Why Convertible Debt Is A Sucker's Play
There are some good posts going around today on the topic of using convertible debt in seed stage venture financings including one by my former colleague Seth Levin over at Foundry that is worth a look.
Rather than beat around the bush, let me just say that as someone who has made numerous angel investments in addition to lots of VC investments, Convertible Notes are generally a sucker’s play in today’s market for angels/investors and can even be bad news for entreprenuers.
Sure back in the day when convertible notes were truely just a very short term “bridge to close” for an institutional financing they made a lot of sense in that they allowed the entreprenuer to close “money on the table” while they hammered out terms with the lead investor. When used in this fashion I still think they are totally appropriate.
However, times have changed and convertible notes no longer make sense from an angel investor’s perspective primarily because startup capital/operating costs are now so low. These days companies can raise a very modest amount of money, say a few hundred thousand dollars, and have 12+ months of cash in the bank. When a company raises 12+ months of capital that’s not a bridge, that’s a financing.
Investors who agree to convertible debt in such a situation are paying for their own participation. They are getting all of the downside and none of the upside between the Seed and Series A and since these days that’s where all of the risk/reward is thanks to insitutional investors abandoning the early stage market, it makes zero sense to give up all that upside … that is if you are investing to actually make money. And people who bring up the point “but the investors are getting debt which is safer than equity so they should be happy” haven’t wound down many seed stage start-ups. All that’s left when a seed stage company fails are some empty Jolt Cola cans and nerf guns.
Now I don’t begrudge entreprenuers for asking for a free ride. Why not? A lot of people are offering them. But what I don’t like is the sermons from entreprenuers who seem to think that angels asking for equity is somehow a violation of the rules of fair play. Let’s all just be honest with ourselves: entreprenuers like convertible debt because it’s a free ride: it allows them to build equity value with no dilution. Who wouldn’t like that deal? There’s nothing wrong with that position but it doesn’t mean investors have to agree.
Granted, at the end of day it’s a market and entrepreneurs should obviously try to raise money at the best possible terms, but entreprenuers should realize that when they ask for convertible debt with a term of greater than 3 to 6 months they are basically asking investors “Just how stupid are you?”
Finally, convertible debt is not without its downsides for an entreprenuer. As another of my former colleagues, Jason Mendleson points out, a convertible debt financing technically makes a start-up insolvent from Day 1. This is bad from a liability perspective but also very bad from a control perspective. If an entreprenuer can’t roll or convert the debt it gets called and the debt holders will own 100% of the company, whereas if you do an equity financing the investors will just have a relatively powerless minority equity position. Also, convertible debt in small amounts won’t screw up an institutional round, but as you get over $500K+ in convertible debt it starts to become very noticeable to VCs and often they will want to “haircut” it in a financing. If you have some particularly hard headed or irationally principled debt holders this can blow up a financing.
So, net, net, convertible debt as a means of angel financing really makes no sense in today’s start-up market from an investor’s perspective and it is not without its downsides from an entreprenuer’s perspective. That doesn’t mean I wouldn’t ask for it I was starting a company but it does mean I wouldn’t be offened when investors said no.
Tesla Worth $1.7BN .... According To Its Bankers
Electric car start-up Tesla Motors set the roadshow terms for it’s IPO today. It plans to sell 11.1MM shares @ $16/share for gross proceeds of $177.6MM (excluding a potential 1.1MM share shoe), plus another $50M worth of stock to Toyota. Total shares outstanding after the IPO, including issued options would be 107.6MM giving the total company a fully diluted market capitalization of $1.72BN post-IPO if all goes according to plan (enterprise value will be over $2BN if they take down all their DoE financing).
This values Tesla at just under 21X its annualized Q1 2010 revenues of $20.6M. For comparison, Ford Motor, trades at about 0.3X annual revenues and did $31.6BN in revenues in Q1.
It will be very interesting to see if they can price this deal at anywhere close to those levels.
Please Note: This is not a recommendation to purchase Tesla stock (not that could if you wanted to because it isn’t even public yet). Please see my disclaimer for more details.
