[james_alonso]

but in the worst case with the convertible note, the investor gets their money back.

and often but not always, the note will also provide that if the note matures hasn't been a QFE, then the note can convert into common stock.

[logicallee]

EDIT: Below, I mean from the point of view of subjective valuation by investors of the different possible outcomes.

Nobody wants to have debt repaid when a company takes off that you could have had early stock in. (And normally I think that convertible debt doesn't allow such provisions.)

Losing the amount invested (investment going to zero) is really, subjectively, not the "worst case" - because it's money the investors could stand to lose.

Instead, subjectively, the worst case (and related to a common investor fear, FOMO, fear of missing out), is making the original and only seed investment that launches the next Snapchat (or whatever), and then getting failing to own any of it due to something like the company not raising another formal round or otherwise repaying the debt instead. That's subjectively a much worse case, then having an investment go to zero, which is rather expected.

Losing 100% of the investment is the "default" case, not at all worst or unexpected, getting converted into equity at a very small and unsure company is the "good" case, getting converted into the next snapchat or whatever is the amazing lottery-winning case, and losing out on the next snapchat or whatever despite ponying up the cash is the worst possible case that you would kick yourself for forever, subjectively speaking. IMHO.

If people here make lots of seed-stage convertible investments they can say whether this matches their valuations, this is just my opinion.

[001sky]

getting x>0 is now worse than getting x=0? No.

When they repay the debt, you're not "stuck with none of it" you're stuck with indeed a x>0 portion of the company's value. Strictly speaking, you are just stuck. What escapes you is the upside of an investment that you <did not make>.

The right (but not the obligation) to make that investment on pre-defined terms is the defintion of an "option".

[EGreg]

That depends, if you have a portfolio of many companies and you expect that most of them will fail but one will bring huge returns -- and then the one that should bring huge returns turns out to merely repay you 10%, then yes, it's worse.

[logicallee]

Clearly I meant from the point of view of a seed-stage investor's subjective valuation of alternatives. Nobody wants to have debt repaid when a company takes off that you could have had early stock in.

[001sky]

The one (only?) thing worse than debt in this case is an option that has CP's for exercise that aren't met. Then, you are truly fucked. I'm not trying to be pedantic, but its the nature of the topic at hand that to make any sense, some precision is required.

[logicallee]

That's fair. But precision isn't really required, because it is a huge mistake to think that investors use precision.

It's possible to think that they do, and that they make a choice based on adding up the dollar-value of alternatives, multiplying each by its probability, and summing the results.

If that were the case then two things would be true (among many others):

  ----------------------------

I

First:

Debt that can be repaid would greatly increase the chances of a landed investment (investment being made in response to pitches), since there are many, many cases in which a small group of people formed into a company can repay an early debt, even if the company ultimately folds. All these cases would detract from the down-side. This would, in theory, tip the investment in the favor of being made. For example, if a company has a story that you might make 15x your money in 2 years, but you believe there is a 1 in 15 chance of this happening, then it should objectively make a big difference whether (or how many) out of the other 14 chances repay your money. If all 15 repay your debt, and 1 in 15 makes 15x, then that's a good investment, slightly beating the alternative places you could park your money. On the other hand if most of the cases end up losing 100% of your investment, that "should" make the investment quite a bit worse. For example if 14 in 15 lose the investmnet and the fifteenth makes 10x in 3 years, then that is not great.

But htis is not how investors actually make their decisions.

No investor will give a seed that has a 8 in 10 chance of being repaid (as debt). Period. They just don't.

Firstly, they are looking for that big, big win. And secondly, they want to skew the probability distribution toward that win.

An investor far prefers: (package 1)

  0.0125 probability of massive, huge, breakaway hit: 500x
  0.05 probability of HUGE growth: 50x
  0.9375 probability of total loss (goes to 0 in 3-7 yrs)
  ------
  0.0125 * 500 + 0.05 * 50 = 8.75x average.

Meaning: if you invest in 67 companies you will get one 500x growth story to woo your next set of LP's with. (1/0.0125 = 67), 1 in 20 of your companies will at least show a 50x growth story, roughly paying for the rest which silently go away within 10 years. If you have a $500M fund you can make 1250 seed-stage investments of $500K. Hopefully you can invest enough Googles with them.

to: (package 2)

  0.05 probabibility of total write-off
  0.15 probability of small win (e.g. 10% p.a., i.e. debt repaid)
  0.459 probability of "failed" i.e. moderate growth (5x)
  0.34 probability of successful growth (20x)
  0.001 probability of 500x
  -----------
  0.15 * 1.1 + 0.459  * 5 + 0.34* 20 + 0.001 * 500 = 9.76.

Even though the first sums to an expected value of less than the second one.

Investors aren't trying to go for the second package - i.e. making a shot at a very sure 20x and maybe missing it and making 5x. That's not what they make seeds into, $2.5M companies they can believe in at $125K (20x).

It's just not what they're about.

That is not the story that is interesting to these investors. They would far prefer the first package (as far as I understand) that comes with a bigger shot at the moon, even though this greatly diminishes the overall return. Tons of companies are very close to being worth $2.5M, and not really more, and don't need much money. They're just not that interesting.

----------------------

II

Second:

A second way you can know that this isn't a case is that nobody would even look at an investment like (package 3, hypothetical)

Hypothetical:

  0.0001 probability of 75000x
  0.9999 unknown result
  ---------

This sums to at least 0.0001 * 75000 = 7.5x. But what does it mean?

Well, it means investing in something that will grow to 75,000 times its size with a 1/10,000 chance of doing so.

It means somehow onboarding 10,000 people - investing $200K into 10000 companies - that are all saying they will turn it into into let's say a $60B company.

Do you see anyone investing $200K at a $800K valuation into 10,000 nascent companies that are saying they will be $60B companies? And showing very, very little chance of doing so - 1/10,000?

Of course not. The amount of money required to invest in, say, 10,000 such companies is $2B. Taking $50K of it would cost $500M. Some VC's have this.

But do you see any VC's with massive, massive onboarding programs where they are pouring $50K into 10,000 companies, that each give you only 1/10 000th confidence that htye're actually the next Apple or Google?

No. It's just not being done. You can play with the numbers but they show that nobody is summing in this way.

They want a different distribution that they can believe in. They're fearing on missing out on something big. Not trying to play the numbers to make something absolutely extraorbital.

[001sky]

But precision isn't really required, because it is a huge mistake to think that investors use precision.

You dismiss the notion of precision in the <Legal> sense. Which is what we are talking about here. EG

But precision isn't really required, because it is a huge mistake to think that investors use <lawyers>.

The problem with the earlier discussion is that it confuses concepts (zero, non-zero returns) and actions (investments made, not made) etc.

The precision needed simply relates to the classes of actions taken (or not) as well as the classes of contracts negotiated (or not), in other words.