About the Author: Stu Strumwasser is the Founder and Managing Director of Green Circle Capital, a leading boutique investment bank focused on the natural products space. He spent the early part of his career at firms that included Paine Webber (now UBS AG) and Oppenheimer & Co., and has been a licensed investment professional for over twenty years. He was also the founder of a natural beverage company which he ran as CEO for six years. Stu is also an author whose novel, “The Organ Broker,” was named a finalist for the Hammet Prize. Securities transactions are conducted through StillPoint Capital. LLC, Tampa, FL. Member FINRA & SIPC. Stu can be reached at email@example.com and www.greencirclecap.com.
Part II of this series focused on the correct and reasonable methodologies for determining fair market valuation for a growth-stage natural products company by using comps and other tools. When a business is too early stage (or not yet generating consistent positive cashflow) relying on traditional financial metrics (starting with multiples to EBITDA adjusted for growth rate, size of margins, etc.) is not possible. In such scenarios, one must rely heavily on comps, artistry, a vague assessment of risk/reward and, as we suggested, the utilization of “empathy.” (Yes, I am aware that sounds odd. Rather than explain it again, please glance at Part II). Comps are very important, and in Part I we discussed what makes for a good comp or a bad one. Most importantly, just try to find apples that are most similar to your own apple, and don’t get confused (or appear stubborn or unfair) by trying to draw comparisons to oranges.
Speaking of things that are orange, in Part III I’m going to address that pink elephant in the virtual room—Donald Trump. JK. What I really want to comment on is convertible notes. Using convertible notes, as opposed to equity with a specific share price and corresponding valuation, allows the company and investors to avoid agreeing on price, when doing so is tricky and uncertain. However, convertible notes are like pina coladas. There is a time and place for them, but you don’t want to use them in most ordinary situations. Stated differently: it’s great to sip on a pina colada once a year when sitting poolside during your tropical vacation, but you don’t want to be overheard ordering that concoction at 10PM on a regular Tuesday night at Peter McManus’s. Similarly, convertible notes can be an appropriate instrument in certain situations—such as bridge financings funded by existing shareholders—but the idea that convertible notes are a panacea to help companies and investors avoid the need to fairly agree on price is incorrect.
A convertible note is a debt instrument, or loan, that eventually will be converted into equity (stock) at pre-determined terms and usually at a time triggered by some future event like the next financing. The loan will convert into shares at a discount (often 20% or 30% less than what new investors are paying) and interest payments which accrued (if they accrued and were not paid out in cash) may also convert into additional shares. Using a convertible note without a “cap” (or maximum conversion price) is something very few sophisticated investors will ever do. Doing so is tantamount to loaning a company money so it can create value and thus justify a higher valuation in the next round (when those original investors will be converting) thus costing themselves money. It literally ends up enabling the company to use investors’ own money against their economic interests.
Using such an instrument can make sense when the people funding are existing shareholders who already have a stake in the company’s success (or continued existence). Not only are these shareholders/investors looking to make a good return on the new investment, but they have other factors affecting their investment decision—their desire to protect their initial investment which is already made. As they are already owners of the Company investing in a transaction that is preferential to the Company is more acceptable to them. Furthermore, if the Company is low on cash, or in some way distressed, it might be beneficial to the Company (and thus to their existing investments) to avoid the perception of a “down round” and finance continued operations and growth with an un-priced security (the aforementioned convertible note) because that could be best for the Company, and thus for their stock in it.
That is not, however, the case for new investors. They have no existing and vested interest in the business yet, and therefore would have no motivation to help the Company maintain valuation optics. They certainly have no reason to want to allow their capital to be used against their own economic interests, and asking them to do so would be unreasonable. To illustrate: if a company is worth between, say, $4MM and $6MM, and the founders and investors can’t agree on a price, they might decide to kick the question down the road by using a convertible note. They might agree to give investors an 8% accruing dividend and to convert at a 25% discount to the price established in the next round (when there are sales and better metrics by which to assess fair valuation). Perhaps the company raises two million dollars in the convertible note round, and with it they generate great traction and meaningful sales. At the next round, two years later, it might be reasonable that the company justifies a $15MM valuation to new investors. The initial investors who participated in the convertible note will therefore convert at roughly a 41% discount (25% plus two years of 8% dividends) or a valuation of $8.85MM. That sounds good compared to $15MM, but it is still far more than the $4MM-$6MM they all thought the company was worth when they invested. Their own money was used against them. And who are these initial investors who participated in a convertible note with no cap? Well, it is unlikely that they were professionals. They were probably friends and family of the founder(s)—and they were given a raw deal, usually without the founders even intending to do so. They thought it made sense to avoid pricing the round because someone incorrectly decided that it was “too early to determine a fair value.”
In recent years, the use of convertible notes is usually inclusive of a “cap.” However, a convertible note with a cap is not an “un-priced round”—it is simply a round with a “maximum price.” While this does limit the risk to investors of their money being used against their own interests, excessively, it can still create other problems. Having a “maximum price” starts to appear, in terms of optics, like a “price” to investors who will assess the investment in the next round. The cap was agreed upon as a “maximum” because both parties felt that it was the highest possible fair valuation. It is therefore quite logical to expect that the next round might need to be priced lower than the cap in order to be priced attractively when the time comes to raise more capital. It may then beg the question, “What went wrong?” even though nothing did, and may give the company the stigma of appearing to be conducting a “down round” because the business is struggling, when in fact things might be going quite well.
Using a convertible note is also a fundamentally flawed way to begin a relationship with your capital partner. It can lead to unrealistic expectations or disappointment over perfectly acceptable outcomes—all of which might have been avoided by better clarifying the valuation of their investment and simply agreeing on a specific price upfront, ensuring that everyone knew exactly what they signed up for when the wires hit. To read a bit more about why convertible notes can be problematic check out a great post by another opinionated guy—Mark Suster from Upfront Capital posted an article called “Bad Notes On Venture Capital” on September 17, 2014. I don’t know Mark, but when a friend forwarded this blog post to me a couple of years ago it had a real impact on me (how great an impact, exactly, will be determined by applying a 25% discount to the amount of the impact at the time of my next life-changing experience).
Here’s one last point that many passionate and confident entrepreneurs also lose sight of when getting stuck on valuation: If you really believe that you have a chance to be the next Bai, or Krave, or Whitewave, or Chobani, or popchips, or Kind, or Plum Organics, or Annies… then a few points either way on your valuation is immaterial. A valuation below what you might have otherwise gotten won’t kill you; but a great, value-added capital partner is often transformative to helping a business succeed and scale. So make a fair deal. Get the money, because cash is still king, and because no one ever went out of business because of dilution. While the odds simply dictate that many of you will fail, some of you WILL succeed. I, for one, will be rooting for you all, because you are the artists of the business world. You are the pilots of innovation and when your talents are applied to consumable products, you also generate ancillary benefits to the world at large, by contributing to the health revolution taking place in America. As a guy who was often criticized for the way I ate, decades ago, I feel a bit vindicated, and included, every time I see another one of you succeed—even if I am occasionally still a bit jealous.