Theater of the Absurd: Capital Gains Now Being Eliminated on Sale of VC/PE Management Companies
According to Bloomberg, there’s a nasty surprise in the bill that eliminates capital gains treatment for carried interest in investment partnerships. Not only is the government planning on eliminating carried interest on the investment profits generated by a partnership, but they are planning on eliminating capital gains treatment on
“the sale of any firms, including hedge funds, founded by financiers to manage funds that generate carried interest. “
The theory behind this latest twist is that nefarious VC/PE/Hedge fund managers will get around the new carried interest rules by selling stakes in their management companies just prior to realizing capital gains in their investment partnerships. Because the management companies are typically organized as C Corps or LLCs, these ownership stakes could be sold, like any stock, to get capital gains rather than the partners being forced to book the income as ordinary income/carried interest.
I don’t know where to start criticizing this latest twist but I’ll start with the fact that it makes no sense at all for two key reasons:
- Many management companies are organized as C Corps and as such don’t realize investment gains or carried interest when a partnership sells an investment interest. The value of these firms is not tied to investment gains but to management fees. Any profits from those fees are already taxed at ordinary rates.
- In those cases where the management company does in fact receive investment gains, those investment gains are typically spread out of many different investments over the life of many different funds. It would make no sense at all to sell off a chunk of a management company in advance of one particular investment realization as once you sell a piece of a management company, that piece (and its claim to all future profits) is gone forever, just like stock sale.
In short, for most firms, it makes no sense at all to sell a piece of a company just to get capital gains on a particular deal because most firms don’t even get capital gains to begin with and those that do would be stupid to sell a permanent piece of the returns generated by their company for the returns on a single investment.
Outside of this, it is blatantly discriminatory against one type of company, i.e. a fund management company, vs. every other kind of company. Look, I can see how people of good faith can argue that investment managers don’t deserve capital gains on their carried interest, but I don’t see how anyone can support this particular provision.
If a group of people get together to start-up an investment manager/adviser and successfully build that start-up into a real business, they should be able to get capital gains on the sale of an ownership stake in that business just like any other business in this county. Anyone who doesn’t think so clearly hasn’t tried to create and build their own investment management company. Believe me, they are as much a start-up as any other kind of business.
At this rate, the entire US investment industry is just going to decamp to either Hong Kong or Switzerland.
Carried Interest Deal Cut, Let the Workarounds Begin! UPDATE: Some More thoughts
So Congress has apparently cut a final deal on taxing carried interest. According the Way and Means Committee the bill will:
" … prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as carried interest in an investment fund. To the extent that carried interest reflects a return on invested capital, the bill would continue to tax carried interest at capital gain tax rates. However, to the extent that carried interest does not reflect a return on invested capital, the bill would require investment fund managers to treat seventy-five percent (75%) of the remaining carried interest as ordinary income. A transition rule would apply prior to January 1, 2013. This proposal is currently being estimated by the Joint Committee on Taxation.”
This compromise drops all pretense about this debate being a principled argument over tax/investment policy and makes it clear it's just about raising cash, which I guess is fair enough. A couple quick points:
- As far as I know, no GPs get “carried interest” on their own invested capital in the fund, so the exemption for that is basically worthless.
- The final solution of taxing carried interest at 75% of ordinary income is obviously just a political compromise to get the deal done. What they are really doing is raising the tax on carried interest from 15% to 26% (29.7% starting in 2011).
Where There’s A Will There’s a Way
The fundamental problem for the government is that carried interest isn’t given to VCs by GPs for the hell of it, it is given to them because the VCs are investing all of their intangible assets (reputations, track records, networks, etc.) into each deal. LPs have traditionally valued these intangible assets enough to give VCs a 15–35% ownership stake in the partnership. The carried interest legal/tax structure just represented the most straight forward way, least hassle way to account for all of this. By putting this option at a significant tax disadvantage, the government is just going to force VCs and Private Equity firms to create more elaborate documentation of this, until now, implicit arrangement. My guess is that after this law goes into effect will we see VC deals restructured into something along the lines of this:
- Step 1: Create special purpose LLC
- Step 2: LP contributes $X
- Step 3: GP contributes $Y
- Step 4: GP contributes non-exclusive trademark license, promotional agreement, strategic partnership agreement, venture services agreement, and other such intangible assets as it deems appropriate in return for 15–35% of equity in SPE
- Step 5: SPE invests $X+$Y in portfolio company.
These kind of structures will cost more to set up and maintain, but they will be very hard for the IRS to attack because the VCs are getting equity for the contribution on clearly identified assets.
