Debt vs. Equity-Battle Royale

At our first members-only fireside chat of 2008 we enjoyed a lively discussion about valuation trends and the merits of debt vs equity with top notch participants David Clarke (partner Perkins Coie), Peter Parsons (partner Davis, Wright, Tremaine), Geoff Entress (Madrona), Robert Headly (Ignition), and Dan Rosen (Chair of Alliance of Angels). With the panelists addressing the issues from the point of view of both investors and entrepreneurs it was a night to remember. Some insights gleaned from the discussion

Valuation

• "More of an art than a science"-Geoff, who went on to remark that you could always try to use a DCF but more than likely it will end up getting thrown away.
• Peter-Angels need to be careful not to be too generous in an A round because they will get crammed down by VC's in the next round.

Term Sheets

• Robert-VC's may get nervous if a company a large number of individual investors (e.g. >30).
• Geoff-In an angel deal find terms consistent with what VC's will look for later on to minimize attorney fees.
• If you are going to pursue more than just friends and family money, convert an LLC to a C-corp early on to save yourself a headache.
• Option pool-be analytical!! Think about necessary hires and what they will expect (eg. CEO 7-10%) and craft size of option pool to conform to needs for that round.

Convertible Debt vs Equity

• Have a clear end point (next round of funding) in mind with convertible debt-6 months is normal outer limit for the next funding to occur. David suggested setting a cap on valuation if there are questions about the timing of the next round.
• Between the attorney's and VC's on the panel the market discount rate for convertible debt appears to be 25-30% with some cases of the rate escalating month to to month after a certain point.
• In a debt deal, make sure to note what will happen if a sale occurs before the next round of financing-set a valuation or an agreed upon return for debt investors.

Expense Budget for an A round

• David gave an estimate of company counsel costing $50K and investor counsel between $25-35K for a normal series A venture round, with an angel round costing perhaps 2/3 of that. Although Peter, in a friendly dig at the competing firm, noted that perhaps Perkins is on the high side and his experience showed it to be a bit lower.
  

Update 5-22

• Since we are still seeing quite a number of debt deals coming through our process I thought it would be interesting to link to a new article contending that convertible debt is a bad deal for angel investors. The arguments put forth in the article are the same we have been making here at the Alliance for some time, regarding the instances where convertible debt is an appropriate instrument. It does make the interesting addition that debt can be a good deal if there is a cap (agreeable to the investors) on the pre-money because in the event of a negative exit, debt holders will at least have first right to any assets...