Convertible Notes or Equity? Who Cares! The Debate Misses The Point

Over the last 24 hours I've read no less than 5 VC luminaries discuss the finer points of Convertible Notes versus  Convertible Preferred Equity.

Fred Wilson is here

Chris Dixon is here

Brad Burnham is here

Seth Levine is here

Mark Suster is here

My answer to the debate is:


The debate misses the essential points.

All of these articles rehash the finer points of the deal structures and the pros and cons of each - but to sum it up - convertible notes (particularly the ones with no caps) are for either unsophisticated investors or professional investors who are desperate to be in a specific seed stage deal. Otherwise, traditional preferred structures are the way to go - as they give you the equity rights you demand for taking equity risk and properly price the deal (why else is a fiduciary giving you money for - to abdicate this duty?)

Okay, so what is the real point behind all of these conversations?

The point is that the VC market has moved from having too much money chasing too few deals in the early to late stages - to having too much money chasing deals at the seed stage.

The outcome of this is that valuations are rising - and terms (thus the debate between convertibles and preferred) for professional investors are getting worse.

For a real VC, not an angel or super angel with $20M to invest, particularly a VC with a "name brand" this is a particularly dangerous position to be in. With enough $ chasing early stage deals - and convertible debt getting more popular, VC's will be forced into a choice of  putting money into structures that are not particularly favorable for them or trying to convince founders to change the structure to an equity position.

The great thing about being a "name brand" investor is that you can get in early, and then get a ride on the valuation as your involvement helps push up valuation to the next round. If the company is really doing well, there are still a host of late round investors who are willing to buy secondary shares - so you could end up in a position to sell a small minority of your shares and get all of your capital back - while continuing to keep all of the upside.

If you agree to a convertible structure - particularly one without a cap - you are working against yourself. A "name brand" VC will push up the next rounds price - and thus they will own less of the company without a cap - and if they are going to have a cap - then they are setting the economics - so why not just go to equity anyway - it is what they are doing.

The flip side of the coin is not really examined either.

For founders, convertibles without a cap are fine - and Brad Burnham explains this in some detail - so I won't rehash it - but they too are missing the bigger picture in all of this debate.

When doing a seed financing, you partners are really all that matters - outside an obviously mispriced valuation (Chris Dixon makes this point well). So when founders demand convertible notes with or without caps because of legal fees or because they feel it is going to give them an extra 2% ownership in the company - it is a rookie mistake - shortsighted and ultimately potentially destructive.

You don't create value on a seed stage deal - but you can set up a situation that makes it more difficult to fund later.

There has been a ton written about the negative signaling effects of a "name" VC who doesn't follow on - but not much written about why this happens. Lost in this structuring debate is an important point for founders which is the following:

1. Pick your financial partners not by what price they are offering you or what structure they are proposing - but based on what they can do for you beyond handing you the check. 1 second after that wire has hit - their money is no different than anybody elses - and you are now stuck with them. Is that a situation you want?

2. Forgetting domain expertise or a VC's ability to get you in doors with partners or buyers - ask yourself whether your new partners are people who you are willing to spend a day a month with - and speak regularly to - and talk and e-mail even more frequently. Because you will.

Just an uninformed opinion, but if you are going to take money from a "name brand" VC - do it in a way that makes the greatest use of their brand name - so it in the form of a simple preferred doc - and get busy building value by executing on your plan. However, only take money from anyone, brand name or not, if you feel strongly that you have some personal chemistry with and who offers you more than a check.

My guess is that when "brand name" investors beg off after an initial seed round they do it for one of two reasons: 1. either the team and company is not performing well, in which case the signal is real and future investors are potentially smart to stay away, or 2. the investment was just money, and there was never any real personal involvement between the founders and the investor and never was going to be. Of course it could be both - but you usually don't see people walk away if things are going well and everyone is getting along and working together toward a common goal.

P.S. While trolling around I just ran across a piece that makes this point perfectly. David Pakman of Venrock has a great post up. Read it here

Digital Filling Stations

Starbucks announced this morning that they would be offering free wi-fi at all of their locations starting July 1st.

See coverage here

How long will it be before they start billing themselves as the digital filling station?

As I wrote earlier this morning - with metered pricing now a reality on AT&T - we will see some real high bills from some people who don't realize just how much data is used streaming a Netflix movie.

