The Illinois state legislature killed convertible debt as a way to finance startups for 2016. How did they do it? They took away the tax incentive. In Illinois, early stage investors have been able to take advantage of a 25% tax credit on investments in early stage companies.
I have several conflicted thoughts and feelings about the decision by the Illinois legislature. The legislature by virtue of their decision has imposed their will on the startup community. I’d rather the participants of the community decide. Legislators really don’t have a clue about what it takes to finance and build a startup. It’s also important to note that governments cannot build a startup community, but they certainly can kill it. Only entrepreneurs can build successful self sustaining startup communities.
There were no investors or entrepreneurs being hurt by the existing policy. Why make the change? If I was a conspiracy theorist, I’d say the Democratically dictatorial Illinois legislature was helping its attorney friends out because the fees on priced rounds are significantly higher than convertible debt or SAFE notes.
Investors and entrepreneurs are left with two options for early stage financing. SAFE notes which were developed by YCombinator, and traditional priced rounds of equity.
Traditional priced rounds of equity are more expensive than convertible debt notes and SAFE notes. Priced rounds are a huge hassle for entrepreneurs if there is no individual investor or fund that decides to lead the deal. In order to lead, one investor generally takes a significant portion of the round, sets the terms of the round, and goes on to help assemble the round. That investor usually winds up taking a board seat as well.
In Chicago, you can count on one hand the investors that will lead a seed round of financing.
Why are priced rounds a hassle without a lead? The entrepreneur is forced to negotiate all kinds of terms with several investors all at once. Without a lead, seed stage financing turns into a mishmash. It takes a massive amount of time and pulls the entrepreneur away from building their business.
However, there are huge benefits to both entrepreneurs and investors by doing priced rounds. In the long run, I think it’s better for companies to do priced rounds earlier. Having a board and having the structure that priced rounds bring are good things for early stage startups. They help bring some discipline and cadence to the firm. Investors also know exactly where they stand on the cap table which helps them align their interests.
Having a conversation about price and equity helps both sides learn about each other. It also sets expectations, and aligns economic interests.
I strongly urge entrepreneurs to price rounds. There are people in the investor community that don’t agree with this opinion. I can appreciate their view that a priced round can cause an entrepreneur to give up too much equity too soon. I can empathize with the opinion that having a priced round puts the entrepreneur in a potentially vulnerable position when it comes to control of the company. But, I see more benefit to a priced round than limitation.
That’s why entrepreneurs have to interview their investors as hard as their investors interview them. It’s a symbiotic relationship, not adversarial.
The data on exits also backs me up. Most startup companies fail. Of the ones that make it, the acquisition price of those companies is between $20-$60M. Very few companies become “unicorns” or even “gazelles”. Venture math is pretty basic. When they do, entrepreneurs and investors have first world problems.
There are a couple of big differences between SAFE Notes and convertible debt.
Convertible debt generates an interest rate payment, SAFE notes do not.
There are two schools of thought here. First, in general, investors are already getting a discount on future valuation with a note. Should they get paid interest on the money they invested as well? Paying an interest rate recognizes there is an opportunity cost to the money. Entrepreneurs essentially give up more equity by paying an interest rate. The question becomes should they? I have been in convertible debt notes for as long as 2-3 years. In that case, I’d prefer the note structure over a SAFE. 1-1.5 years, I prefer a SAFE with a discount. At seed, you never know how long it’s going to take to raise the first priced round-which is why I favor priced rounds sooner.
Convertible debt has a time limit on it, SAFE notes do not.
One thing the term on the note does, it forces a conversation. At least the entrepreneur has to check in with investors to extend the note. Investors also have the option of calling the note and bankrupting the company if the entrepreneur hasn’t made any progress. It is extremely rare when this sort of thing happens. But, it does give investors some leverage. I have been involved in situations where having the convertible debt saved the company, and bailed out investors. A SAFE would have killed the company.
Convertible debt allows the company to remain an LLC, SAFE notes do not.
If a company wants to seek out institutional financing of any kind, they should be a C corp. It’s easy to startup a company as an LLC, but if an angel group or seed fund is going to invest, they aren’t going to do it into an LLC. Early stage companies form as LLC’s early because it’s cheap and easy.
The rest of the differences between the two forms of financing generally favor doing a SAFE over a convertible debt note.
SAFE notes are relatively new to the investing world. I can honestly say I have never seen one yet in Chicago. But, due to the legislature decision they will become the defacto way to finance a company so both entrepreneurs and investors better get comfortable with them.
Here is a link to a Quora discussion on SAFE notes. Here is a link to the Y Combinator discussion on SAFE notes. Y Combinator also has a place for you to download a longer discussion on SAFE notes along with documents to get you started.
My hope is that the decision by the Illinois legislature won’t deplete the amount of capital that goes into early stage startups. By eliminating convertible debt, it eliminated an avenue that most investors and entrepreneurs became comfortable with. The SAFE is a good alternative with the limitations I described. Illinois needs as much capital to go into the seed/early stage startup community as it possibly can get. It takes a lot of at bats to grow one platform company. This only happens with a tremendous amount of seed activity, not later stage investing.
Financing will just be in other structures – equity or SAFE or other. Seeing more straight debt as of late. https://t.co/mdDN2xBsuJ
— Chris Randle (@crandl) December 27, 2015
Straight debt is not a good way to finance a startup. Seed stage startups should rarely, if ever, have debt on their cap table. I also received a PM that in YCombinator’s case, there is a lot of competition to get into the deal. That puts the negotiating advantage in the startup’s hands. Here in the Midwest capital is much more scarce-especially early stage capital.