Convertible Notes: A Conceptual Perspective

There was a great discussion started by Mark Suster and Brad Feld around convertible notes and the many issues associated with a round in which they convert. This includes a hidden potential for a “multiple liquidation preference” if not adjusted for in the Series A and how the mechanics of the conversion could lead to differences in ownership than a new investor is expecting. Mark and Brad did a fantastic job walking through how the problem arises and the math that drives it.

I’d like to take a crack as to why, in theory, the treatment of the Notes in the pre-money valuation makes sense as the starting point. Of course everything can be a function of negotiation, as Brad points out, but it’s nice when positions have some grounding in principles, and I find many times entrepreneurs and investors can get frustrated by the advice “because that’s the way it is done”.

Let’s start with a discussion of valuation theory. In a perfect world, the value of a company is the sum of the FUTURE discounted cash flows that the business will generate over it’s life, discounted back to today. That discounted cash flow includes all expenses associated with operating the business in the future. The one assumption most Finance classes make is that the shareholding is FIXED for that analysis; however, in venture backed businesses, significant equity cost (dilution) is also required to build to those cash flows. If your share of an ownership is expected to decline over time, obviously you’d need to build in that dilution to your present value calculations. This is a subtle point but I’ll come back to it later. [Never mind whether we actually build models like these in VC or use shorthand methods, as this is a discussion of the principles.]

Convertible notes are used by a Company during its Seed to build to the current Series A valuation. The cash resources associated with them have been exhausted and any remainder is assumed in the current valuation. As such, they should be treated as part of the pre-money valuation — as part of the historical cost and cash flows that were sunk to get to a given set of assets and therefore valuation. Said differently, the expenses that the convertible notes would be funding have already occurred in the past and therefore no longer part of the future cash flows used to get to the current period valuation.  New investors are investing on top of, and building off of, that valuation.

If that’s too esoteric, here’s another way to think about it. If you were to have raised equity financing for your Seed, you would not add that invested dollar into the amount raised of the current round. Convertible notes are useful, so they say, because they are expedient and more efficient than an equity round, and are generally intended by investors to act in a similar manner (particularly where there are valuation caps). In any of these rounds, I have not heard seed investors negotiating for a more efficient way to get a multiple liquidation preference or asking future unknown investors to pay for their dilution. The treatment of convertible notes in the pre-money valuation would make it consistent with a round done as equity, which in the vast majority of times is the “spirit” of the creation.

The other way to look at convertible notes relates to my point above about how dilution must be accounted for in any valuation framework. The pre-money valuation has always, from the beginning of venture time, assumed the fully diluted share count. This is so the valuation captures any and all historical equity “cost” associated with building the company to this point when getting to a per share value (common stock, warrants, options, and … convertible notes). A convertible note clearly is an example of issuable shares that should form a part of the fully diluted share count, and therefore part of the pre-money valuation. New prospective shareholders set an “all-in” valuation so that they can clearly know the ownership they are buying in a company for a given dollar amount; everything from the past is not their burden to bear and should be resolved prior to their money coming in. This is exactly why many investors are clarifying the post money valuation and their ownership.

As an aside, I’ve sometimes been asked why is the Option Pool for future employees included in a pre-money valuation. Well, for the same reasons above, just as any valuation is assumed to be the present value of FUTURE cash flows (theoretically), it should also include FUTURE dilution. The future cash flows are generated by a certain set of employees, who require equity compensation as well as cash. The cash expense of those employees has already been incorporated by the future cash flows of the business (as expenses); similarly, the equity “cost” by way of dilution has to be be built in somewhere. This is where the Option Pool in the pre-money comes in. The market has settled out that 18 to 24 months is the reasonable range for the “options cost”, as that usually ties to the next milestone or round.

Hopefully the above offers some conceptual underpinnings to commonly discussed items. Practically speaking like anything else, everything is a matter of negotiation. The challenge is that the unintended consequences of convertible notes sometimes pit the un-informed against the ambiguous, leading to confusion. Sometimes it is helpful to understand the WHY to find a way out.

New Investment: Engagio

One of the most important things that we have built at FirstMark Capital is our platform and community.  It is an infrastructure that connects and empowers hundreds of employees across our portfolio companies and tens of thousands of people in the NYC ecosystem to world class content, relationships, customers and expertise.

