It is 2019 and you are the founder of an ambitious startup with a buzzy tech product. You are burning through more than £300,000 a month, but you can justify it with £20m turnover that is growing at a clip and fuelling a burgeoning brand and reputation: time for Series ‘X’.
Your existing investors are solid, and they would like to re-up. However, you are struggling to align your expectations for a valuation. You know your trajectory is up and to the right, you have faith in your team, you know the market is working in your favour, and you feel certain that the business is worth top dollar.
The solution? The friend of any aspirational founder — the Convertible Loan Note!
A typical structure for a CLN means that investors receive the incentive of a 20% discount on the valuation at the next round of funding. In turn, you get to delay committing to a valuation while you focus on the hard work of building your business without the distractions of a painstaking fundraise.
What could there be to lose?
When everything looks rosy
CLNs are genuinely useful tools in the right circumstances. I would argue these conditions include: healthy performance in a sector on a positive trajectory, meaning your valuation is likely to be ticking upwards; a receptive market responding well to your product, increasing the likelihood of a further round of funding; time-sensitive opportunities that you feel you need to capitalise on without the delays of a formal fundraising process; and, importantly, solid investor interest. Many European startups have taken advantage of these favourable conditions and benefitted from CLNs in recent years.
“It is no coincidence that we see the volume of CLNs increase dramatically as the venture market becomes more bullish.”
However, it is no coincidence that we see the volume of CLNs increase dramatically as the venture market becomes more competitive and more bullish. With a growing deviation between what investors are willing to pay and the valuations targeted by founders, CLNs are seen as the solution.
Here, we reach the crux of the problem with CLNs today: there is often an assumption that CLNs mean that the valuation will inherently go up. But what happens if your valuation remains flat or you have to take a down-round? Can CLNs actually ‘backfire’, resulting in an even lower valuation than investors offered at the time the note was issued? In short, yes.
Note the downside
Founders must realise that CLNs have the potential upside of raising at a later (assumed higher) valuation, but they can also have a downside. The majority of VC-backed founders in Europe have not experienced this phenomenon thanks to a lengthy bull run. However, we are seeing flat and down rounds across the market since Covid-19 struck, with more expected, which means that the CLNs remaining in the market have the potential to convert an even lower discount.
Let us return to our hypothetical founder. Say you raised a CLN in mid-2019 for $10m, a year after your Series A which had valued the company at $100m. At the time of the CLN, you were looking for a valuation of $200m, and your investors offered $150m. You settle on a CLN with a 20% discount to the next round.
Enter Covid-19. While the company has done nothing ‘wrong’, the market is heading in the wrong direction. Whether your sales are stagnant, declining, or even marginally growing, the comparable valuations for companies in your sector have fallen through the floor. This is the case today: look at Farfetch which went from being valued at 27x revenue in mid-2019 to 7.5x in March 2020, falling to 3.9x by May.
Even if you have outperformed your peers and grown by 20% year-on-year, it is possible or even likely that your valuation is going down based on how the market is pricing companies in your sector. Further, your existing investors now have the right to convert at a 20% discount to that down-round pricing. You might have been worth $150m before Covid-19; now, you might receive a $100m valuation from new investors allowing your existing backers to convert at $80m.
“A CLN is not a guarantee to valuations heading up — they can just as easily come down.”
This is the situation facing many founders today. It can be intensely painful, but it is the reality of kicking the can down the road rather than agreeing a set price. A CLN is not a guarantee to valuations heading up — they can just as easily come down.
As an investor, I can sympathise that the current situation is outside the control of an early-stage founder, and I would encourage founders and investors to look for rational compromises.
One example might be continuing with a down-round for the new funding but agreeing not to convert the historic CLNs at this point. Once again, be warned that this can cause the situation to get even worse if your sector continues to decline. Another solution might be creating new option pools for management and/or new hires alongside the down-round.
Either way, it is essential that founders recognise that even once we emerge from the immediate impact of Covid-19, there is downside risk to CLNs that can be outside of your control. If it’s not coronavirus, it could be a multibillion-dollar VC over-funding your nearest competitor, an oil shock in a far-flung corner of the world, or a simple market downturn.
Karen McCormick is chief investment officer at VC firm Beringea.