2007 Deal Trends

As the Alliance of Angels enters its 10th anniversary year, we’ve been struck by the opportunity to pass on the insights we glean from daily discussions with entrepreneurs and investors. Thirteen months and 191 interviews into my tenure here, I’m lucky enough to be sitting on a wealth of data that we can mine for answers to the questions CEOs ask us every day. The graph charts our monthly 90-minute coaching sessions with entrepreneurs. We’re averaging about 17 of these interviews per month, and after a busy July, have met with 120 early-stage companies this year.



Some interesting trends have arisen, and when a CEO called me on Tuesday to ask about our “policy” on convertible notes, it inspired some investigation. For those unfamiliar with this type of structure for angel financing, here’s an excerpt from
Brad Feld’s clear but thorough description:

"a promissory note that converts into equity on the terms of a qualified financing. The note will either convert at a discount, will have warrant coverage, or both, to give angel investors some additional ownership in exchange for taking the early risk.”

In the second half of 2006, we saw a significant uptick in this type of financing, and 50% of the companies that presented to our membership were convertible notes. However, in the first half of 2007, only 26% of the deals presented to the members were structured this way. Is the observation affecting the observed? Is the word on the street that AoA "doesn't do" convertible notes? Though we are not in the business of giving financing advice, we are in the business of presenting the best deals to our membership and getting the deals done. From a Program Director's perspective, part of the coaching we provide applicants is to share aggregate data on the companies that successfully make it through our four-step process and get funded. When it comes to deal terms, the feedback from our screening committee and membership has been clear: convertible notes can be attractive to our angels if and only if the timing and the terms are right.
Historically, our angels would get involved in a convertible debt round when it was a true bridge, i.e., funding at a critical juncture that would enable a company to hit milestones which would in attractively position it to institutional investors. This was predicated on an imminent round of venture or institutional funding, which, given the time it can take to close this kind of deal, would suggest the company was already in discussion with this class of investors. In terms of a time-frame, this might suggest a priced Series A round three (and possibly up to six) months out.
Last year, we started seeing debt rounds that wouldn't convert for 9,12, and in one case, even 18 months. While our membership is by no means monolithic, a prevailing perception was that this structure wouldn't properly reward the highest risk class of investors: the angels. Imagine the progress that a successful company could make in 18 months, achieving its development, traffic, staffing, or other significant business plan goals. If the initial funding round had been priced, those who participated could enjoy an impressive step-up in valuation, with a pre-money on the Series A significantly higher than when the angels got involved. Instead, in a convertible debt round such as this, early investors are instantly diluted when it eventually converts to equity.
As to our policy? We don't have a policy per se, just a preference towards deals that are structured to reward both the entrepreneur and the angel. A convertible round doesn't have to be a deal-killer, but timing is everything. Much has been written on this topic, but for some validation from the east coast, here's a link to a Redeye VC post by Josh Kopelman, Managing Director of First Round Capital.