Dear clear-eyed one, you must be looking for founder-friendly flexible warrant Instruments, so that you can play The Sovereignty Game! Ah, well then, you’re welcome…
First, read about our FLEX Notes and FLEX Warrants - this is a series. If you haven’t wrapped your mind around those, then this might not makes sense at first 😳…
Originally Published on July 18, 2022 8:20 PM (EDT)
The feedback I've gotten on this idea is overwhelmingly positive from founders. This tells me that we should get a selection advantage - ie. get into all the good deals.
Investors are also intrigued. But the main investor pushback I get is around the capped upside - they have bought into the dogma that the mega winners pay them back for all the losers... The argument is that all the successful companies will exercise this option and refinance, instead of converting. ie. adverse selection.
The first counter-argument to this is that there is a logical position that exists on the risk spectrum between equity and debt, and as more and more debt becomes available to profitable or capital efficient companies at medium to late stages, it is logical that more structured capital would also become available to them. So our loss ratio would be lower than VCs, and we would have a selection advantage on the deals themselves, getting into every good deal bc we're offering this thing that everybody wants.
The second counter-argument to this is that the Secondary ROFR is a bit of a virus: you can buy up more and more of the cap table by offering liquidity... If you have capital and appetite, then you are effectively providing all the early investors with an exit.
But this leads to a design question that we did not solve for initially: When we exercise the secondary ROFR, do we inherit the same security that we are buying? We could. But I bet that companies would see it as in their interest to let us convert the securities we are purchasing via secondaries into a new class of share:
The Flex Share...
Basically the same type of preferred share that you are buying, gets converted into a special new class. That class then also gets a dynamic buyback price. The buyback price should have a floor that would be the minimum multiple that justifies you buying that share in a secondary... But again, as long as you're getting your desired IRR + risk premium... why not increase your overall position... The bigger the overall position, the harder it is to refinance and the longer your capital will be outstanding, compounding...
From the existing investors' perspective this is good, because you are providing liquidity
From the founders' perspective this is excellent, because you are A) relieving exit pressure, and B) converting their cap table from uncapped and controlling upside to capped upside with no control...
Lastly, this solves the major con that was raised about the Flex Notes >>> TAX TREATMENT... Equity is more tax favorable... So all else being equal, we should prefer Flex Shares to Flex Notes...
Oh and one more thing, Flex Shares imply the possible existence of an entire round that would be done in this way, so the Flex Round... same idea.
Zooming out: we're creating a category of STRUCTURED capital that exists between equity and debt, that is counter-positioned against both VCs and Debt Funds, that exists at a logical point in the risk spectrum that nobody currently exists in... a blindspot in the capital markets
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