We need to destigmatize down rounds in 2023

A new year is upon us, and with it comes uncertain, and uncomfortable, market conditions. Accompanying those conditions are equally uncomfortable decisions. For startup founders, determining which path is right for their business may require fundamentally rethinking the way they measure success.

The business climate in 2023 will be unfamiliar to many who founded a company in the past decade. Until now, a seemingly endless stream of relatively cheap capital has been at the disposal of any startup deemed by the VC world to have high growth potential. Everyone wanted a piece of “the next Facebook.” With interest rates near zero, the risks were relatively low and the prospective rewards were astronomical.

Burning money to chase growth became the norm; you’d just raise more money when you ran out. Debt? Who needs it! Existing investors were happy to play along, even if their share in the company was somewhat diluted — growing valuations kept everyone sated.

Over the years, this pattern of rapidly rising valuations and a pie growing fast enough to compensate for any dilution — fueled by “free money” that made almost any investment justifiable — crystallized into a mythology at the core of startup culture. It was a culture that nearly everyone, from founders and investors to the media, fed into.

Climbing valuations made for great headlines, which sent a signal, both to potential employees and the markets, that a company had momentum. High valuations quickly became one of the first things new investors looked to when it was time to raise additional capital, whether that was through a private round of funding or an IPO.

The funding route you take has enormous consequences for the future of your company; it shouldn’t be clouded by ego or driven by media appetites.

But tough economic conditions tend to dispel complacency with hard realities, and we’ll see reality checking in when it comes to funding this year. Amid rising interest rates and a generally negative macroeconomic outlook, the tap will run slowly –– or not at all. Equity financing is no longer cheap and plentiful, and as drought strikes, a sense of anxiety will grip founders. They can no longer burn cash without seriously contemplating where they’ll get more when it’s gone.

When that time comes, founders will be faced with a choice that could make or break their business. Do they turn to alternatives like convertible notes, or do they approach new investors for more equity funding? Tech stocks have been pummeled in the past year, which could mean their company’s value has taken a hit since the last time they raised capital, leaving them with the prospect of the dreaded “down round.”

It’s easy to see why down rounds seem out of the question for many startup founders. For starters, they’d face the flip side of the positive media mania, which risks eroding employee morale and investor confidence. In a culture where growing valuations are worn like a badge of honor, founders may fear that taking a down round would render them Silicon Valley pariahs.

Down rounds don’t spell the end of your business

The truth is, there’s no one-size-fits-all solution. The funding route you take has enormous consequences for the future of your company, and so it shouldn’t be clouded by ego or driven by media appetites.

We need to destigmatize down rounds in 2023 by Ram Iyer originally published on TechCrunch

Interim rate of return: A better approach to valuing early-stage startups

Convertible instruments, whether in the form of convertible notes, simple agreements for future equity (SAFEs) or otherwise, have long been used in the startup world to avoid a fundamental issue: the extreme difficulty associated with valuing early-stage companies. But what happens when the very mechanisms designed to address this problem become a part of it?

Valuation caps, for instance, are now employed in most early-stage convertible instruments. By imposing a ceiling on the price at which a convertible instrument converts to future stock ownership, valuation caps were intended to protect early-stage investors from extreme, unexpected growth (and, consequently, equity positions deemed excessively small by such investors).

However, valuation caps are increasingly being used as a proxy for the value of the company at the time of the investment — creating the very problem they were designed to help avoid, while adding unnecessary complexity for inexperienced founders and investors.

It isn’t surprising that founders and investors struggle to resist the lure to discuss present value when using valuation caps, despite efforts to push back against that use. This is especially true in contexts where the valuation cap “ceiling” expressly values the investment in a pre-conversion exit event (e.g., both the old pre-money valuation cap SAFEs and the newer post-money valuation cap SAFEs made available by Y Combinator).

Fortunately, there’s a better approach: the interim rate of return method.

The problem with early-stage valuations, or the crystal ball

However well intentioned, valuation caps directly reintroduced valuations to early-stage convertible instrument negotiations.

Before we get to the solution, it’s useful to provide additional context on the problem — namely, why it’s so difficult to thoughtfully and rationally negotiate the value of early-stage companies.

Some will say that such valuations are difficult because early-stage companies don’t have meaningful (if any) revenue, have limited assets or are just an idea. Yet, while these arguments identify real issues, they miss what may be the most important one: Investors at the earliest stages are investing in a possible ownership structure that will typically only fully exist in the future upon completion of the founders’ vesting schedules.

