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The Year of the Startup Default

TheFunded.com Open Letter

Posted by The Founding Member on 2011-03-10

PUBLIC:

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.

Posted by goodform on 2011-03-10 17:13:38

Adeo - thank you for addressing a problem I have talked about for quite a while - you cannot keep on creating Supply (startups) without creating Demand (validation and funding.) It is not so much much a "bubble" as an inefficient liquidity food chain - especially in the Early Stage Community.

Note how later stages in the liquidity food chain have managed to find creative financing alternatives: private market networks such Secondmarket and Sharespost; and alternative trding systems such as Xpert Financial.

Elliott Dahan
www.earlystagemarketplace.com

Posted by Imran Anwar IMRAN.TV on 2011-03-12 18:53:45

I've bootstrapped startups, done funded startup(s) within Fortune 500 firms, and been part of funded global JV startups of 3 Fortune 500 firms. Though I barely stayed awake through my Baby Finance MBA course at Columbia Business School :-) I have to say this was a great analysis and commentary. It was easy to read, understand, and see the implications. Thank you.

IMRAN
www.linkedin.com/in/imran

Posted by LJR on 2011-03-14 00:47:26

Really timely point. Another important question is how many of these are earning enough revenue to service and/or at least pacify existing angels. Angels, like any other creditor, would always be better off not causing a company to go bankrupt if there is any prospect that the company can survive and eventually pull through, bring in money (whether it be through sales, selling equity, government funding, etc.). If the angels are not impacted by the economy in general (i.e. forced to call in loans because they need the money themselves), they should be helping the company not hurting it.

Treating a start up as a pinata, whacking it to see if candy will drop out is not productive. When people panic, including founders who dont wish to go the extra mile to see a company through dark times, they sabotage the likelihood that the company will pull through. If they founded, early invested in the company in the first place that should not be an issue...

Posted by cmanning on 2011-03-16 16:32:07

I thought this was a great summary - got me thinking if there were some list of these startups where one could do a roll-up of IP similar to what people are doing in the short market in commercial real-estate.

Great opportunity for someone to create a web-based system for angels to submit their company for distressed debt in a pseudo exchange format...

If someone is interested in putting this together, let me know - sounds like a fun project!

Bottom line is that angels (like any other creditor) is in a better place salvaging their investment through another roll up than to have a full-blown wipe-out.

cfm

Posted by bobthebuilder on 2011-03-18 12:10:40

The best defense against a default is to make sure you have run out of money by the time the debt matures. The more you have in the bank the more incentive to call the debt.