Every journey has its start, and ours began shortly after we launched FirstMark Capital in 2008 and held our inaugural Marketing Summit.  The idea was simple: marketing was evolving rapidly, the channels through which customers and consumers engaged were changing, and those that moved to take advantage could build unfair scale ahead of others.  If we could get the best minds talking about leading technologies and their approaches, the entire portfolio could benefit.

One of the earliest speakers at our Marketing Summit was Jon Miller, the co-founder of Marketo, who evangelized a new way of thinking about customers, content, and marketing automation.  Jon and I stayed in touch over the years, becoming an advisor and friend to several of our portfolio companies.  Marketo, of course, went on to become a powerhouse in marketing automation and is a $1B+ public company today.

Fast forward 6 years and I’m delighted to announce that we are leading a $10MM Series A financing for Engagio, a new company created by Jon Miller and his co-founder Brian Babcock.  I have gotten to know Brian more recently, but he has a fantastic and very relevant background for what Engagio is doing from both the ad tech and big data worlds, having been an early engineer at successful companies like RocketFuel and Platfora.  Jon and Brian in fact worked together at Epiphany in the 90s, which was one of the early pioneers in the world of marketing software.

Engagio is at the start of its mission but is building a new software platform focused on Account Based Marketing.  Jon has written an entire post dedicated to the topic here.  Said simply, Engagio provides one place for B2B marketers to understand all the campaigns, touch points, and interactions a company has with a target customer and plan the optimal ways to engage them over time.

We are excited to be joined by many of Marketo’s prior investors, including Storm Ventures and Bruce Cleveland/Doug Pepper, alongside First Round Capital and Amplify.  Stay tuned for much, much more!

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Alibaba vs Google & Amazon

Having felt like I was reading about a new investment every month from Alibaba, it got me thinking about how rapidly they are expanding their reach outside of China. While many have written about this recent frenzy, I had not seen anything comparing Alibaba’s investing activities in the US to that of Google and/or Amazon in China.  As the digital platforms move towards true global competition, I got curious about the data.

Thanks to the folks at CB Insights, I looked at the data of investments made in the US by Alibaba and in China by Google and Amazon as far back as the data went.


By number of deals, Alibaba has a substantial lead, but by investment value (shown below), the difference becomes staggering.

The data is fairly stark.  If you look at the individual deals, Alibaba is investing in all the areas you would expect — mobile, gaming, ecommerce — and even some you would not, expanding their sphere of knowledge and influence as they chart their inevitable global push.  For Google and Amazon, is the difference deliberate and due to different strategic choices or is it because China remains a more difficult and protected environment to enter and invest?  If it’s the latter, does that put the leading US platforms at a structural disadvantage competing in the global stage? We are entering a new era of the digital Game of Thrones and this will be interesting to watch play out.

Some notes on the data:

1) Investment dollars reflects total round size, as a reasonable proxy for invested dollars, as well as acquisitions. Some deals did not have any announced round size and are included at $0.

2) This is solely focused on investments and does not include capital associated with local operations in country.

Thanks to my colleague David Rogg for assistance pulling this post together.

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A Mighty Swing

News has now spread on Aereo’s filing for bankruptcy. While folks in venture generally don’t talk about their failures, this is one I’m exceptionally proud to talk about.

We are in the business of backing innovation and taking big swings. Companies that can be change agents for their industries. Aereo is the very definition of that. Long before Aereo stood in front of the Supreme Court of the United States, the Company ignited conversations about the future of television and its delivery at a time when these services remained fixed, bundled and costly.

Since Aereo’s launch and first victory, we’ve seen cable companies introduce “TV Everywhere” strategies, networks announce over the top mobile apps and unbundled streaming options, and even the FCC take dramatic steps to define OTT players alongside cable and satellite companies. Can Aereo take credit for all of it? Probably not. But I think it’s fair to say they accelerated many of those discussions and helped re-shape an industry perspective.

While that impact may not be found financially, it is felt in the hands of consumers everywhere. For that, we at FirstMark are exceptionally proud to have partnered on this journey with Chet Kanojia and his incredible team. And as I’ve said before, we’d do it again in a heart beat.

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New Investment: ROLI

I am excited to announce our investment in ROLI, the inventor of the Seaboard.

The Seaboard is a beautiful redesign of one of the world’s most iconic instruments – the piano – for the modern digital world we live in.  It is the first in a line of digitally programmable, highly interactive, connected music products for ROLI that combine novel design aesthetics, proprietary touch interfaces, and powerful social elements.