Now some might say, these “assets” are intangible assets and therefore the IRS will be able to claim they are bogus, but the problem for the IRS is that there are a ton of deals, outside of venture investments, that are structured exactly this way, especially in areas such as pharma and entertainment, where different parties contribute intangible assets in lieu of cash for ownership stakes. For example, there are a ton of pharma and biotech JVs and investments made by simply contributing intellectual property (patents, research, data, etc.). Thus this change is likely to set off a cat and mouse game between lawyers and tax accountants and the IRS with the only real winners being, as usual, the lawyers and the accountants (Hey start-ups, that $30K you pay to close your Series A, just went to $100K!).
Hollywood Holds The Key
All that said, since this whole exercise is really just about extracting cash, one would assume that Congress will amend the law to try and cut off whatever workarounds are developed. The key for VCs then is to choose a workaround that Congress can’t/won’t cut off because it hurts another powerful political constituency they aren’t trying to shake down. Enter Hollywood.
From what I understand, the entertainment industry has created tax and legal structures that would put any VC lawyer to shame. Contribution of intangible assets (such as development rights, creative services, trademarks, etc.) for equity is apparently widespread. After all, lots of people want to invest alongside successful Hollywood producers/directors/actors and are happy to give up a big cut of deal to draft off of these people’s reputations, project sourcing, creative talent, etc. It also happens to be that Hollywood is major source of Democratic campaign contributions and therefore Democratic politicians are careful not to screw with the structures hollywood has created to turn ordinary income into capital gains.
Given all this, the NVCA would be wise to send a crack team of accountants and lawyers to LA for the next few months with the goal of creating venture investment structures that effectively mimic the byzantine structures the entertainment industry uses to magically turn intangible assets and work product into JV/LLC/partnership equity. Should they successfully do this, the politicians will face a catch-22 and will likely be forced to call off the dogs.
It will be fun to see the game of cat and mouse plays out because with California’s marginal rates on ordinary income headed to almost 54% (including the 2011 tax hikes and the health care tax hikes), there’s clearly enough cash at stake for people to invest a lot of time and effort into beating the system.
UPDATE: I thought I would post a few more thoughts on this issue based on some comments I've gotten. First, I've written about the whole carried interest issue in the past here and here in case you are curious.
Second, I thought I would re-post a excerpt of a conversation I had with Dan Primack via e-mail a couple years ago on this topic as I think it nicely summarizes my thoughts on one of the key issues: why should entrepreneurs get carried interest and not VCs.
"When an entrepreneur gets 20% of the economic interest in a company, yet invests well less than 1% of the actual capital, everyone seems to get that concept with no problem, but when a VC does the same thing everyone acts perplexed and seems to think this is some kind of unnatural tax dodge.
If the VC is just getting returns for investing “someone else’s money” what in the world do you think the entrepreneur/manager is getting those outsized returns for??? Both VCs/PEs and entrepreneurs/managers create businesses that try to earn a return on invested capital. Both take risk to do it (and incidentally both get salaries for their time in addition to their capital ownership). Why is taking the risk to start a business that invests capital in financial assets any different than taking the risk to start a business that invests capital in operating assets? Both businesses invest other people’s money and both managers receive an economic interest in the business that is disproportionate to their contributed capital . Fact is, a successful economy needs both sets of managers badly as there is a deep symbiosis between them, therefore why shouldn’t the government support both with the same tax treatment?
I think much of the opposition to carried interest tax treatment is based on somewhat latent, deep seated populist and socialist sentiments that hold capitalism and for that matter most of modern finance in moral contempt. This contempt stems largely from the abstract, opaque nature of modern finance as well as the great wealth it has produced, but also from either genuine or willful ignorance about the importance of capitalism and modern finance to overall economic growth and human prosperity. Without sophisticated financial entities (and their managers) that are willing to take risks the economy would be far smaller and the overall standard of living throughout the world would be a lot lower.
It seems to me that one can argue whether or not preferential capital gains tax treatment, in general, is a good idea, but to split hairs and say that one set of managers (corporate guys, entrepreneurs) deserve it, but another set of managers (VC, PE guys) do not, evidences both a fundamental lack of appreciation for just what financial managers do within the context of a modern economy but also a willingness to sustain a clearly illogical and contradictory position in order to maintain some romantic, populist and dated notions about the relative social value of different kinds of labor."
The thoughts and opinions on this blog are mine and mine alone and not affiliated in any way with Inductive Capital LP, San Andreas Capital LLC, or any other company I am involved with. Nothing written in this blog should be considered investment, tax, legal,financial or any other kind of advice. These writings, misinformed as they may be, are just my personal opinions.