May 8th, 2007
“[Our existing investors] had put in a right of first refusal. Since I was a young entrepreneur at the time, I didn’t understand that this basically meant that you couldn’t go to any other VC… We could not get a higher valuation because [our existing investors] wanted to put more money in the company themselves. So any time we would talk to another VC, they would talk him out of it: “This is not a good company, don’t worry about it.” So we were really stuck with [our existing investors] for the next round.”
Summary: Raising convertible debt from venture capitalists can restrict your Series A options and lower your Series A valuation—whether or not your investors have a right of first refusal on the Series A. You can keep your options open by raising debt from angels exclusively or raising debt from more than one VC.
Raising convertible debt from angels usually leaves your Series A options open. Why? Angels send a positive signal if they want to re-invest in the Series A, but they don’t send any negative signals to your prospective investors if they decide to pass. There are many simple reasons why an angel may not re-invest in the next round.
You need to be more careful if you raise convertible debt from a venture capital firm. They are more likely to ask for a right of first refusal with respect to some, or all, of the Series A. And, with or without a right of first refusal (ROFR), they can send signals that give them leverage and restrict your options in the Series A financing.
Prospective investors don’t appreciate ROFRs.
Let’s assume your existing debt investors, Blue Shirt Capital, have a right of first refusal on all of the Series A. You’re ready to raise your Series A and Blue Shirt says they want to re-invest. Other prospective Series A investors, such as Herd Mentality Management, will have a standard reaction when they learn that your existing investors have a right of first refusal:
A ROFR can restrict your options and lower your valuation.
At worst, your prospective investors will decide not to waste their time with you, leaving you to take money from your existing investors at a low valuation.
At best, your prospective investors won’t give you an offer unless they are assured that they may co-invest with your existing investors. This forces you to raise money from two investors, implying that you will have to (1) raise more cash than you expected and (2) take 30%-40% dilution from two investors instead of 20%-30% dilution from one investor. Your prospective investors can also coordinate with your existing investors to drive down your valuation:
(Blue Shirt can use this same signal to drive down your valuation even if they have a right of first refusal on just a portion of the Series A.)
It sucks if your existing VCs don’t want to re-invest.
What if Blue Shirt says they don’t want to re-invest in the Series A at all—whether or not they have a right of first refusal? Herd Mentality will gag on their feed when they learn that your existing investors don’t want to re-invest:
At best, once there is no interest left in your Series A financing, Blue Shirt may tell you that they actually do want to invest in the Series A—at the right price. There’s no competition left, so you’re stuck with whatever Blue Shirt offers. However, this is an unlikely outcome since it’s not good for Blue Shirt’s reputation among investors.
More likely, Blue Shirt really doesn’t want to invest in the Series A and this negative signal makes it difficult or impossible for you to raise any more money.
You have the same problems with or without a ROFR.
If you raise convertible debt from a venture firm, you will have the same problems whether or not they have a right of first refusal:
Herd Mentality will still wonder whether they are wasting time since you already have investors on the “inside track”. They will still make an offer only if they are assured that they may co-invest with Blue Shirt. They will still coordinate with Blue Shirt to drive down your valuation. They will still gag if Blue Shirt doesn’t want to re-invest.
Your existing investors can send the same signals with or without a right of first refusal—the signals are simply stronger if they have the right of first refusal. This is a small taste of the game you will have to play when you raise a Series B and your prospective Series B investors interact with your existing Series A investors. Some solutions to this game are coming in a future hack.
For now, you can set up the seed round to avoid playing this game in the Series A.
Try to remove the ROFR.
First, try to remove the right of first refusal by applying the reciprocity norm:
“If you have a right to buy equity in our next round, shouldn’t we have a reciprocal right to sell you equity in the next round? In other words, why should you have a call option to buy the company’s equity if we don’t have a put option to sell you the company’s equity?
Why are we negotiating the next round of financing now? If we’re going to negotiate the next round now, we should negotiate all of the next round, not just your right to invest in it. I don’t want to do the next deal now, I want to do this deal now.”
If you lose this argument, try to contain the right of first refusal to a portion of the Series A. For example, if you raise money from three investors in the Series A, your debt investors would have the right to take up to one third of the Series A.
Overall, accepting a right of first refusal is a minor concession in your debt agreement. Don’t blow up the deal over this term since you will have the same problems whether or not you win this item.
Get multiple investors if you raise debt from VCs.
If you decide to raise debt from venture capitalists, you should try to close two, three, or more venture firms.
As the number of insider investors increases, the influence of any one insider decreases. There is no single source with a single agenda that can send whatever signals it likes. Multiple investors will send multiple conflicting signals that outsiders will not be able to distinguish from noise.
And as the number of insider investors increases, the probability that one of them will send a positive signal increases. For example, at least one of your existing investors may state that they want to invest in your Series A.
You can also make the case to your prospective investors that you raised debt from multiple firms specifically to reduce their individual influence on the Series A:
“Raising debt from multiple VCs is our signal that these insiders are really no different than you. They know nothing more about the business than you do by now. The debt round was simply their opportunity to demonstrate their value to us.”
Finally, you can pit multiple firms against each other to get the best terms for the convertible debt:
Determine what terms Blue Shirt will offer to purchase the entire note. Then tell Herd Mentality that Blue Shirt wants to take the entire note at those terms. Would Herd Mentality consider a more favorable offer? Repeat. Finally, split the debt among all the investors.
What are your experiences with keeping your Series A options open?
Use the comments to share your experiences with keeping your Series A options open. We’ll discuss the most interesting comments in a future article!