The degree of difficulty on executing a product like this is extraordinarily high.  It requires expertise in material design, fabrication, manufacturing, hardware, and software.  It has to satisfy the demands of the world’s leading artists, while incorporating social elements that appeal to the masses.  Getting to a shipping product was no small feat, and we believe ROLI is at the forefront of a transformation in the music creation, collaboration and consumption process.

We are delighted to partner with Roland Lamb, the founder/CEO of  ROLI, and welcome him to the FirstMark family!

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New Investment: Gravie

Well, we foreshadowed we’d be doing more around the intersection of healthcare and technology.  On the heels of our BioDigital and Recombine announcements, I’m excited to publicly announce our newest investment in Gravie.

Gravie sits at the intersection of some profound changes in healthcare.  Consumers are becoming empowered (or forced) to take control of their healthcare decisions more than ever before.  Employers are struggling with the increasing cost curves in healthcare, and in many cases, as disinterested parties, are phasing out coverage.  Insurers and insurance remain incredibly complex to navigate and difficult for the lay person to understand, often times only figuring things out in their moment of greatest need.  And finally a regulatory backdrop that is forcing major change on the system in the form of the ACA (“Obamacare”). 

Gravie emerged to bring simplicity and transparency to this new world order.  An intelligent, easy to use platform to navigate all the complex decisions in terms people can understand and a single place to consolidate all the information around health in one’s lives.  Gravie also offers advocacy to consumers, acting as a voice for individuals and offering help when questions or problems arise.  In short, Gravie is one place to go for peace of mind around your family’s health. 

The company was founded by three fantastic entrepreneurs who have a long history together and in the space.  Abir Sen, Jill Prevost and Marek Ciolko all worked together at Bloom Health, a company they started to bring Private Exchanges to employers, and successfully acquired by Wellpoint.  Abir has also been part of the founding team at Definity (acquired by United) and Red Brick Health (pioneer of corporate health & wellness plans).

We seeded the company in the summer of 2013, and have witnessed swift execution on both product, launch and adoption.  We are delighted to announce the close of a $10.5MM Series A, in which we participated heavily.  We are quite excited to continue our partnership with the team at Gravie and welcome in Mo Kaushal and the Aberdare team!

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New Investment: BioDigital

I am excited to announce one of our latest investments, BioDigital.  BioDigital is one of several investments we have made at the intersection of healthcare and technology.  I laid out our rationale at a high level here.

BioDigital is based in NYC and has built a powerful platform around 3D visualization and immersion of the human body.  Our short hand for BioDigital is “Google Earth for the human body”.  Their team sits at the intersection of 3D / CAD software, web technologies (HTML5/WebGL), human anatomy and physiology, bio mechanics and high scale back end infrastructure.  A rich, deep, powerful service made simply available via APIs.  If you want a wicked engineering challenge, apply here.

The team has been working on complex 3D human modeling for the last several years, but with the introduction of WebGL and HTML5, saw a profound opportunity to instantiate all of their models into a Web based platform called the Human.  In the brief period of time since launch, the company has surpassed over 1 million registrants.  Even more exciting to us was the breath of use cases for the product.   Frank Sculli, founder and CEO, details some of them here.

There will be a number of ways to access the Human.  Their web, mobile and tablet apps will appeal to the millions of consumers interested in learning what’s inside our body and how it works.  Consumer health sites will be able to easily use our widgets to offer much richer representations of health conditions that afflict us.  Search engines can embed physiology and conditions directly into rich snippets.  Content publishers can enrich the learning experiences for students across the globe.  Doctor offices and hospitals can use the Human as their front end UI, with patient records mapped to the Human’s ontology.  And more exciting are the ways we cannot think of via our APIs.

In addition, we also can’t predict the ways in which individual consumers will add to the platform  People will be able to append all sorts of information into the Human to improve it in a Wikipedia like model – MRIs, content, interactions, etc.  People will also be able to personalize the human to the things they care about and share them out to the people they love or groups they interact with.  It will be exciting to see how people engage with an experience that was never possible before.

We believe this will be a transformative project and we are at the very beginning.  We are delighted to partner with Frank Sculli, John Qualter, Aaron Oliker and the entire BioDigital team!  Frank’s announcement on the BioDigital blog is here.

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