A big winner will be companies that can stream with efficiency - or apps that are more self contained and don't need to go out to the web.

Another winner might just be media companies who allow for caching on devices. Music companies only get paid when songs are played - yet caching is generally not allowed under the free services like Pandora. With these new rules in place - it might make sense to revisit this. Same with Netflix. Studios want their movies played - because that is how they get paid. Hulu wants videos watched (as does YouTube)  - because the greater the viewing - the more commercials get run. Yet if it is going to cost you another $25 per month to watch an ABC video - are you really going to do it?

I predict a real renewed level of discussions around the idea of caching

And I expect there to be more and more digital filling stations out there on the information super highway.

The Efficiency Premium

If you live in the traditional media world - one of your main attributes and advantages are a lack of efficiency.

HD video is beautiful - but takes a lot of bandwidth.

Radio broadcasts on the FM band sound fantastic  - but are uncompressed and take up multiples of the bandwidth used by Satellite Radio or Pandora.

Books are an exercise in a lack of efficiency - killing trees by the score to get the message out.

So how does this play in the new media world?

Not so well.

With A T & T having a virtual monopoly on all things Apple - and with the all you can eat data buffet coming to a close - it is going to get increasingly expensive to consume data on the go.

According to a recent Sanford Bernstein report, watching a Netflix movie on your iPad will use up your data allocation in about 41 minutes (assuming you use the iPad for no other data). Throw on a few hours of Pandora - a ton of web browsing - e-mails, etc... and you are looking at a very large data bill unless you spend a lot of time in wi-fi hotspots.

Given that, do you want AOL IM pushing you messages? Do you want facebook sending you e-mails? Who wants to download large attachments?

The obvious answer to me is that you want to look at companies that offer efficiency.

Who can do the best job of compressing audio and video files? Which systems to the best job of caching? Which applications are simply the least data intensive? Who offers some sort of variability in how I use a mobile device depending on just how much data I have left under my plan?

All of these factors will come to the fore in the not too distant future.

The relentless march of richer and richer websites will be met with higher and higher user bills - which will ultimately result in lower and lower usage for those applications that are spending your money the fastest.

Seems like there will be a real premium on efficiency coming up - or put another way - it seems like with the proliferation of distribution points - there will need to be a wide variety of different formats that are optimized for the platform itself. So for movies - if I am watching on a 60 inch plasma display - I want 1080p. If I watch the same movie on my iPhone, not only do I not want 1080p (it doesn't have the resolution) but I may want a differing quality level depending on whether I  have the movie cached or it is streamed - and I may want a different level of quality depending on whether it is streamed over wi-fi or over a 3G or 4G network.

It's a lot of variables.

Companies that figure out how to easily optimize for all of these variables should do okay.

The Value Of Information - I Am My Own Editor

With the whole Facebook privacy kerfuffle still fresh in peoples minds (see this back and forth between Techcrunch and Jason Calicanis on the subject), I read a great post this morning from Brad Burnham of Union Square Ventures - who talked about platforms as governments. The question is, what sort of government is Craigslist, Facebook, Apple, Google, etc....

As usual, some of the best ideas came in the comment section

What really struck me was the large number of comments I read this morning - as well as other days on just who owns the infomation on these services.

Do you own your own info when you post it up there? Can you take it with you?

As I said on Fred Wilson's blog this morning:

I've never really gotten the idea of people expecting the data they provide to be theirs exclusively. If you want exclusivity - don't post it online - and then see if there is real value for you insights and personal lifestream. Unless you can get reality show contract - my guess is that the internet has taken data that has heretofore had little value - and by aggregating it and distributing it to the people for whom it does have some meaning - has created a ton of value. Whether some of that value is captured by the platforms is almost irrelevant to my way of thinking - I am providing value - and am receiving value - and I can opt out at any time. A pretty fair trade in my opinion.

This got me thinking more about the value of information.

There really is no value to my comments or posts without an audience of people who may or may not find them interesting. Pictures of my kids are useless to anybody but my friends and family. Where I ate breakfast is generally of little import to anybody, but by posting it up via Foursquare - it might reach a few folks to whom it does resonate.

