2016 turned out to be a terrible year for IPOs, both in terms of number of deals and aggregate proceeds.

According to Renaissance Capital’s U.S. IPO Market 2016 Annual Review, only 105 companies went public on U.S. exchanges in 2016, raising only $19 billion in aggregate proceeds. The deal count of 105 IPOs was downrenaissance 38% from 2015 and the lowest level since 2009.  The $19 billion in aggregate proceeds was down 37% from 2015 and the lowest level since 2003.  In fact, if you remove the financial recession years of 2008 and 2009, the 105 IPOs in 2016 were also the lowest since 2003.  And the drop in deal activity was indiscriminate; both VC- and PE-backed IPOs were at their lowest levels by deal count and proceeds raised since 2009.

The temptation would be to blame the weak IPO market on political election 2016uncertainty, with Brexit and the U.S. election being the biggest culprits. But then how to explain the broader U.S. capital markets, which were hot in 2016. The Dow Jones Industrial Average hovered around 20,000 at year end, and the S&P 500 Index was up 9.5% for the year.  One would expect that the market for IPOs would be pretty strong, as bullish markets normally encourage companies to go public.  To be fair, much of the market gains took place in the latter half of the fourth quarter.  But market weakness doesn’t explain the two-year drought in IPOs for technology companies, considered the mainstay of the IPO market.

Another common theory is that over-regulation, particularly Sarbanes Oxley, has made it much more expensive to go and remain public, thus discouraging many growth companies from doing so. The 2012 JOBS Act tried to remedy this by creating an IPO on-ramp for emerging growth companies, allowing for confidential registration statement filings with the SEC, “testing-the-waters” and scaled disclosure.  The immediate results were encouraging: a dramatic increase in IPO deals and aggregate proceeds in 2014.  Yet IPOs plummeted in 2015 and even further in 2016.

Renaissance Capital’s report points the finger squarely at the public-private valuation disconnect. The tech startup space in 2015 was a mystifying series of mega rounds, sky-high valuations, unicorns and unicornbubble fears. But another trend has been IPOs being priced below the company’s most recent private funding round.  In its pre-IPO round, Square Inc. was valued at approximately $6 billion, but IPO’d at just over half that valuation and then plunged further post-IPO.  Etsy Inc. and Box Inc. both reported $5 billion plus private valuations, only to plunge in the days leading up to their IPOs.  Many, including Benchmark Capital’s Bill Gurley, have blamed the late-stage bidding frenzy on institutional public investors such as mutual funds rushing into late-stage private investing.  Another major contributing factor in the escalation of late stage valuations is the trend toward generous downside protections being given to investors in exchange for lofty valuations, such as IPO ratchets and M&A senior participating liquidation preferences.  The former is simply antidilution protection that entitles the investor to receive extra shares on conversion in the IPO if the IPO price is below either the price paid by the late-stage investor or some premium above that price.  The latter means that, in an acquisition, the investor gets first dollars out ahead of earlier series of preferred and then participates with the common pro rata on an as converted basis.

Renaissance maintains that VC-backed tech companies with lofty late round private valuations chose in 2016 to avoid inevitably lower public-market valuations and had the luxury of remaining private due to ample available cash in the private markets. Mergers and acquisitions offered alternate pathways for other tech companies, such as TransFirst, BlueCoat and Optiv, all of which had previously filed S-1s for IPOs.

Although the private-public valuation disconnect was a major impediment to IPOs in 2015 and 2016, Renaissance believes this phenomenon is close to correcting itself and is optimistic about 2017. Many growth companies have seen their valuations flat or down in new funding rounds to levels that will be more palatable to public investors.  Also, the election results will likely bring a dramatic change in fiscal, regulatory, energy and healthcare policies, all of which should be stimulative to equity markets, new company formation and, ultimately, IPOs.

Another reason for tech IPO optimism for 2017 is Snap, Inc.’s highly anticipated IPO in the first half of 2017. It filed confidentially under the snapJOBS Act, and has begun testing the waters with investors.  The Snap IPO is rumored to raise $4 billion at a valuation of over $25 billion. Another one is Spotify, which raised $1 billion in convertible debt in March 2016 which signals a likely imminent IPO. These two IPOs might raise more capital than all VC-backed tech IPOs in the last two years combined.

In Part I of this two part series on model structures for seed rounds, I explained how the dramatic decline in the cost of launching an internet-based startup over the last 15 years primarily due to the disruptive effects of open source software and cloud computing has led to a surge in seed stage investing by angels and early stage VCs.  In Part I, I addressed seed rounds structured as equity, the two most common forms of which involve the issuance of modified versions of preferred stock designated as Series AA or Series Seed.

