It’s an exciting time in North Texas for startups. We are on the verge, if not already in the midst of, a legitimate startup boom. This is being driven by a good mix of entrepreneurial spirit, a favorable economic climate, and a number of individuals and organizations that have dedicated themselves to driving startups in Dallas. We have the resources and talent right here in the area, and the capital is starting to flow.
We are on the verge, if not already in the midst of, a legitimate startup boom.
At my firm, Vela Wood (formerly Vela Keller), we recently performed a deal audit to better understand early-stage investment deals happening in North Texas over the past three years. Several themes have emerged from this report. Over the next few weeks on our blog, I’ll take you through these themes and explain why I believe Dallas is the next startup haven.
In our report, I was not surprised to see that we facilitated an equal number of debt and equity deals over the past three years. In the past, debt appeared to be the preferred financing mechanism for early stage rounds, but lately, I’m seeing more early-stage equity raises. At this point, the ratio has evened out.
Lately, I’m seeing more early-stage equity raises.
I believe that there are three reasons for the shift from convertible notes to equity rounds as the preferred seed-stage investment vehicle: 1.) investors in North Texas are becoming more sophisticated and are asking for equity in lieu of convertible notes; 2.) large convertible note rounds are getting out of hand; and 3.) document collaboration spearheaded by big law firms has lowered legal fees for equity rounds.
Investors in North Texas Are Becoming More Sophisticated
I believe investors generally prefer equity, because it removes the unknown and gets them on the cap table (or the company’s ownership chart). By “unknown” I mean that the investor can negotiate the valuation now, rather than waiting to see what the next round investors do and converting into those terms, which are likely outside of the investor’s control. A few years ago, I saw angel investors wildly throwing money into seed deals like Vegas newbies aimlessly tossing chips onto a craps table. They would happily accept convertible notes without ever asking if equity was an option. But angels have become smarter as a result of a few things, mainly from the plethora of educational opportunities around town. With pitch days, online and print content, and angel-education seminars, it’s easy to see why angels are getting smarter. And then they are collaborating to share deal intelligence and perform due diligence. This angel intelligence is manifesting itself in more sophisticated negotiations and deal terms, oftentimes leading to equity rounds. So not only am I seeing more angel investing in North Texas; but also I’m seeing smarter investing.
Large Convertible Note Rounds Are Getting Out of Hand
I’m not a fan of large convertible note rounds. You usually end up with way too many tiny investors, which makes communication for future rounds and voting a pain, and the conversion very expensive. I also feel that the dilution gets ignored until it’s too late — noteholders don’t necessarily go on the cap table immediately, so it’s easy for the founders to ignore the dilutive effect of the conversion. But then a company gets to Series A and is selling a typical 20 percent, but the noteholders are converting in for another 15 percent, and suddenly, the founders and early shareholders/members are being diluted by nearly a third in total. I love small convertible note rounds — as seed rounds or bridge rounds. But convertible note rounds greater than $500,000-$750,000 don’t make a whole lot of sense to me.
Document Collaboration by big Law Firms Has Lowered Legal Fees for Equity Rounds
Years ago, I would often hear that equity rounds were cost prohibitive for a startup; thus convertible debt became the de facto mechanism for seed rounds. But over the last five years or so, there has been a real movement among lawyers, particularly the largest law firms with active venture practices, to share venture templates in an effort to facilitate more deals.
Well, it’s definitely working. Seventy-five percent of the deals I see where we don’t originate the docs still use the SeriesSeed.com templates (we do as well) and an even higher percentage use the NVCA docs for Series A/B rounds.
Next time, I’ll present more conclusions about what to expect for early stage companies raising money in DFW.
For a daily dose of what’s new and next in Dallas-Fort Worth innovation, subscribe to our Dallas Innovates e-newsletter.