Use Convertible Debt

The question of seed round valuation is perfectly fair, and one I found myself contemplating as I drove home from work, on the Capital Beltway in Washington, DC., sometime in March, 2009. On one of my Skype calls with Sharat, I asked him what he thought about this.

“Dude, we don’t set a valuation, ” Sharat responded even as I barely got the words out of my mouth.

“What do you mean we don’t set a valuation? How will we decide how much equity to give them?” I countered.

“We’ll use a convertible note to raise this seed round, and defer the valuation-setting song and dance to the next round of financing, which should be in about a year. All we need to do is ensure that the investors in this round are adequately compensated for the risk of investing in us this early.” Sharat told me in his pedantic voice, which he rarely used except when I asked him questions related to finance.

“Ummm, ok … and how exactly do we do that?”

“We’ll raise the money as debt that compulsorily flips into equity when the next round happens. At that point, we give the seed investors (the angels we’re raising money from now) a discount on the valuation, because they invested in us when the uncertainty was much higher.” Sharat went on, evidently quite at ease with how this all actually works.

“Woah, slow down, this is all going over my head. What is this discount thing you’re talking about?”

Even though I am the technologist and Sharat the banker, I thought it was important for me to understand how this really works. For that matter, I think every entrepreneur ought to understand the mechanics of deal financing, because the details are important and knowing them in your head is crucial to being able to effectively negotiate financing rounds.

“Okay, lemme explain with an example,” Sharat continued, being patient as always. “Let’s say we raise $50k as a convertible note from angels in our seed round. We take the money as a loan, basically, promising them that the loan converts into equity under certain conditions. You with me so far?”

“Yeah, go on.”

“Now when we raise our next round (Series A), let’s say we raise $500k from a VC firm at a pre-money valuation of $1 million. Since the seed round helped us increase the company’s value to that much, we ought to give the angels a valuation that is lower than this $1 million, because at the point they invested, there was a lot less. Just you and me and a prototype, basically. Right?”

“Right. So you’re saying that that is the point at which we say, Ok angel, you get a discount on the $1 million valuation so to determine how much equity your money buys, we say the valuation for the seed round is $750k (equivalent to a 25% discount)”

“Exactly. $750k or $600k or whatever. That is the discount that all seed round investors get, which is fair given that the amount of risk they took on was greater than the VC firm is taking on a whole year later.”

And that my fellow entrepreneurs is basically how a convertible note works.

At MobStac, we used a convertible note (in India, this is often called a convertible debenture) to raise our seed round back in June 2009. Our logic for using a convertible note was quite simple: neither the angels nor us entrepreneurs have a clue what the company really is worth so why make it their word against ours or vice versa? And what if we get it completely wrong and the next round is actually a down round? I hardly think there’s anything more depressing for everyone than a round in which the valuation of the company actually goes down, especially in the seed stage. Angels are unhappy because their investment is worth less, not more. And entrepreneurs are unhappy because no one likes to see the value of their company go down – it’s a hard pill to swallow. So a convertible note just seemed to be the proper (not to mention uncomplicated) route to take.

Increasingly, quite a few startups in India are considering taking this route, and I think even more startups should. If you raise money on AngelList or from anywhere in the Valley, you’ll find that convertible notes are the lingua franca of seed stage investing. Why should seed investing in India be any different?

The Venture Hacks guys have a bunch of articles on the topic, if you’d like to do some more reading to understand the nuances of convertible notes. There are also other good posts by Brad Feld and Paul Graham.

MobStac’s 2009 Convertible Note: Open-sourced

To kickstart our enthusiastic support of this method, we’re open-sourcing the convertible note that we used in 2009 as a template that anyone can use for their own seed rounds:

MobStac Convertible Note.doc

A couple of notes about the template:

• All variables are highlighted and for you to fill out based on your situation. For e.g., the maximum size of the round, the interest rate on the note, etc.
• The cap on the discount is set to 25% as an example – you can make it whatever you and your investors agree to.
• In the event there is no follow-on round of financing within the stipulated time, the valuation is decided based on mutual consent, subject to a minimum value.
• Of course, you’re free to modify any clauses and add others that may be relevant to your situation.

I hope this helps some of you out there get your seed round closed faster so that you can move on to building the product!

As always, I would love to hear what you think. I’m also happy to answer questions that you may have so feel free to leave me a comment or shoot me an email.

(May 24: Updated to reflect Pranay Gupta’s comment – thanks!)

