Capping the conversion valuation for a convertible note investment into a new startup, prior to the first equity raise, has become more and more common over the last few years.  For instance, in the example below, a startup raising its first capital takes $500,000 at a capped valuation of $2.5 M.  The investors get the lower of a 20% discount or a share price calculated based on a the $2.5M valuation when considering conversion of all shares reserved for options, warrants, etc.  Here is the comparison of how a subsequent financing would play out in two traditional, uncapped scenarios:

cap note

In the above, the early note holders own a little less at the Series A than if they were equity investors but they got downside protection AND all the rights of being preferred stock.  Now looks at what happens when the conversion of the note is capped at $2.5M:


cap note 2

In the Capped Low case (above) the bridge note holder gets $2 of stock for every $1 invested.  The math is driven by the option pool inclusion in the capped note conversion calculation (I have yet to see a capped note where the option pool does not reduce the share price to note holders).

Who cares about this?  Well, it takes a small amount out of the common holder ownership but this can be important, or larger,  in some scenarios (large option pool for instance) or where there are other owners with rights that depend on this round (like a university with non-diluting shares).  The new investor (Investor 2) cares because the bridge investor often gets all the same rights (voting, liquidation preference) as the new money and yet, if the note investors are angels, they may not be in a position to keep supporting the company in future rounds  – a serious problem if the company struggles to raise money (maybe a posting on this issue later).

I get why the low valuation conversion cap agreement is struck – often the founders are frugal and don’t want to do a priced round where the legal expenses are going to be higher and the early investors see this as an ideal arrangement (low valuation AND protection against even lower pricing).   However, I can tell you that, as a Series A investor, it is difficult for me to see a note holder coming into the preferred round at half the share price when they didn’t take any of the pricing risk. And, I find that, while it might not affect my fund’s ownership, the additional equity to the note holders can negatively impact the founders and that’s something that we care about.

The bottom line is that one unexpected effect of the low cap is to depress the valuation that future, new investors are willing to pay either because of the impact on founders or just the emotional issue of another investor converting at a much lower valuation.  Given this tendency for the cap to depress subsequent valuations, early investors and founders would both be advised to consider either a priced round or a higher cap on conversion.  My opinion is that the right way to implement a cap is to set it in the range of where a Series A is expected.  For example:


cap note 3


Note that some of these concerns go away if the note holder is also the lead on the Series A financing.  In fact, I have seen it lead to a higher valuation because that’s what gets the investor to their ownership percentage target.


3-D Printing wish list

August 5, 2013

I am waiting for someone to be able to print up inexpensive parts for a working model of the Antikythera mechanism or an Enigma Machine (wiring it up after).  Not a big market but would be cool.

I just came across an interesting blog post about decision making at a blog called Sabermetric Research.  Phil Birnbaum, makes the case that in a decisions like the MLB draft, it is better to not be stupid than it is to be smart.  By easier, my interpretation is that he means that there is more potential net-benefit in having some insight that helps you avoid picking a player that others might rate highly than it is spotting an overlooked superstar.

The example is that, your MLB team scouts two players prior to the draft and comes to the conclusion that one hot prospect, lets call him A-Lemon, is not as good as his ranking and another player, Hot-Rod, is better than he is ranked.  Many other teams have scouted these players and some teams are probably about as good as your team in judging talent.  When it is your turn to draft a player, do you get more advantage by knowing that A-Lemon) is a dud than by knowing Hot-Rod is a hidden gem?  The author’s logic behind the reason that avoiding the stupid decision (drafting A-Lemon) is better than picking the hidden gem (Hot-Rod) is a little fuzzy but it is tied up in the fact that the competition is doing scouting as well so you won’t be the only one thinking about drafting Hot-Rod – someone else may grab him –  but by doing nothing, you add value by keeping A-Lemon off your team.  There is something like an efficient market hypothesis here except, in this case, you assume that there are always some smart teams that reach the right scouting conclusion and some stupid teams that reach the wrong conclusion.