As I explained in Part I of this Series, the more complex, time consuming and expensive to negotiate deal documentation associated with Series A and later rounds can be justified when a company is raising several millions of dollars, but makes little sense for a seed round of a few hundred thousand dollars. The resulting pressure for deal document simplification has resulted over the last several years in innovative seed investment deal documents.  This Part II of the Series will address seed round structures fashioned as convertible notes or alternative instruments that functionally resemble convertible notes.

Convertible Notes

Convertible Notes advance the objective of deal document simplification and cost effectiveness even more than Series Seed and Series AA structures because they allow parties to defer negotiation of the thorniest issues to a next significant equity round.

Technically, convertible notes provide for payment of principal and interest on a maturity date of typically one to two years, but in reality these notes are not expected to be repaid.  Instead, the principal and interest is intended to get converted into the security issued in a next equity round meeting some minimum dollar amount, albeit typically at a discount to the next round’s pricing in an effort to reward the seed investors for the additional risk they’re assuming by investing at a more vulnerable juncture for the company.   In recent years, it has also become common for the valuation at which the seed investment is converted to be capped, in which case  the conversion price would be the lower of the discounted rate or the price based on the capped valuation.  Less sophisticated angels will focus on the interest rate and try to negotiate that higher; those more experienced in startup investing will understand that the conversion terms will have a far more significant impact on the value of their investment and thus focus on discount and cap.

Another way the practical reality departs from the technical is that if a qualified funding has not occurred and the note is not converted prior to maturity, the note is rarely paid at that point. Instead, a difficult conversation takes place between the company and the seed investor in which the company seeks to extend the maturity date.  The price for any such extension is usually in the form of more generous conversion terms for the investor.

Simple Agreement for Future Equity or “SAFE”

In 2013, the legendary accelerator Y Combinator introduced an alternative to theY Combinator convertible note which it called a Simple Agreement for Future Equity or “SAFE”. Although it looks like a convertible note in that it converts the investment amount into the next round’s security and typically features discounts and caps, it is not a promissory note for the simple reason that, unlike a note, there is no basic promise to repay the invested amount.  Essentially, a SAFE is a contract that provides for the type and amount of shares that will be issued in a qualified next round, if there is such a round, along with an option to receive either common stock or a return of the invested amount if the company is acquired prior to a qualified round.

The absence of a payment on maturity date feature is a major advantage to companies and a serious drawback for seed investors relative to convertible notes in that it removes an important source of leverage that the investor would otherwise have as a convertible noteholder if the company has been unable to raise a qualified next round before maturity. If that were to happen in the context of a convertible note, the note holder could demand payment and force the company into dissolution or bankruptcy.  That leverage would allow the investor to negotiate for an increase in the conversion discount or decrease in the cap.

The lack of a maturity date means that the SAFE is really only appropriate for a technology based startup that could scale quickly and achieve rapid growth. Conversely, a non-technology based startup could theoretically prosper and enrich its shareholders without the SAFE holder receiving anything for a long time, if ever.  In other words, a company may be able to grow organically without the need to do another significant raise, and may even be able to dividend out cash to its stockholders (not shared by the SAFE holders because they’re not yet stockholders), and the SAFE holders would not receive anything until the company gets acquired, if ever.

Keep it Simple Security or KISS

The Keep it Simple Security or KISS was created by another accelerator, 500 500 startupsStartups, in 2014, in reaction to resistance to SAFEs because of their lack of investor protections. KISSes more closely resemble traditional convertible notes, i.e., promise to pay on a maturity date, etc., and contain certain other important investor protections such as an option at maturity to convert into a newly created Series Seed (see my discussion of Series Seed in Part I of this two-part series), information rights and the right to participate in future funding rounds.  But inasmuch as the impetus for convertible note alternatives was a desire for simplification, cost effectiveness and time saving, it’s unclear whether the KISS, which actually contains a few more deal points to negotiate than convertible notes, will gain significant traction among seed stage companies and investors.

Seed stage investment deals, i.e., those in a range of approximately $100,000 on the low end and around $1.3 million on the high end, are structured either as straight equity or as convertible loans. If straight equity, the company typically issues to the investor shares of preferred stock usually designated as Series Seed which includes a package of enhanced rights but usually stripped down from seed investingthose typically associated with Series A shares.  Alternatively, the investor could invest in the form of a loan that converts into the security issued in the next equity round, usually at some discount to the next round’s price.

This post will focus on convertible note deal term trends based on the 2016 Venture Capital Report recently released by the helpful folks at Wilmer Hale. The convertible note data in the Report was compiled from over 100 deals handled by the firm from 2013 through 2015 for companies and investors in the U.S.