Disclaimer: This post and its associated document does not constitute (and is no substitute for) legal advice. I write to share my experiences with the entrepreneur community, but am in no way responsible for any legal consequences that may arise from applying this information. My recommendation is to consult a lawyer for advice during fundraising.

These days I find myself talking a lot more to people who ask me about starting up and raising money, and I often repeat the same stories about the lessons Sharat and I learned and how we navigated what was a pretty bleak funding landscape, back in 2009, at the time we were just getting started with MobStac.

Venture Hacks, a popular blog for startups, has a wealth of information on how to raise money in the Valley, but most of it really doesn’t apply in India because our startup ecosystem is still in its infancy. But this ecosystem does exist, and what we did is apply some of the same principles advocated by the VH guys here in Bangalore. Much of what follows is how our thought process unfolded as we raised angel funding for MobStac last year.

Raising Angel Funding

In my mind, there are really three questions an entrepreneur needs to answer at the outset.

The first question is: when is the right time to start talking to investors?

I think the right time is after you’ve done the following:

• Found a motivated partner to start the company with
• Invested your own money first (whatever amount)
• Put together some prototype of your product, if your idea involves one
• Quit your day job and started working on your startup full-time

If you’re serious about starting a company that will seek external funding, you really should be demonstrating your commitment to this new venture through your actions. If you think about the message you’re trying to convey, you’re essentially saying, “I’m doing this whether you buy my fancy new idea or not.”

The second question is: whom do you raise a seed round from? The answer is that the small amount of capital for a company to get off the ground invariably comes from angel investors, because angels are the only ones who invest in people when all they have is an idea and maybe a crude prototype of their product. Angels don’t usually care about scalable business models and they don’t obsess over all the minute details of technology risk, business model risk, and barriers to entry. An angel’s motivation to invest in startups typically comes from a strong desire to give back and help mentor the next generation of entrepreneurs.

So if it’s angels you need to seek, where do you find these rich people who’re willing to part with substantial sums of money (with a very little chance of ever seeing it again) to put into a risky venture? And where do you find these people if you aren’t planning to startup in the Valley but in Bangalore?

When you’re really just starting out and have very little to show, these “angels” are usually friends and family. The only ones who probably believe in your wild idea and your ability to pull it off. I guess that’s why this round is often called the “friends, family, and fools” round

At MobStac, two of our angel investors are really dear friends and classmates of ours from college and graduate school. They wanted in even before we asked! Their faith in us quite frankly astonished me, but I guess somebody needs to believe in you when the world is trying to talk you out of the insanity of chucking your stable job

One angel investor in MobStac is a fellow alumnus of IIT Madras, a successful entrepreneur from the Valley, and a true-blooded angel investor if you ask me. We got an introduction to him, made a pitch with our slide deck and prototype demo. We got an answer in less than 24 hours and the money in less than 2 weeks! Wouldn’t we all love to be able to pitch to such awesome angels?

To get in front of such angels, you have to have what the Venture Hacks guys call social proof. Find a way of getting introduced to these angels from people they know well and respect. A cold call or email is certainly not the way I recommend you do it. It’s just as annoying and ineffective as the bulk SMS spam we all get and hate

Another way is to reach out is via alumni of your university, in a way that will help you establish credibility and build a connection up front. In general, the more people you talk to, the more you’ll find that people are ready to help you out and in ways that you would never ever expect. Too many people think of networking as something that happens only at organized events. It does not. You network as part of your daily life, and the best networkers are those who don’t do it consciously, but have made it part of the way they connect with people in general.

The third question an entrepreneur must answer is: how much should you raise? While the answer really depends, for a tech start-up in India that does not have any significant capital expenses up front (say, to acquire a govt. license), the amount is usually somewhere between $50k and $200k. If your plan needs a million dollars up front and you happen to be a first-time entrepreneur with no connections to the Ambanis, I strongly urge you revise your plan in a way that lets you start off with $200k. That’s an amount you can raise right here in Bangalore.

At MobStac we raised our seed funding from angels and closed the round in about 4 months. While it took us longer to close the round than it probably took some others, a 3-month time frame is definitely reasonable (and perhaps what you should expect).

Alternatives: Startup Accelerators

While angel investors in India are these days doing a lot for us entrepreneurs, there are also a number of startup accelerator programs that are doing their bit to support startups in India. Two such noteworthy programs are The Morpheus (run by Sameer Guglani, Nandini Hirianniah, and Indus Khaitan), and iAccelerator (run by Freeman Murray). In addition, there are a number of incubators in the country, including one at my alma mater, IIT Madras. I am not yet convinced of the efficacy of these incubators and believe that a start-up should survive in the real world on its own. This may not apply, though, to start-ups that have a heavy research bend and are typically born out of cutting-edge work done only in universities.