My opinion is that the real reason that this makes sense is that one fatal flaw is enough to kill an investment into a player (or in our case a company).  Not all flaws are fatal but, find the fatal flaw and you can walk away.

Look, VC investing is not the MLB draft.  We don’t all look at the same deals to build our portfolio and our portfolios don’t play each other.  We succeed or fail pretty much independently of the other VC’s (we are actually more likely to win when other VC’s win).  However, this got me thinking about the value of avoiding stupid decisions (passing on bad deals) versus making smart ones versus deal flow.  Specifically:

1. One way to make smarter decisions is draft deals that others have rated lower for what is clearly the wrong reason. Many Boston or Silicon Valley (BSV) funds rate deals that are outside of BSV lower just because of location.  The trap for the mid-continent VC is that there are both important and unimportant reasons for this.  The important reasons are that local access to talent, strategic partners, mentors, additional capital can be huge advantages. Sometimes a mid-continent company will get crushed by the talent and capital available to a BSV based company.  However, this does not have to always be the case, especially if the VC can bring some of those resources to the table or manage the company is way that is more appropriate to its location.  The unimportant reason for a BSV VC firm to pass on a deal include the simple fact that it is harder work to manage an investment farther away from home perhaps in a city to which he doesn’t already travel.  For the VC’s active in that geography or willing to do the hard work, finding a overlooked investment opportunity is entirely possible and can be the smart, proactive decision.

2. The way to make stupider decisions is to “draft” deals where there are a lot of smart, deep pocketed, brand named VC’s.  That’s why I don’t even look at companies coming out of BSV.  Of course, I don’t assume that the VC’s there are ALL smart, only that enough of them are going to be smart enough to grab up the better deals.  I think that this is supported by the data – we have not seen any mid-continent VC firms succeed with the strategy of leading or joining in syndicates for BSV deals.

For investment decisions, I come out the opposite of the blogger; for venture investments in the mid-continent, it is better to find the underrated startup or, better yet, the undiscovered startup.  In the middle of the country, VCs win by scouting new territory for world class deals not hunting the same deals as the funds in Boston or Silicon Valley.


I was doing some research for a talk to a group of people who were planning to star angel investing and came across some interesting research on angel investor returns.  I thought I would share some of the observations that make sense here as well as some of the concerns I had over the accuracy of the data.

The 2007 Kauffman study of Returns to Angel Investors and related studies are the most data driven analyses of angel investing that I have seen. Some of the conclusions are a little surprising to me (like the low percentage – 30% –  of follow on financing participation by angels) and many of the conclusions feel directionally correct.  To me, the most important, but not surprising, conclusions from the Kauffman study were in the passage:

We also evaluated three factors that appear to impact these angel investors’ outcomes:

  1. Due diligence time: More hours of due diligence positively relates to greater returns.
  2. Experience: An angel investor’s expertise in the industry of the venture in which they invest also is related to greater returns.
  3. Participation: Angel investors that interacted with their portfolio companies at least a couple of times per month by mentoring, coaching, providing leads, and/or monitoring performance experienced greater returns.

On the other hand, I don’t know if I believe the exit multiple average of 2.6x in 3.6 years; it concerns me is that the data are self-reported so probably does not include the angels who lost money and are out of the market.  I see a lot of one time angels.  Another concern that I had is that there is likely a very wide gap between the high and low performing angels (just like with VC funds). Also, the study authors note that 7% of the exits account for 75% of the returns so one question is how evenly distributed are those 7% by angels, industry and geography.  Since there is no analysis of returns versus geography if may be that some regions are better for angels (in recent years, silicon valley angels have done very well so the returns for mid-continent angels might be somewhat lower).  Finally, these results are from 2007 – angel and vc investing has changed dramatically since then with more super angels and fewer active venture funds in many sectors so there is the question of whether this study is still relevant in 2013.

