Firms derive competitive advantages by exploiting opportunities that emerge from macro-environment shifts. Entrepreneurial organizations are quick to explore and develop new business ideas and access sufficient capital to drive their growth. To be functional, these enterprises must possess certain defining characteristics that foster exploratory entrepreneurship moves in specific industries. Therefore, the defining inclusion criteria for entrepreneurial firms would include four elements: age, size, founder status, and innovativeness.
The age of an organization is a key determinant of growth and profitability. Assuming no externality or staff turnover to other companies, older firms may exhibit greater entrepreneurial activities due to years of learning and experience compared to new entrants. Additionally, accumulated reputational effects may lead to higher sales revenue for such businesses. It also has a well-developed R&D function that ensures innovative products for the market.
Conversely, age may make older firms less flexible to changing market dynamics compared to start-ups, but this behavior is dependent on managerial decisions to develop dynamic capabilities. Therefore, in terms of age, an entrepreneurial firm would be a much older, experienced organization.
The size of a firm predicts its pro-activeness in its industry. Larger, proactive firms have a higher risk-taking propensity than micro-enterprises. Thus, a presumed profile of an entrepreneurial firm includes a large enterprise that gains from economies of scale due to the expansion and diversification strategies implemented by entrepreneurs, who would be expected to possess superior managerial capabilities. Such firms explore and exploit entrepreneurial opportunities for growth through effective resource assembly, organizational design or models, and competing strategies. It can also be assumed that they possess unique capabilities and capital to venture into new industries or markets.
Founder status may affect the financial performance of firms. One might expect that an entrepreneur who serves as the CEO of the company he or she founded has the skills and incentives to drive growth compared to non-founder managers. For instance, founder CEOs may regard their reputational stake in the enterprise highly and thus, strive to achieve superior firm performance. Since in most cases they have significant equity ownership in the company; hence, they are likely to be diligent leaders. Thus, founder management is a defining characteristic of successful firms, assuming the individual relinquishes greater control of corporate resources to line managers.
Innovativeness is a key pillar of entrepreneurial success. Innovative products or modifications of existing ones can lead to competitive gains associated with first-mover advantage. A truly entrepreneurial firm must move boldly and adopt innovative processes (e.g., R&D), business models, or products quickly to differentiate itself from rivals. Thus, the development of a new product or modification of an existing one to respond to customer tastes or preferences is a defining feature of an entrepreneurial firm.
Convertible Notes in Angel Financing
Seed funds are catching on as popular mechanisms for financing start-ups. A convertible note is a short-term loan that readily converts into equity in a Series A round of funding. Differing incentives exist between the angel and entrepreneur. From an investor’s view, lower costs of due diligence in note valuation may produce favorable returns and increased stocks in the firm. Thus, he or she is incentivized to invest in the firm in the hope of receiving shares when subsequent rounds of preferred stock financing. However, the valuation of convertible notes requires advanced skill sets, which an angel may not possess.
On the other hand, entrepreneurs may prefer convertible notes to other seed funds because they are an easier and cheaper funding mechanism. They involve low financing costs, which mainly come from legal fees. Convertible notes also make variable pricing possible. A new enterprise can offer distinct prices to different investors. Further, delayed pricing allows the entrepreneur to bump up valuation before the maturity date, and thus, increase his or her ownership share in the start-up.
To address the moral hazard that arises from differing incentives, convertible notes have caps and discount rates, as illustrated in the following example. Assuming an angel invests in a start-up using an uncapped convertible note that includes a 10% discount in a subsequent round of financing at a price per share (PPS) of $10, he or she will receive shares at a discounted rate of $9. Thus, an investment of $50,000 would earn him or her 5556 shares compared to only 5,000 for new investors.
On the other hand, assuming a convertible note capped at $5M in Series A round with no discount and a valuation of $7.5M at $10 per share, the angel will get apps of $6.67. A hypothetical investment of $50,000 would yield 7496 shares, which are higher than in uncapped convertible notes. Thus, caps compensate angels for the risk taken and protects them from the effects of ownership dilution.
Another important feature of convertible notes is the pre-money valuation. By valuing the firm before any external funding, investors get an idea of the start-up’s actual value currently. Thus, pre-money valuation is not likely to reduce the ownership percentages of the angels before the next round of financing. Assuming a pre-money valuation of $1M (before an investment of $250,000), the entrepreneur will own 80% of the company and the investor 20%. However, the post-money valuation would reveal that the venture capitalist and angel invested $750,000 $250,000, which translates to 75% and 25% ownership percentages, respectively. Thus, pre-money evaluation ensures that the entrepreneur’s level in the company is not affected. It also gives potential investors a picture of the firm’s worth before receiving investments.
Evaluating a Prospect
As a partner is a VC evaluating a prospect, I may not be concerned about convertible note-holders for three reasons. First, typically this financing method does not entail an obligation to pay the principal amount of interest before the maturity date. Convertible notes are some kind of loan that only mature at the next financing round, and the VC can even negotiate for an extension if there is no cash. Thus, they offer an attractive, more flexible financing mechanism. Second, the note does not involve any collateral or security. Since the new prospect is a risky venture, angels will not auction the VC’s assets to recoup their investment in case of insolvency or failure.
They can only bet on its success, whereby the note converts to equity. Third, the angels will have no significant control rights, unlike preferred stockholders who have an influential role in board decisions. Thus, they are less likely to affect my stake as a partner in the VC.
The price of a convertible note may or may not be set at the time of issuance. I would prefer unpriced debts to priced ones because they are typically never meant to be repaid but converted into equity. Thus, VC can finance its business using new investments that will convert into shares in a future date at a price that will be negotiated later. In contrast, a priced round will require an agreement on stock price before investment.
This approach may disadvantage the VC because if the price is too low, the angels will receive more shares for their initial investment. As a result, we will relinquish an equivalent of our stocks to investors, which will dilute our ownership and control rights in the enterprise. Thus, unpriced notes make sense to entrepreneurs because they eliminate the pricing risk, at least in the initial seed round.
I would prefer a set cap on convertible notes to no cap. Capped convertible notes include the highest price investors can convert. Setting an appropriate cap will work for both the angel and entrepreneur, as a high or low value would affect stock prices in the next round of financing. Such a provision sends a strong pricing signal to investors, motivating them to finance the business. It will also give the angels more security of being rewarded for investing in risky deals in the next round of pre-money valuation. Thus, caps are an incentive to investors because they guarantee an increase in ownership percentage in the subsequent financing round.
On the other hand, angels may not prefer uncapped convertible notes because they may not get a favorable number of stocks. With a cap, the risk of founder dilution is minimal and investors are also protected from unpredictable prices that reduce their confidence in convertible notes.