My inspiration for this post comes from a desire to encourage more knowledge-sharing amongst entrepreneurs within the startup community here in India. Sharat and I are in the midst of raising our next round of funding for MobStac, and when that closes I hope to have a lot more to share on matters such as valuation in seed rounds, stock options, common terms seen in term sheets, etc.

A lot of people have been calling me through the day and some of them have asked me how it feels to be 30. Although I had earlier expected to worry more about the piling on of years, I’m quite happy to report that I’m feeling quite the opposite – a sense of contentment.

Priya, my sister-in-law, asked me when she called about what I thought about 30 being the “top of the hill”. I told her that I thought of 30 being really half-way up the hill. Everything that I dream about and hope to accomplish in the future is really going to happen over the next 30 years so if you think of 60 being Mt. Everest, I’m probably still at base camp!

There’s this moment from 8th grade history class that I remember very distinctly. We were learning about Chinese history and famous philosophers like Confucius and Lao-Tzu. I came across this quote by Confucius that has stuck in my mind ever since:

Do what you love and you’ll never work a day in your life

From teaching myself computers and programming in the 5th grade, learning Carnatic singing, training in long-distance swimming, playing tournament-level chess, studying for the IIT exam, contributing to open source projects, singing in a rock band, leaving Morgan Stanley to join Hillcrest, driving a BMW, to giving it all up and striking it out on my own, all I’ve ever done is follow my heart and do what I truly love.

So when Sharat, my cofounder and one of my dearest friends, asked me if I had any unfulfilled desires or regrets, it really got me thinking. And after thinking about it for nearly the entire day I realized that I had no answer for him.

I’ve actually done every single thing that I had wanted to do by 30. And I’m married to the woman of my dreams.

What else could I ask for?

I think it can safely be said that in the months I’ve lived here, I am now as much a feature of 6th Main, Indiranagar 2nd Stage, as the local chai shop, the security guards blowing their noisy whistles as cars whiz in and out of basement car parks, and the stray dogs that congregate in front of our apartment building every night and howl like their ancestors I live at one end of 6th Main and work at the other end. One end of it is secluded, with apartment buildings that house the urban rich and as prosaic in their design as they usually are in most urban parts of India. At the other end of 6th Main is a busy, noisy street, what they call Indiranagar Double Road and at that intersection lives my cofounder and partner in crime, Sharat. Every morning, I make my way from one end of 6th Main to the other, without being run over by honking cars, passing a cow or two on the way, sometimes a vegetable or fruit cart, before showing up at our office, which we currently run out of Sharat’s apartment.

As bootstrapping entrepreneurs, Sharat and I work out of a one-room office which serves as everything that you’d imagine we need – conference room, cubicle room, server room, war room, you name it. Out of this office we work to build our company one day at a time.

Sometimes I think about how far we’ve come from that day in October when I first had the conversation with Sharat about working together on a little idea that just may be something we could make a company out of. With me in DC and Sharat in Bangalore, and with Skype to help us out, we started putting together what we called an investor “teaser” presentation.

It took us nearly 6 weeks before we had a first working draft of our 6-slide deck. Another 10 weeks of vigorous brainstorming and revisions based on feedback resulted in a version that we had a lot more confidence in. By Jan 2009, we decided that we were getting closer to what seemed like a real idea with a defensible value proposition. It was time to start reaching out to investors and raise money for our venture. By February 2009, all Sharat and I were doing in our time outside of our day jobs was connecting with potential angel investors to drum up support for our idea. While we did the bit on pitching to investors with our slide deck, we also reckoned that it was important to put together a working prototype that would demonstrate our idea more directly. It was also real proof of our commitment, since we were pouring our time and money into making this real, not just peddling a slide deck to gauge interest in the investment community. Through the months of March, April, and May, we continued to seek money in what (we were told) was possibly the worst economic climate since the tech bubble burst in 2000, and in spite of being told by numerous people that raising money for a start-up at such a time didn’t sound like it would go anywhere.

It helps that Sharat and I both share a healthy disregard for the impossible. We kept ploughing ahead, pitching to investors, refining our business plan continuously, and always listening to the feedback we got but making our own judgements. Today we have a real company, an (albeit small) office, a solid business plan, and funding committed from angel investors who believe in our vision.

Clearly, this is only the tip of the iceberg and a lot remains to be done. But at least we’ve made it this far from being merely a thought that started in my head as I drove home each evening on the 495 Capital Beltway in DC.