When you think about it, the internet has taken information and made it available to anyone with a connection - and then allowed that person to collate their own information - bringing far greater value to each member of the ecosystem.

Think about it in terms of old media. Before the internet (yes there was such a time) - all of your information was gathered and collated by "professionals" who fed it to you where they decided and when they decided. Newspapers, television , magazines, radio, etc... all depended heavily on someones editorial judgment as to what I might like or be interested in - and to make it all the more clear - since all of these companies were (and still are) for profit entities - the editorial decisions were (and still are) made based on aggregating the largest audience for the information provided.

Fast forward to today and I am my own editor.

On Pandora - I decide what I want to listen to - not some program director looking at the middle of an 18-34 year old bell curve.

With blogs and news aggregators, I am my own Ben Bradlee.

With Hulu and YouTube, I am my own Brandon Tartikoff.

And the great thing is - the more I want to put into my editorial job - the more I am going to get out - almost guaranteed.

Sure there are nights when I want to kick back and watch Lost or 24 (neither of them around anymore alas) - but more and more I spend my time with my own curated information.

Whether I own this information or not is irrelevant to me. I move freely between the differing governments - Facebook, Google, Apple, etc... using each for what I believe is its most relevant facet for myself - and pay my taxes by contributing to each ecosystem. If someone finds my contributions worthwhile - all the better.

And if enough people people find enough other peoples informational contributions worthwhile - well then the value of all the collective contributions has increased dramatically.

New media gets this. Google was built on it. Facebook is a product of it. Apple provides the digital picks and shovels to create and access it. And so on.

If the old media guys are to have any sort of future - and regain any semblance of real growth - then they are going to have to realize that their information -  whether it be in the form of a tv show, a newspaper article, a new song, a movie, whatever - needs to be produced so that people can not only consume it in the traditional manner - but also curate it, embed it, check in with it, scrobble it, clip it - and ultimately make it part of their own creations. It's only then that they really will be able to move past the traditional - and into the new.

Information is valuable - but in order to really understand its value - you need to understand the ecosystem in which the information lives - or can be used.  The best information can be tailored to all different ecosystems - and ultimately monetized across the lot. There's not much of that going on - but as I am my own editor - there will be.

The Carried Interest Tax Debate - My Own Take

The last week or so has brought a ton of posts and commentary regarding the issue of taxing the carried interest that VC's generate from successful investments.

Of late the topic has gotten heated - and the remarks have gone from the benign to the belligerent.

My own take on the matter is that people are confusing several interlocking issues - and getting all heated up about it without really understanding or thinking through the facts and the implications of any changes.

Fred Wilson started the ball rolling at AVC with his post on the subject over Memorial Day weekend  - here. His basic premise is that the carried interest is a fee and thus should be taxed at ordinary income levels - as that is a fair way of looking at the tax.  Others have weighed in in favor of the increased tax - most prominently Chris Dixon here. The naysayers on the tax have come from all angles, but prominently Jim Robinson of RRE here, Jeff Busgang here and BillBurnham here.

All of these posts - whether for or against the higher tax rates for carried interests are well written cogent arguments. What is really impressive however, is the comment threads on these posts which run to hundreds of comments - and are heated to say the least (and thus very well worth the time to read them all). So much so that Roger Ehrenberg today penned a piece talking almost solely about civility on comment threads - using this debate as an example.

Before getting out the scalpel and dissecting all the issues - let me state upfront that it is only because the US has such a great entrepreneurial spirit and culture that we can even have this debate. There's a reason "Silicon Valley" and the VC system exist in the US like nowhere else - and there is a reason why we an have debates on start-up visas etc... There's no doubt that we have to pay for the privilidge of living in such an opportunisitic society - but how we pay - and how much is the question that is really open to debate.

So to it:

The carried interest is a fee. No mistake about it. Unlike a management fee (now typically 2% in VC, hedge funds and private equity shops) it is different in that it is a fee paid solely upon the successful sale of an asset after a period of investment. It is thus and artificial construct of the original partnership accounting rules under which almost all private investment partnerships are governed. Invest in an asset and hold it for a certain length of time (1 year for a company - 5 years for a home - assuming you have lived in it) and you qualify for a lower tax rate. As Fred Wilson replied to a comment on Chris Dixon's blog, "you play the game by the rules that are in place. if you don't like them, you try to change them" Fair enough. For years the rules have been pretty clear - hold an asset in a partnership for a certain amount of time - and if there is a gain, then someone with a carried interest in the partnership gets paid their fee as a slice of the partnership - retaining all of the tax characteristics of that partnership.

