Understanding the Mechanics of Venture Capital
Updated: Jun 17, 2020
The views portrayed in this blog are subject to change at any time based upon market or other conditions and are current as of May 13th, 2020. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed.
When we meet very early-stage founders— the most common refrain we hear is that they thought it was too early to speak with us. Many entrepreneurs let perfection get in the way. They believe they need a finished product, customers, and early revenue before talking with us.
I sat in a garage and invented the future.” – Steve Jobs
At AFZA Capital, we would like to put these myths to rest, share our approach to seed investing, and explain why it’s never too early to talk with us.
First and foremost, we are a social impact fund. We want to partner early, and we want to help! Some of our fund's methodologies are based on the principle of if you set it up right, it will land right.
During our early days at AFZA, everyone wanted to pitch convertible note opportunities. It took approximately three meetings to identify that we needed to help entrepreneurs understand cap table management. Convertible being the main word in our conversations.
A convertible note is a form of short-term debt that converts into equity, typically in conjunction with a future financing round; in effect, the investor would be loaning money to a startup and instead of a return in the form of principal plus interest, the investor would receive equity in the company.
While in days of yore it was basically the case that convertible notes had no discernible link to any particular valuation, those days have passed. As businesses are able to go a lot farther with less cash, convertible notes are cropping up earlier and earlier, and more traditional funding is coming in at times when the business has grown considerably (often after you have a product or even revenue), resulting in higher valuations than historically for a company’s first equity financing.
People are smart and always find ways forward. In response to this general trend, early investors started introducing a conversion mechanic (the so-called “cap”) designed to provide a ceiling on the price the noteholders would be deemed to pay for the stock they get on conversion. For example, if your business raises a venture round at a $10 million pre-financing valuation but your notes have a $3 million cap, your noteholders just got a 70% discount (yep, you read that right).
And as much as we want to make money, we want to educate our entrepreneurs, as they are our partners.