You know what they say about succeeding in golf? It’s the direction that matters, not how far you hit the ball.

I think starting up is a little bit like that.

Today is my last day as an employee of Hillcrest Labs, Inc., where I’ve spent nearly the last 4 years working on exciting products at a young and dynamic start-up company.  For the first time in my career that began after I graduated from IIT Madras in 2001, I will no longer be seeking employment at a major (or start-up) corporation. I am leaving to pursue what has long been my dream and the singular goal of my career – to start my own company.

Today not only marks the end of what is perhaps the most defining experience in my career so far, but also the beginning of my last 17 days of residence in the United States of America. After 7 years in 3 different cities of the US I’m moving back to the only country that is my home, India.

People close to me have always known that when I first set foot on American soil on January 20th, 2002, I had every intention of tracing this exact path through my time in the US and eventually returning to India one day. And following through on a promise I made to myself all those years ago is a truly liberating feeling. I don’t know if the word “liberating” quite captures how I feel, but knowing that I am still in control of my life and not yet the victim of inescapable routine that seems to engulf us all as we grow older and more accustomed to a steady life, definitely feels quite liberating.

The logical question to ask (and no doubt one that I’ve been asked a lot these last few weeks) is why I’m choosing to leave the US and go back to India.

My arrival in the US was in pursuit of a dream that I had nurtured my entire life. I had been admitted to Wash U to pursue a degree in Computer Science and it was my shot at making my career in the only thing that ever truly captivated my imagination and it meant the world to me. It was a vindication of everything I had taught myself outside of classrooms (given that I was learning Chemical Engineering inside!) and a reinforcement of my belief that one’s determination and steady effort towards a goal could get you there, even if it was not obvious to everybody around you how you possibly could pull it off.

In the years I have spent living in the US I have grown to love and appreciate America for what it is. My varied experiences have influenced my growth and broadened my outlook as an individual, which is why I feel so overwhelmingly positive about the life I have led. As I often like to say, I may not be an American citizen but I am to some extent American in my thinking, having spent some of my most crucial years in the universities and companies of the US.

I am returning to India now mostly in pursuit of yet another dream. I say mostly because there are of course a multitude of reasons but the most important one is really about a dream. A dream that I have nurtured from the time I was first fascinated by the history of the great technology companies of America and when I first came across the word start-up. As I read everything I could on the subject, sitting on the trading desks at Morgan Stanley in New York, it became quite apparent to me that if I wanted to really do this myself some day I had to learn by being at a start-up to begin with. Where could I learn the ropes than at an actual start-up? Where could I gather the skills that were crucial to making an actual company out of nothing more than an idea and pure determination? Hillcrest Labs is where I trained to one day start my own company and today I’m moving on to the second and most important part of any real training course: doing it yourself.

I’m 28 years old and I owe myself a shot at pursuing my dream. It is time to follow up with action on what have only been words and thoughts so far. This is about doing what I truly believe in and irrespective of how this turns out in the end I know it will be one hell of a ride!

(Editorial note: This post was originally composed on April 24th, 2009, but did not make the presses at that time because of an intervening vacation in Hawaii.)

Barack Obama’s sweeping win of the US Presidential Election yesterday re-ignited the hope that millions around the world carry in their hearts for the promise that is democracy. That humans are capable of transcending their differences, rising above race, class, and creed, and acting together for a greater common purpose. That a people that were once bitterly divided over racial equality only 40 years ago can cross over into a new era and elect a black president, and truly deliver on the promise of liberty, equality, and opportunity that is the cornerstone of the American dream.

Obama’s speech last night moved me to tears in a way I had never experienced before. For me and millions of others around the world, America had become a new nation and had shown to the world that it could once again claim its place as the beacon of hope for democracy and its ideals, as a country where the possibilities are limitless. I could now hope that the injustice I had seen the last 7 years in America, mostly hidden away in corners of decrepit neighbourhoods, may one day only be told about in history books as atrocities of the past. I could now hope for an America that views its responsibilities to the world (and the planet) in a radically different way, one that breaks away from the arrogance that has characterized its behaviour this past decade.

The promise of this historic moment was so powerful that I forgot briefly that I am not an American citizen and that my association with this country had only begun a few years ago. But in today’s world, in which we are all global citizens, does it matter that I belong to a land 10,000 miles away?

