to partner with the best possible companies. However, if we do participate in Notes or SAFES we work extremely diligently to make sure the terms are clear and founders thoroughly understand the pros and cons of the structure.