TheFunded.com Open Letter
Posted by The Founding Member on 2011-03-10
I have been watching a series of negative trends emerge in angel financings over the last 6 months. Unfortunately, nobody has incentive to say anything negative about these trends because everyone is riding a gravy train.
Founders are getting funded again. Angels are backing venture-quality companies with best-in-class securities. Venture capitalists are seeing higher quality dealflow from more advanced startups, and vendors are billing away. What is wrong with that, right?
Well, if 2010 was the Year of the Angel, then 2011 will be the Year of the Startup Default. There has been a convergence of trends where massive amounts of angel debt has been accumulating with no ability to pay it back and no conversion in sight. Let's look at what is going on.
Angels have picked up the funding pace after the venture market collapsed in 2009, and more angel deals are being done as technology startups required less capital. Anecdotal evidence suggests that angels are now investing as much as $50 billion per year, nearly doubling from the pre-crash level of around $30 billion.
Both startups and angels have recently favored convertible debt, particularly in the United States. Startups like debt deals because they are quick and cheap to close by avoiding price negotiations for equity. Angels like debt because it is the most senior security in a company. Estimates are that there are now 10,000 angel financings per year, and as much as 70% of these deals are now convertible debt. The majority of convertible debt deals have no mechanism to convert to equity without the occurrence of a Series A, and standard convertible debt deals come due in 12 to 18 months.
Here is the problem. The number of seed-stage Series A deals led by venture capitalists have fallen from 400 in 2007 to 241 in 2010, and it's declining further. Series A deals for any type of early-stage company declined from a total of 961 to 741 first-time financings in the same time (NVCA). Billions of dollars of angel debt across thousands of investments is coming due in 2011 and 2012 without any ability to be repaid or any prospect of conversion. The numbers are hard to come by for angel deals, so a lot of this is based on macro-trends and conversations with attorneys and startups, but maybe 5% of convertible debt will experience a proper conversion event.
This is a serious *potential* problem for startups. First, startups with large debts on their balance sheet will have challenges securing loans, partnerships and vendor credit, impeding their growth. Second, it will be nearly impossible for a startup with outstanding senior debt to secure additional angel financing, which is the most likely source of capital today due to the decline in venture. Third, it only takes one or two jittery angels to call their note on maturity, rather than re-negotiate, and bankrupt the startup, even if the startup is doing fine. If one jittery angel pulls out of 10 deals at once, a chain reaction is possible, and there are many more angels than ever before with varying levels of sophistication.
The Year of the Startup Default can be avoided with some actions today by, first, changing the type of deals that are being done and by, second, negotiating the terms of existing debt. New angel deals should either be (1) a "priced" angel round for equity or, if you choose convertible debt, there needs to be (2) a forced conversion event to equity if the Series A never happens. For anyone that has existing convertible debt, read your documents and understand the timeline. If there is no forced conversion event and if you don't have clear prospects for a Series A, negotiations should start sooner rather than later about converting the debt to equity upon maturity with your debt holders.
Of course, the best scenario is to pay back the debt, but that will not be an option for everyone.