“[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.”

– A Founder

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:

If we make an offer to invest and Blue Shirt exercises their ROFR, then we just wasted our time. If we make an offer to invest and Blue Shirt doesn’t exercise their right of first refusal, then we Offered too much. Yeah… Blue Shirt knows a lot more about the company than we do—they should know what the company is really worth. So, we can only invest in this company if we pay too much. Why should we spend time looking at a company if we won’t have the chance to invest at a reasonable price?

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:

Hey, Blue Shirt buddy, would you split the deal with us at a $5M pre-money? If that’s what you’re offering, you should go ahead and take the entire round. We won’t exercise our ROFR at that price. We think the company is worth $3M. Sweet! let’s split it at $3M.

(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:

What has Blue Shirt learned since the debt round? Why did they lose interest? They know a lot more about the company than we do—they’ve spent a lot of time with the company. Something is obviously wrong with this company. The only thing worse than this is an episode of Golden Girls. Pass!

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!

Topics Convertible Debt · Future Financings

13 comments · Show

  • Mark Fletcher

    “Nobody expects angels to re-invest after the seed round.” Perhaps you really mean something like “Nobody expects angels to lead a future round.”? I would expect an angel, like any of my VC investors, to maintain their pro-rata over later rounds.

    • Brad Feld

      Mark – I agree. Whenever I invest as an angel, I typically maintain my prorata in future rounds unless explicitly asked not to in order to make room for the new lead VC to take as big a piece of the round as they can.

    • Nivi

      Mark, Brad,

      I tried to clarify the writing:

      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.

      VCs send a strong negative signal if they say they are not going to re-invest as you start raising your next round.

      Angels are followers, if the terms of the next round make sense, they will join. As you start raising your Series A, nobody is looking to the angels for any specific signal that they are going to re-invest in the next round since there are many simple reasons an angel may not re-invest. Angels are not expected to maintain their pro rata like a VC.

      Getting bad references from your angels is obviously another story…

      It’s tough to articulate this in detail at the beginning of the article since the purpose of the article is to describe these mechanics. These ‘game theory’ articles are a pain in the ass to write!

      Let me know if you think we’re off the mark.

      • Knox Massey

        Nivi writes: “Angels are followers…”

        Really? They certainly weren’t when they wrote the first check to the company….

        • Nivi

          Knox, I meant follower in the sense that angels are not going to lead the Series A. They will follow a leader in the Series A if they want to re-invest.

  • Zach Coelius

    Great post as usual. Though given all the downsides of debt, I think you might also do well to list the upsides. Particularly how advantageous it is for a young company to not get locked into a valuation- too high or too low- when things are changing fast.

    Keep up the amazing work….

  • Suzie Dingwall Williams(Venture Law Lines)

    Here’s a new problem for me, that has cropped up with my clients that have US investors: what happens if your investor is nearing the end of his current fund and isn’t having much luck with the next fund raise? Other VCs can be reluctant to partner in a Series B or C round with a VC who may not be able to participate in further follow on rounds. Especially if the existing VC has a ROFR – if he/she doesn’t invest it underscores the weakness of the current investor. The ROFR also allows him to draw out the process and hedge for time. If someone is more than halfway through their current fund, I woudl take the arguments you’ve placed in your ost and apply them with extreme prejudice.

  • J Lyons

    I expect to close a convertible debt round with a group of reasonably sophisticated angels. One of the provisions they want to include is their ability to invest up to $2MM in the series A. I expect that the series A will be a total of $4MM (excluding the notes converting). Will I have problems attracting potential series A investors with this provision — if the angels opt to invest the $2MM, they would be the largest holder of series A (when accounting for the conversion of the debt).

    • Nivi

      Feel free to ping me and Naval at nandn at venturehacks dot com regarding your fundraising. We’re both investing and we would be glad to take a look.

      This ROFR is onerous. This is what you would give to someone whom you expect to lead the next round. This is also going to screw up your valuation in the next round: the new Series A investor will pay $2M for 20% of the company instead of $4M for 20% of the company. This halves your pre-money!

      If you accept this term you’re going to have all the issues we described in this article with respect to ROFRs and in our attractive debt article with respect to insiders who want to increase their percent ownership in the next round.

      VCs usually only ask for the right to do their pro rata in the next round. So if a VC owns 20% of the post-money, he has the right to invest 20% of the capital raised in the next round. Furthermore, the good ones make it a policy to take exactly their pro rata in the next round so they don’t send signals. (Angels and smaller funds aren’t necessarily expected to do their full pro rata since they have limited funds.) What are your angels’ policy?

      If you don’t have enough competition to get rid of this term, I suggest giving the angels 20% – 100% warrant coverage. This lets them participate in the next round in line with their participation in this round but doesn’t really send any signals if they participate or don’t participate in the next round.

  • MSJ


    What about Special Conversion, where if there is no Series A raised, the note holder must convert at a pre-defined valuation. I’m concerned that establishing a valuation now (albeit “worst case”) might decrease our leverage when negotiating valuation with VCs at Series A. On the other hand, I don’t want to remove the protection that this clause give us by not having to pay back the note at Maturity. Thoughts?

    • Nivi

      As long as the company makes significant progress after raising the debt, the pre-defined valuation shouldn’t anchor the valuation of the Series A.

  • JWR

    Maybe the VC who invests in the seed round should have to pay for his information advantage in the follow-on: he can join the Series A only at a 15% valuation premium to other investors. This strips away his ability to signal and collude. It wouldn’t even have to be in the seed term sheet–it only needs to be the public policy of the entrepreneur when raising Series A.