I realized that I care deeply about what had transpired here in the US because of what Obama stands for and his message to people everywhere, not just in America. I believe that in the decades and centuries to come, people all around the world will be inspired by Obama and this historic election in much the same way people have been inspired by Gandhi and MLK. I say this because I hope that one day the Indian democracy, the largest in the world, will too scale the same heights in what people believe is possible through self-determination in a multi-cultural, multi-religious, multi-ethnic country.

Many years from now, I know I will be telling my children about this day. The day that Obama and America reminded the world that there always is hope. Always.

In the meantime, if you want to say something, please write to me at ravi at rpmduplex dot net. I’d love to hear from you!

In truth, it is an affliction that affects everybody from politicians who make sweeping statements on camera (NT Rama Rao, former CM of Andhra Pradesh, perfected this to an art when he was alive) to business leaders who use the media to make bombastic pronouncements as if they were actors in the grandest soap of them all.

This past week saw much the same penchant for melodrama on display, as Jet Airways unceremoniously laid off 1900 of its employees and then turned right around and hired them back in a heartbeat as the political and media heat got turned up on them.

The whole incident was ridiculous at so many levels that I don’t even know where to begin.

Let’s start with Jet Airways and the manner in which they went about laying people off. Clearly, the once-booming aviation sector in India has hit a really rough patch. With the price of oil more than doubling over the last year and the global financial meltdown hitting home, it was clear that the airline had to do some serious cost-cutting or run the risk of going bankrupt. While any professionally-managed company would go about this in a more sensible way, Jet decided that the best way to inform employees that they were being terminated was by announcing it to the media! Wait, the stupidity doesn’t end there. Employees were called up at the end of their day and simply told not to bother coming back the next! If there was ever the worst possible execution of a round of layoffs, this had to be it.

But it didn’t end there, of course. Before you knew it, there was an uproar amongst politicians, one of whom promised Jet that none of its flights would take off from Mumbai unless it took all employees back without condition. The ultimate quote came from Veerappa Moily, who said, “Hire and fire is not a proper labour policy… we do not approve [of] this.” The Congress also added, “India is not America.”

There you have it, the classic Indian socialist mindset mixed with hypocrisy at its best. We love capitalism only as long as it’s boom-time!

And sure enough, two days later, Jet’s Chairman, Naresh Goyal, announced that it was his decision to reinstate all employees who had been laid off.

“I apologise for all the agony you went through,” he told a news conference in Mumbai, adding that he could not bear to “see tears in their eyes”. “The management will have to understand sometimes in a family there are disagreements, but the father of the family decides.”

Although it was stressed over and over that the decision was not made under political pressure, I think we all know what went on behind the scenes!

This whole incident, I believe, is a reminder of how our country’s brush with globalization until now has been one really long party, starting from the early 90s. Salaries went up, up, up. You could change jobs every month of the year and only scale greater heights. The stock market kept smashing records and made us all feel like we had truly arrived on the global stage. In all the euphoria, nobody really cared that globalization is really a two-way street.

But make no mistake, the global financial crisis will take its toll in India. There will be retrenchment, cost-cutting and an overall slowdown of growth. People will be reminded that what goes up must indeed come down.

As they say in America, “The party’s over.”

Just this past week, on the 26th of July, 2007, Vidya successfully defended her Ph.D thesis at Washington University in St. Louis. After 6 long, arduous years of a life dedicated to a single research problem in Chemical Engineering, she now rightly carries the right to be addressed as Dr. Vidya for the rest of her life. Dr. Vidya, if you’re reading this, let me just say – congratulations on getting done and reaching the very pinnacle of academic education!

I have to admit that I really didn’t know much about what it really took to get a Ph.D before I came to know Vidya, and didn’t give it much thought either. But when you think about it, can you imagine dedicating 6 years of your life working on solving a single research problem that has probably not been tackled before? Never giving up in spite of all the dead ends that seem to crop up every now and then? Finding ways to stay enthused and energetic about it even after frustrating moments that nearly killed the resolve and drive in you to do research? Having all kinds of people lecture you about doing a Ph.D when clearly you’re the one actually doing it and they are the ones hypothesizing?

I’ve realized that it takes an extraordinary amount of courage, grit, and determination to earn a doctorate and I’ve seen it all in Vidya as she went through the toughest of times in getting to where she is today.

Congratulations on earning your doctoral degree, Dr. Vidya. You have truly earned the 2 letters in front of your name.

On January 26th this year (Republic Day), I’m getting married to my girlfriend of 3 years and the love of my life, Vidya.

Here’s a picture of the two of us outside her apartment in St. Louis:

The wedding’s in Bangalore and I’m currently enjoying the excitement in the family and all the usual chaos that accompanies every Indian wedding!