Let’s say you’re an early-stage investor writing a $500,000 check for a startup at a stated pre-money valuation of $4.5 million, where 100% of the existing equity is held by a single founder and subject to a 4-year vesting schedule that just started.

On its face, that would entitle you to a 10% ownership in the company (i.e., the post-money value would be $5 million, with your capital representing 10% of the value). But your stake and the pre-money valuation at which you effectively invested depends on how much of the founder’s vesting schedule is actually completed, as shown by the following table:

Interim rate of return: A better approach to valuing early-stage startups by Ram Iyer originally published on TechCrunch

Are convertible notes the right way to fund your startup?

If an early-stage startup is ready to raise money but its valuation hasn’t been established yet, a convertible note can serve as a good fundraising option.

A convertible note is a debt instrument that typically converts into equity at a later date. Investors who invest in a note are effectively loaning money to the startup, but instead of getting their investment back as dollars with interest, they get it back in the form of equity once a valuation is assigned at a later fundraising round.

This approach has a number of advantages for both the company and investors. Convertible notes allow companies to delay being valued until an equity funding round, extending the time they have to build a product and flesh it out. And for investors, while riskier than the traditional funding route, convertible notes give them an opportunity to get more equity for their money than if they wait until Series A.

How to tell if convertible notes are a good fit for your startup

One advantage to convertible notes that founders shouldn’t overlook is that they typically don’t come with any control or board seats.

Convertible notes work best for early-stage companies, especially pre-revenue startups. That could mean a company that has a solid proof of concept — a product that’s proven to work on the current scale or a medical device in the early stages of applying for FDA approval.

In both cases, the companies are building their value, and the dollars they raise with a convertible note help them scale. The end result is that when they’re ready for an equity financing round, they’re already at a higher pre-money valuation than they would be otherwise.

When funding a company with a convertible note, investors look for massive upside potential. The best-case scenario is when the company ends up having a substantially higher-than-anticipated valuation by the time it gets to Series A.

Convertible notes typically include a valuation cap so that early investors don’t lose out if the company’s value skyrockets before a Series A. When the note converts, investors get more equity at the price of the valuation cap, and they share the benefits of the company’s increased value.

What kind of investors use convertible notes?

Ali Partovi has a new accelerator promising to connect founders with star engineers

Ali Partovi prides himself on the many relationships he has built throughout Silicon Valley as a highly successful entrepreneur and investor. For example, two years ago, Partovi launched a program through his nearly five-year-old networking organization and associated venture firm, Neo, wherein he connects computer engineering students he helps to vet to fast-growing companies like the design software Figma.

Partovi does it to build goodwill. He knows students sometimes become founders and that company executives might more inclined to make room for Neo in future funding rounds if Neo has helped them win the war for talent.

Now, Partovi is putting some of those company relationships to the test. How? Through a three-month-long accelerator program taking place this summer for just 20 teams that will end not with an investor demo day but with a presentation to top engineers who might be willing to throw in their lot with a promising brand-new outfit.

It’s an accelerator that’s focused on hiring and not fundraising and could, in some cases, put Neo in the category of foe and not friend.

Partovi acknowledges it’s a “valid issue and it’s one that we need to put more thought into solving.” He also says that “each person is their own individual with their own journey” and that “if somebody is at a company where they’re unhappy, it’s not doing anyone a service to try to prevent them from seeing their options.”

Certainly, it would take a bold company to cut off access to Partovi for opening Neo’s doors wide to engineering talent. He has co-founded numerous companies, including LinkExchange, which sold to Microsoft for roughly $250 million in stock in the late ’90s. He also has a solid track record of investing in talented founders, including Mark Zuckerberg and Drew Houston.

For his part, Partovi doesn’t view his accelerator as a threat to growth-stage startups so much as to other accelerators and seemingly Y Combinator in particular —  though he speaks in general terms about the competition.

“It’s hard to find anybody from a top university or a top tech pedigree, applying to an accelerator,” asserts Partovi. Partly, he says, it’s because “other accelerators have pivoted to focus on the developing world and to pursue quantity over quality.” Neo’s goal, he continues is “not to beat any of these existing accelerators,” he adds, “but to reimagine the accelerator to make it relevant again.”

Whatever the case, it’s easy to appreciate why promising teams would be drawn to what Neo is putting together.

