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April 11, 2006

Bridge Loans vs. Preferred Equity: A VC's perspective

Some Seed Funds and entrepreneurs like to use convertible notes, which pegs the valuation of the seed investment to that of the first round (which is typically expected to happen a few months down the line). In response to an earlier post by Brad Feld on "What's The Best Structure For A Pre-VC Investment?", Josh Kopelman, Managing Director of First Round Capital, explains why he has a strong preference for Preferred Equity versus Convertible Notes.
A typical convertible note allows an investor to convert from debt into equity at some discount to the Series A price (typically 20-40%). I believe that this often has an unanticipated outcome -- it puts the seed-stage investor and entrepreneur on different sides of the table. The entrepreneur wants the Series A price to be as high as possible, while the note holder wants the Series A price to be as low as possible (since the conversion price of their note will be based on the Series A price). This misalignment of interest creates a number of problems for me. Once I invest in a company, I would like to focus on adding as much value as possible - I want to help the company refine their strategy and business model. I want to help them build their team. I want to introduce them to business development partners. I want to help them generate PR. I want to introduce them to several VCs so they can raise their next round on good terms. However, as a note holder, there is an economic penalty for adding value -- the more I try to help the company, the more expensive my equity ultimately becomes. In effect, I have to pay for any value I help create. If I was an equity holder, those conflicts would not exist. I would benefit directly from any value I help create.

Arun Natarajan is the Founder of Venture Intelligence India, which tracks venture capital activity in India and Indian-founded companies worldwide. View sample issues of Venture Intelligence India newsletters and reports.