Financial instrument to build unicorns
When venture capital was first institutionalized in the late 1950s, the most prominent instrument was the subordinated convertible loan with detachable warrants – “Convertibles”. The main reason for using it was the funding 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 that leverage their equity with government bonds. With the exception of SBICs owned by banks, most SBICs were funded with equity and loans from the SBA. These SBICs required regular repayments from the companies they financed, and they used convertible bonds because:
Convertibles were preferred over common and preferred shareholders
Convertibles had liquidity (if the company could afford to repay or refinance the loans)
Convertibles charged interest allowing the SBICs to repay their own interest to the SBA
· Convertibles could be converted to common stock for upside potential if the company had an attractive exit event.
The negative aspect of Convertibles was that the companies had to pay interest and repay the principal, although they could both defer for a while. But the overhang meant the company couldn’t spend like the proverbial sailor and often had to curtail growth to have positive cash flow. After the company’s potential was clear, it was able to be refinanced through equity instruments, including IPOs.
The second phase of the VC evolution, in the late 1970s, was legislation allowing the formation of VC limited partnerships (LPs) with one of the most profound changes in VC:
VC LPs used preferred stock to gain an edge over SBICs. Preferred stocks had less heavy dividend payments and principal repayment requirements, allowing the company to grow faster
With VC LPs offering financing at different stages, companies can obtain growth financing in successive rounds to reach their full potential
· Without SBA restrictions, VC LPs were more attractive to start-ups, high-growth companies
At the time, Silicon Valley’s VC LPs were in the best position among VCs since the semiconductor industry attracted leading tech-skilled entrepreneurs who went on to dominate successive emerging industries such as PCs and the Internet, and they haven’t given up their dominance.
The third stage in this evolution was the development of the Simple Agreement for Future Equity (SAFE), developed in Silicon Valley. In this agreement, angels have primarily invested in companies and valued their equity based on a future round of VC financing. In effect, it allowed investors to convert their investment into shares, but without a price being set at the time of the investment. SAFEs are promoted as simpler, shorter and with “fewer complications”, but the investors could be stuck in the venture if there is no attractive exit through a strategic sale or IPO, and/or no VC financing that allows valuation and an attractive exit .
Considering that VC has mainly worked in Silicon Valley and SAFE’s need VC except in some industries like medical devices, is it time to bring back convertibles?
That’s exactly what a financially advanced entrepreneur has done. Alex Ehrlich, who worked for some of the most famous names on Wall Street, tried to get his startup, “non-racist” financial services firm (PerCapita) funded using 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 potential benefit. Ehrlich got his money.
But convertibles may need to upgrade to Unicorn-Convertibles (UC) to compete and build unicorns in the world of SAFE and VC, and especially outside of Silicon Valley for the 99.9% who don’t get VC and the 80% who get it. will fail. UC21 can be used as a medium-term convertible debt instrument with lifetime redeemable callable warrants and an investor-tooth put option to ensure entrepreneurs do not take advantage of the crowds and angels investing in UC:
UC could be more balanced to protect investors and attract more funding outside of Silicon Valley
UC will require entrepreneurs to use financially savvy strategies to grow more with less before Aha, as was done by 99% of unicorn entrepreneurs, as the capital will come at a real cost
· By converting the warrants into lifetime warrants with puts and calls, investors will have teeth to protect their rights.
MY TAKE: The “Simple” in SAFE might be great for a few, especially in Silicon Valley. But there can be value in complexity outside of Silicon Valley. Unicorn-Convertibles can meet this need by not blindly following Silicon Valley, but by developing the right “complex” financial instrument 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.