I also found a more recent statistical analysis of the same 2007 data that resulted in the following observations:

Median returns vary substantially with portfolio size. Going from 5 investments to 10 investments increases median return by 68%, from right around 1x to nearly 1.7x. There are diminishing returns to growing portfolio size. Going from 10 to 15 increases median returns by another 40%. Doubling portfolio size from 15 to 30 adds another 50% but then in takes going all the way to a whopping 125 company portfolio to triple median returns compared to the 5 company portfolio. Similar conclusions apply with respect to other metrics. The probability of getting a return that’s greater than 2x doubles (from 34% to 69%) as one moves from a five company portfolio to a 50 company portfolio.

The data unequivocally suggest that playing like a super angel or an active seed fund as opposed to dabbling with the occasional angel investment is a key strategy to consider if financial returns are important. The data also call into question the behavior of some angel groups that do just a few investments per year.

The question over the absolute values of the returns aside, the idea of a larger portfolio in order to capture one of the 7% of giant winners makes total sense.  Conclusion: Angels should invest in areas where they have some expertise, do a lot of diligence and build a large enough portfolio to capture a few big winners – just like VCs.


If you want to learn how to run a lean science startup, read this history of Genentech and Bob Swanson. And take a look at the cap table (at the bottom of the page).

What Swanson accomplished was incredible.  And KP funded the achievement of key technology milestones that drove creation of value rather than just creating a small company structure.

When I am in the term sheet stage with a company, sometimes (maybe half of the time) I’ll hear that the company Founder or CEO is calling around to my current portfolio companies to get the scoop on our fund and how I behave as a board member and investor.  It ALWAYS makes me feel better about the investment if the Founder or CEO is smart enough to do this. It is the same level of thoroughness and thoughtfulness that will be needed after the investment in evaluating partners, future employees, customers, etc.

My guess is that company teams do anything more than cursory diligence only about half the time  – maybe we should make it a final “pop quiz” before funding by asking them “what did you find out about us and how did you do it?”

Entrepreneurs should  not hesitate to ask the potential investor for introductions to portfolio company CEOs and Founders.  To be honest, only one founder has ever done this in my personal portfolio – maybe teams are are worried about offending their potential investor so call around quietly.  My 2 cents is that you should run away from a VC investor that does not appreciate that the company should do some due diligence just like an investor so go ahead and ask for the contacts.

Here is my advice to entrepreneurs:

You should feel free reach out to the CEOs and founders in the VCs portfolio.  Ask the VC for the contact, or not, as you wish.  It probably makes sense to tell the VCs that you are doing it (at minimum to see how they react).

You pick which of the portfolio companies to call.

Recognize that CEOs that were hired in by the VC will almost always be positive and CEOs hired in later, when more VCs are in the deal, are likely to know less than perhaps a founder that was there at the start (many of our companies have scientific founders who participate in hiring CEOs later).

Ask about how the VC handled unexpected setbacks.  Did they panic? Did they demotivate the team? or did they support the CEO?

Ask about how the VC looked at difficult financing situations in the past.  Was it simply a chance to get a financial advantage or did the VC think about things like fairness?  Was the VC working to make the pie bigger for everyone or just have more pie for themselves?

Ask whether the VC style focuses on helping to solve problems or whether the VC is a micromanager

Recognize that people come and go in startups for lots of reasons – not everyone will be happy all of the time and everyone has a deal where lots of people are unhappy.  When my oldest daughter was applying to college, I spent some time looking at the student reviews of their own colleges and decided that the key metric was “Would you go there again?”  My recollection is that the best rankings were at around 85% and the big name colleges often were somewhat lower.  It feels like the same thing applies in VC – even the best don’t score 100% and the biggest names don’t always get the best “I would go there again.”

Finally, go back to the VC and tell them about what you learned, it is a good way to build the relationship and get some additional insight into the person you will be working with for the next 2 to 8 years.