In addition to the hiring help that Neo is promising, it’s offering the teams that it accepts access to a four-week residential campus at an “all-inclusive  mountain retreat in Oregon,” which does not sound terrible. It is offering up to $625,000 for a maximum of 5% of their company and with a $20 million “floor” valuation (more on that here). It is also giving every founder a small share in every other startup in the batch as an incentive to help each other.

Not last, Neo is giving the teams access to some heavyweight tech veterans, including Alfred Lin of Sequoia Capital, LinkedIn cofounder Reid Hoffman; Notion’s marketing chief Camille Rockets; investor Brianne Kimmel; Lin-Hua Wu, who is the VP of global communications at Google; and actor-investor Ashton Kutcher.

Partovi notes that the “VIPs” involved in the program are diverse because the program itself counts diversity as a pillar. (He says that, since inception, 49% of Neo’s capital has funded companies led by female or underrepresented minority CEOs, which far surpasses broader industry stats.)

It’s worth noting that, as with YC, Neo is willing to be flexible around how “set” or not an idea is. Neo’s accelerator is also willing to accept founders who have no idea, as well as solo founders, says Partovi.

Where it won’t budge, he says, is on having at least one strong technical leader involved, whether it’s the founder or a three-person team with a strong CTO on board. “No matter how awesome your business idea is, and no matter how charismatic you might be, recruiting a technical partner is probably the hardest part of starting a company, so that’s a key qualification, Partovi says. “It’s also the thing that is we have the most experience and credibility at assessing.”

As for perhaps the biggest selling point of Neo’s accelerator plans — the promise that it will help startups recruit engineers — Partovi is persuasive in explaining why, in today’s fundraising market, it can, and should, mean far more to founders than accelerators whose promise instead ties to helping teams raise capital.

“Right now, if you’re leaving Figma or Stripe or even just graduating from MIT, you can fundraise by changing your Twitter bio to say you are starting something new,” notes Partovi. (We wrote recently about the willingness of VCs to write checks to people with no idea at all, based on their education and employment history.)

“Literally, you do that and within a week, you’ll probably have a term sheet.”


With Neo, he says to “imagine not a Demo Day but a pitch day that’s more like a career fair, where you get to present to hundreds of star engineers and where, instead of walk off stage to a dozen meeting requests with potential VCs, you walk off stage with a dozen meeting requests [from] potential candidates to join your team.

That,” Partovi says, “is the real pain point for startups right now. That is something that, even people who are already funded, when they hear it are like, ‘Oh, wow, I wish I’d had that.'”

For startups interested in applying, you can do that here. Note that the cut-off for applications is coming up in just less than three weeks, on March 21.

Why convertible notes are safer than SAFEs

As the saying goes, where you stand on an issue often rests on where you sit. Translated into startup law and finance, your views on how to approach fundraising are often heavily influenced by where your company and your investors are located. As a startup lawyer at Egan Nelson LLP (E/N), a leading boutique firm focused on tech markets outside of Silicon Valley — like Austin, Seattle, NYC, Denver, etc. — that’s the perspective I bring to this post. 

At a very high level, the three most common financing structures for startup seed rounds across the country are (i) equity, (ii) convertible notes and (iii) SAFEs. Others have come and gone, but never really achieved much traction. As to which one is appropriate for your company’s early funding, there’s no universal answer. It depends heavily on the context; not just of what the company’s own priorities and leverage are, but also the expectations and norms of the investors you plan to approach. Maintaining flexibility, and not getting bogged down by a rigid one-approach-fits-all mindset is important in that regard.

Here’s the TL;DR: When a client comes to me suggesting they might do a SAFE round, my first piece of advice is that a convertible note with a long maturity (three years) and low interest rate (like 2 percent or 3 percent) will give them functionally the same thing — while minimizing friction with more traditional investors.

Why? Read on for more details.

Convertible notes for smaller seed rounds

Convertible securities (convertible notes and SAFEs) are often favored, particularly for smaller rounds (less than $2 million), for their simplicity and speed to close. They defer a lot of the heavier terms and negotiation to a later date. The dominant convertible security (when equity is not being issued) across the country for seed funding is a convertible note, which is basically a debt instrument that is intended to convert into equity in the future when you close a larger round (usually a Series A). The note’s conversion economics are more favorable than what Series A investors pay, due to the greater risk the seed investors took on.