Entrepreneurs are already well versed on the intricacies of startup financing and the pernicious effects it may have on their companies: down-rounds, dilution, preferred stock and stock with different voting rights, among others. For that reason, they plan ahead and try their best not to find themselves caught in stalemates and catch-22 situations with no possible resolution.
But what I find fascinating is the lack of thought exhibited by VCs on their term sheets, driven more by custom and just plain imitation than by economically rational designs. The case is most notorious in the disregard of debt instruments (convertible debt and notes), of which their advantageous properties to the entrepreneurial side of the investment are widely known, but not their equally valuable properties to the other side of equation.
The detailed study of the financing structures of tech startups is a puzzling experience of negation of the received wisdom from the classic Corporate Finance results, especially the Myers-Majluf theorem: given a project within a startup, with positive or negative NPV, and the founders knowing the project’s NPV with very high certainty but startup outsiders do not, ceteris paribus, the founders may not invest in the project with positive NPV if outside equity must be issued to finance it, because the value of the project may go to the new shareholders at the expense of earlier shareholders . That is, the asymmetric information is causing an agency cost to the current shareholders if the startup issues equity, but not if it issues debt. This straightforward result is key to explain the low start-up survival rates through the different rounds of financing since, in the light of the full lifecycle of the entrepreneur, it’s perfectly rational to prefer that the current startup goes bankrupt to start a new one with the project with positive NPV if the cost of issuing new equity is so high, avoiding any pivot in the process.
And then, by Green Theorem (from Corporate Finance, not from Calculus) convertible debt, not straight, would be the ideal instrument: if the startup can choose investment levels between different projects with different risks, and outsiders don’t know the relative scale of the investments then, ceteris paribus, current shareholders bear an agency cost if the startup gets financed only by straight debt, a cost that can be avoided by issuing convertible debt.
These pecking order results hold even with stock options and without asymmetric information or managerial firm-specific human capital (see Stock Options and Capital Structure), so I wonder how many decades it will take for practice to meet theory… if they dare!
