Risk is an interesting thing. It’s always there, and how you divide it is the key question.

I this morning read about Spotify’s $1 billion convertible note financing. Some interesting terms have been leaked, though I don’t know why the company would want those out in the market. And, I’m sure, there are other terms.

Financing structures are all about dividing risk. It sometimes really concentrates risk and creates dis-alignment, too. Let me explain.

As an early-stage VC, equity is pretty straightforward. We give the company money, own a minority piece, and share the gains with the management team, if and when there is an exit. If there isn’t an exit, everybody loses. Preferred does get priority in a downside scenario, but, as a VC, you end up negotiating a carve-out for the team anyways to make sure a sale goes through.

Things can get very tricky with pure debt. I hate debt for our companies, unless they’re close to profitability or are there already. That’s because of risk.

If things go well, you can make your debt payments easily. If they don’t, the debt underwriter can own your company and force a firesale. In general, people who offer debt are fine with an interest rate and some minor equity upside. But, as one of them told me, it’s a cardinal sin to lose any money.

So, if a start-up has debt and hits the wall, debt providers normally just push for a sale to get their money back. As a debt provider, they’re senior in the liquidation stack and get paid first. There’s dis-alignment in the capital structure in a downside scenario.

Now, a convertible note financing, as Spotify has done, is an interesting hybrid instrument. The note investors can convert to equity at a discount to the IPO price. They’re also getting an interest rate. Both the discount and the rate become less favorable for the company over time. And, the note investors get to sell IPO shares earlier than anybody else.

This is a clever way for Spotify to lower dilution by effectively skipping a down round. It also is a clever way for the investors to try to protect their downside as they await an IPO.

But, here’s the question for me: if there is no IPO, what happens then? All convertible notes are subject to a term, and all terms expire eventually. So, I suspect there is a mandatory conversion feature in this note. And, that feature usually specifies a conversion price. And, that price sometimes can be set very low.

Moreover, the note investors might have a voting block on any new financing needed. They might allow a new financing to come in, or they can ask for deal sweeteners to waive their block.

In another era, I saw this happen. An investment bank put money into a company, but insisted on a voting block. Fast forward three years. That bank was no longer in the VC business and had fired its VC team. The start-up needed more capital, and the bank would not waive its block until it got better economics. It was legal, of course, but the company was held hostage for a bit of time.

Extreme dis-alignment.

So, the TL;DR here is this: if things go well for Spotify, this was a great financing. If a macro-economic event completely shuts down the IPO window and the note’s term expires, this was not so great. The structure will have shifted a disproportionate benefit to the new investors. There’s dis-alignment.

So, a note thereby can shift more risk to the management team and early investors. It can concentrate risk. And, if the prior VCs have enough reserves to keep supporting the company, they’ll end up being fine. It’s the team that will be penalized.

I’m hoping it all works out for Spotify. It’s a great product, and our household is a huge fan.

But, I can’t forget the case of Federal Express, which is common folklore in the VC world. The financing round that did “the best”?

The last one.

7 thoughts on “Risk

  1. I was intrigued by some of the leaked terms too. As high level, it felt a bit like when USV did the late stage convertible debt round in Fourquare back in 2013 when I think the company was in transition and Mgmt and investors don’t want to do a down round and opted to give the Mgmt team a grace period to course correct to hopefully flat or higher round later on. I wonder how much of these sort of calculus are mostly/wholly driven by short term view (Really don’t want a downround *now* and everyone’s projection is rosy) and just kick the can down the road.

    1. Great points, W.L.

      Regarding the leaks, who has an incentive to leak the terms? The new investors to show that they negotiated a very rational set of terms? The management team that wants to show acquirers that they do have the capital to go public, and so, any offers should come now?

  2. @Jo, I’ve been reading your posts for many years and have never commented. This was a good one, thank you. Would you be willing to elaborate on the topic of risk concentration of VC vs common shareholders when a VC is involved at an early stage? From my experience, a VC is typically protected with preferred shares that are senior to common shares that founders and employees hold. It is also typical that these preferred shares will include preferences where paid in capital and accrued dividends are paid out to VC’s before a any capital is left for common shareholders. I should say that I personally believe that the founders should bear this burden of risk and should learn to accept it. A bankers moto may be that it’s, “a sin to lose money,” but VC’s need to be looking out for their LP’s interest too.

    This may be a naive question, but why wouldn’t Spotify’s existing equity investors be willing to offer competitive terms for the most current round of financing vs. going to preferred debt?

    Thanks in advance for a response.

    Mike Maziarz

    1. Hi Mike,

      Question #1: I recall some really good posts from Brad Feld on why VCs go with preferred stock, and he’ll be more eloquent than me.

      Question #2: Honestly, I don’t know and no one will know. The reasons could vary a great deal. Some reasons could be one or more of the following:

      • Management is insisting on this
      • This is truly viewed as the last round before a sale or IPO
      • Adding more and new dollars to the syndicate is a good thing
      • Some existing investors’ funds are tapped out

      That’s just for starters. There could be many more.

  3. Hi Jo,

    Why do you assume that there would be a mandatory conversion at maturity? In public markets, I’ve seen a small number of pre-IPO convertibles and, from memory, they don’t typically include a mandatory conversion clause. With those structures, in the event of no IPO, the bondholder must be paid back the principle.


    1. Good point. I think the bigger point is this: the investors won’t want to be in the security forever. So, there could be an option to redeem their money or convert.

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