Conversion Discount

Seed investors often negotiate for a discount from the price per share in the next equity round to reward the seed investor for investing at an earlier, riskier stage. discount89% of convertible loan deals covered by the Report in 2015 had discounts, a significant increase from the 66% that had them in 2013.  Sometimes parties negotiate for an ascending discount in which the discount increases as the period between seed and next round increases.  The Report doesn’t provide any information on time periods between seed and next round, or on the percentage of deals that had a sliding discount.  The range of discounts was between 10% and 50%, with 74% of discounted deals having a discount of 20% or less and 26% having discounts of more than 20%.

Conversion Caps

A major advantage of convertible loans is that they allow the parties to defer negotiation of probably the most difficult business issue until the next round: valuation. But that advantage also poses a risk to the seed investor, namely that at the time of conversion at the next round the company’s pre-money valuation will be much higher and thus much more expensive for the seed round investor. caps A discount offers protection against valuation inflation, but only relative to what the next round investors are paying.  An added measure of protection is a cap on the next round valuation applicable to the seed investor’s conversion rate.  For example, imagine a $1 million convertible loan with no discount, no cap, and the company subsequently raises $5 million in a Series A round at a pre-money valuation of $20 million with a per share price of $1.  The note would convert into one million shares ($1 million loan (leaving aside interest for simplicity) divided by $1/share).  But if the note had a $5 million cap, the shares would convert at the rate of, not $1 per share, but $0.50 per share, so that the seed investor would receive two million shares ($1,000,000/$0.50) rather than one million.  I’ve previously blogged here about why valuation caps are loved by angels, tolerated by VCs and hated by entrepreneurs.

Although still popular, valuation caps seem to be trending down somewhat. The Report indicates that only 55% of convertible loan deals contained caps in 2015, nearly a 20% drop from the 74% that featured them the year before.

Conversion on Maturity

The truth about seed round convertible promissory notes is that they are promises that no one intends to be kept. At least the repayment part.  They are intended to be converted into equity.  But what happens if a qualified next round doesn’t occur prior to the maturity date of the note?  Very often, the note will provide that the outstanding principal and interest will convert on a given date, either automatically or at the option of the holder, at a set price or a price determined by a formula or procedure.  According to the Report, 60% of deals in 2015 had some kind of conversion at maturity.  Of those, 89% were at the investor’s option (up from 80% in 2013) and 11% were mandatory (down from 20% in 2013).  In addition, 32% of the 2015 deals that converted upon maturity convert into common stock, substantially unchanged from 2013 but a dramatic decline from the 54% of the conversion-at-maturity deals in 2015 that convert into common.  68% of the 2015 convert-at-maturity deals convert into preferred, also substantially unchanged from 2013, but a sharp increase from the 46% of the 2014 deals that convert into preferred.

Sale of the Company

Upon a sale of the company prior to maturity and prior to a next-round conversion, the outstanding principal and interest may convert into common or preferred stock, either automatically or at the option of the debt holder. In 2015, 74% of the convertible deals covered in the Report had some kind of conversion on a sale of the company, up from 66% in 2014.  Of those, the conversion-on-sale feature was overwhelmingly at the option of the holder (91%, up from 86% in 2014; 9% were mandatory).  Of these deals, they were pretty evenly split in 2015 between those converting into common and those converting into preferred.  In 2014, on the other hand, the conversion-on-sale provisions tended to favor conversions into common (60%) rather than preferred (40%).

Conversion Premiums on Sale of the Company

Seed investors sometimes negotiate for the right to be paid a multiple of principal and interest upon a sale of the company, similar to a liquidation preference associated with preferred stock. Roughly one half of the deals in the Report had company sale premiums.  The premiums ranged from 1.5x (i.e., 1.5 times the outstanding principal and interest) on the low end to 4x on the upper end, an increase from the upper range of 3x in 2014, although the median multiple was steady throughout 2013-2015 at 2x.

Secured Notes

Convertible note investors sometimes negotiate for the note to be secured by some or all of the company’s assets. If the note is not repaid or converted at maturity, the investor could look to the pledged assets to satisfy the loan.  Investors in 2015 were not as successful as they were in 2013 in getting their notes secured.  Only 15% of the convertible notes covered by the Report in 2015 were secured (85% unsecured), down from 25% in 2013 (75% unsecured in 2013).

Conclusion

The foregoing data on conversion discounts, caps, conversion at maturity, sale-of-company conversions and premiums and security suggests that the convertible note deal term pendulum may have started to swing back in favor of investors in 2015. Deal terms in the categories of conversion discounts, conversion at maturity, sale-of-company conversions and sale-of-company premiums were more favorable to investors in 2015.  Terms were more favorable to companies in 2015 with respect to caps and note security.  Given recent developments regarding cooling valuations and a stalled technology IPO market, it will be interesting to see whether the pendulum for convertible deal terms will move more significantly in favor of investors in 2016.