So here we are now intensely debating whether it is fair to change the rules - and in essence  - double the tax on the carried interest from 20% (assuming the Bush tax cuts are allowed to lapse) to roughly 40%.

I'll skip the details for now - but my view on this concept is that if the government sees fit to tax VC's, hedge funds, and PE firms at the higher rate - then everyone should be taxed at the higher rate on capital gains. When you start breaking down taxes based on the perceived success of a class of business - you are starting to set dangerous precedents - and really starting to eat into the framework that makes the US such a great place for investing.

As Fred puts it, it is a matter of fairness. I always thought fairness meant that everyone got treated equally. To me that is fair. As your kids what is fair. If you have 2 kids and two ice cream cones - they'll tell you that it is fair that they each get one. If there are 4 dishes on the table and they are going to clean the table - fair means that each one is clearing two plates. You never hear them claim that one is bigger than the other and therefore should carry 3 plates because capacity is the issue.

Fair is equal.

The media has gotten away from that in talking taxes. In the mainstream media - fair means paying what you can afford - and what you can afford is generally determined by someone who is being subsidized by someone else. When the head tax writer of the House (Charlie Rangel) can't pay his taxes like everyone else - and the Secretary of the Treasury (Tim Geithner) can't pay his taxes fairly - is there any wonder why this debate has gotten so vitriolic. Everyone loves the American way - and everyone understands that there is a bill to be paid - so how do we fairly split the check?

This populist sentiment has extended into the capital gains treatment for the sale of stakes in VC shops along with hedge funds and PE firms - and this is clearly wrong in my opinion. Why are these entrepreneurs any different from anyone else? They founded a business, they took risk, they paid taxes at the prevailing rates - and if they should decide to sell, why is that any different than when a start up sells to Google? Why should it be treated any differently? Of course it shouldn't.

Strangely, you haven't heard much about this part of the debate - largely because VC firms just don't sell. They are a collection of individuals with little ongoing equity value in the firm without the founders. While there have been some hedge funds and PE firms that have either sold stakes or gone public - they are the exception - and anyone big enough to really enter into one of these transactions has likely accumulated enough wealth that in this environment it has just become unseemly to complain in public. Am I worth $300M or $400M is not a question that is going to get a sympathetic hearing.

You do, however, hear about whether angels should be taxed differently. The argument goes that angels are smaller - make no money on their management fees and thus have to rely on carried interest - so don't tax them as much. Of course, this is a facetious argument. No one demanded that they become angels and keep their business small - and no one told them they could not scale it to become bigger and institutional. If you are good enough to be a successful angel - chances are you are good enough to join or grow a much bigger entity - but chances are that you like working with smaller companies at the formative stages - and you don't want to be beholden to institutional investors - and deal with a mess of partners all competing for capital - and for this reason you remain small. It is a business choice with a real trade off - you have to be right more often.

So what's really going on here?

We're not really debating as to whether or not the carried interest is a fee or not. And we're not debating whether it is right or wrong to raise the tax on it.

What we are really debating is tax fairness - or more properly put - the level of transfer payments from those who have the most to those who have the least.

And why are we having this debate?

I would argue that we are having it because we have a spending problem - not a revenue problem - and the political cost of fixing the spending problem is too high for politicians to tackle - and thus we resort to populist measures like raising the level of "fairness" in the system. When entitlement spending  - be it social Security - Medicare - Obamacare - Public Pensions - are out of hand, and cutting them is political death - you can be guaranteed that the politicians will "kick the can down the road" and tax whoever they can to live to fight another day. If they can do it in populist way "don't tax me - tax that banker behind the tree" - all the better.

We would all be better off if we just tacked the problem once and for all - and fix the issue.

Since we are not going to do that, by all means raise the carried interest tax - but do it fairly - by raising it for everyone across the board - or by changing the partnership accounting rules - and by no means tax the capital value of fund managers who built up their companies.

Let's not disincent success - or at least if we are going to tax success to pay for an untenable future - let's do it evenhandedly.
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