Why is a “large overhang of convertible debt resulting from numerous convertible note rounds” bad for startups before a series A round?

Debt can be good for SaaS. The key is — just not too much of it.

For convertible debt, a little can help you make that extra hire, extend the runway, go more upmarket.

But when it comes time to raise a Series A, assume that anything much more than 20% of a debt:equity ratio for the next round will spook Series A investors.

In other words, assume for each $1 in SAFEs and convertible debt you raise, you’ll probably need to raise 4x than in the next round.

So if you raise say $1m-$2m in debt+SAFEs, you are probably OK. Once start-ups these days raise $4m-$6m in SAFEs though, you’re gunning already for a $15m-$20m+ Series A.

Put differently: it’s really, really hard to raise $5m in SAFEs and then raise a “normal” round of $5m in equity (a 1:1 ratio). Like, close to impossible. Investors will just see this as too much of a sign of an over-funded, under-performing start-up. Most will pass. That’s just too much money into a company that hasn’t gone far enough, on a traditional enough path.

At a minimum, if you are going to raise a relatively large amount of early capital — more than say $2m — consider doing it instead in equity. Raising a “second seed” of say $2m-$5m after a small SAFE round isn’t easy. But it is a lot easier than raising $5m after $5m of SAFEs. A lot, lot easier.

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Published on June 17, 2019

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