Seth Levine from Foundry Group touched off a debate on which is the best way to raise startup financing: convertible debt or equity. Paul Graham (intentionally or not) actually started things with a tweet, “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”

Fred Wilson joined the conversation, as did Mark Suster. All prominent and successful investors. And generally, they’re not fans of convertible debt. But oftentimes, entrepreneurs are attracted to convertible debt, and clearly with Y Combinator, the trend is moving strongly in that direction.

The two main reasons why entrepreneurs are attracted to convertible debt are:

• It’s supposed to be easier; and,
• It delays pricing the round.

Pricing a round and the value of a startup is hard. It can be an uncomfortable conversation to have with investors, and it can turn into a bit of a stand-off, where no one wants to be the first one to name a price. So I understand why delaying it sounds appealing. But the truth is that a convertible debenture doesn’t really delay pricing, especially when you set a cap on the conversion in the next round.

Let’s say I’m going to raise $500,000. And I’d like the pre-money value to be $1.5M. The post money-value would be $2M and the $500k is worth 25% of the company. That’s the way you would price it for equity. When you raise the next round, they would of course get diluted.

With a convertible debenture you’ll get $500,000 (and there’s interest payments to be made too.) When you raise the next round, the initial investors convert their debt into equity, but typically at a discount. Let’s say 20%. So in the Series A, when you now want to raise $2M and the pre-money valuation is $6M, the $500k is measured against a pre-money valuation of $4.8M. They would own 10.4% instead of 6.25%. (Not including interest in the calculation.)

But there’s also the issue of a cap. The cap is put in place by investors with a convertible debenture to peg the value of their debt (with the discount), regardless of what you raise the Series A at. So, let’s say the cap is $5M. Now when you apply the 20% discount, the first investors’ money converts in at $4M. They now own 12.5% instead of 10.4%.

Investors will peg the cap amount at what they think you’ll raise the Series A value at. If you raise a lower Series A they still have the discount and own a bigger piece of the company. If you raise a killer Series A at an astronomical value, the cap protects them.

When raising financing with a cap, you’re basically negotiating the price of the deal, it’s just the mechanisms you’re using (% discount and cap) are different than company valuation.

I’ve raised money as convertible debt. And I’ve spoken to others that have done so (and others that have raised money through equity.)

In my experience, it wasn’t any easier to raise financing through convertible debt. It didn’t take any less time, and it wasn’t that much less expensive. It might seem easier because it avoids the big question about “the price of your startup”, but it’s really not doing that. Remember: Investors know how much of your company they want to own, and whether they price the deal upfront or delay it through convertible debt, they’re likely (and you’re likely) going to end up pretty much in the same place.

Generally, I expect (and have seen) fairly common standards for early stage companies. So I would bet that most convertible debt deals are being done around the same % discount and cap numbers. The same is true when pricing deals (angels and investors have told me, “When we see an early stage deal, it’s always in this range…”) That might be less true these days with the market being as frothy as it would appear to be (in Silicon Valley) but I don’t think there’s a whole lot of mystery around the value of early stage companies. Assume that’s true, and the stress of “pricing a deal” is lowered.

For entrepreneurs, here are the important things to ask yourself:

• How can I get a deal done as quickly as possible?
• But without sacrificing value-add for speed (Yes, I do believe in “smart money”)?
• How can I make sure interests are truly aligned (as best as possible!) between me and investors?
• Being more blunt, can I stomach working with these investors for the next 3-10 years of my life?
• What deal is the least likely to bite me in the ass later and make my life miserable?
• Do I really understand all the math at play and the various scenarios (not just the good ones!)?
• How does taking this money really impact the strategy and focus of my startup?

Where a convertible debenture can be very valuable to entrepreneurs is for early exits that don’t require follow-on financing. If that’s the case, when a company is acquired (let’s say for $10M), it’s likely the debt will convert at the same price as was agreed upon if the company was to raise a Series A. So the initial investors get a smaller piece of the pie and the founders get more (compare 12.5% to 25%, because there’s no further dilution.) For a lot of web startups and founders, this is appealing. Raise a bit of money and see if you can exit before raising too much. And I think that’s a perfectly legitimate strategy.

Overall, the debate is an interesting one, especially because it helps shed light on how investors are thinking and educates entrepreneurs on the different investment mechanisms and strategies that exist. But I certainly don’t believe that a convertible debt structure is a slam dunk win for entrepreneurs when raising early stage financing.

In a recent conversation with a friend (and fellow entrepreneur) we were discussing a couple of his bootstrapped initiatives. He’s struggling with the pace at which things are going, partially because he has to “pay the bills” through consulting. That time away from his startup and startup projects is hugely distracting. I know the feeling, since I’m in the middle of bootstrapping a couple initiatives and doing consulting work as well.

But this was my comment: “Money doesn’t always accelerate things.”

Correction: Money does accelerate things, but not always in the right way.

One of my favorite posts about funding (that I wrote) is this one: What Does Your Brain on Funding Look Like? For starters, the visuals still crack me up (yes, I can laugh at myself plenty.) And it’s still so damn true.

So money does accelerate things. You spend more money, things feel like they’re moving faster. But is that necessarily real and useful progress?

The minute you have money you start doing things that you otherwise wouldn’t do. You hire people. You get an office. You create (or are forced to deal with) administrative overhead. You buy fancy business cards. You do more stuff but “stuff” doesn’t equal “success”.

While bootstrappers struggle to juggle their startups (typically non-paying at the start) and paying work, funded companies are juggling a whole bunch of other issues. Probably more issues. And they can also get lulled into a false sense of security because they now have “runway.” Runway is almost a meaningless concept unless you know where you’re going. A runway ends somewhere, and if it’s ending at a cliff, who cares that you had money to spend all the way?

Funding does accelerate things. It automatically creates a sense of urgency, but not a sense of focus. It doesn’t automatically make your product better. It doesn’t guarantee anything … except that you’ll spend more money.

Sebastien Provencher (from Praized Media) tweeted recently:

The great un-cracked opportunity: small and medium-sized businesses. #geoloco

He was at an event; not sure if someone said that or if there was a group discussing it. But it’s something I’ve been thinking about for awhile.

And there’s certainly a lot of truth to the statement. Most B2B startups immediately target small and medium-sized businesses. It looks so appealing; after all, most companies are small and medium-sized businesses. The SMB market (or SME – small & medium size enterprises) is conceptually easy to target – with such big numbers of companies, startups only need a very small percentage of them to have a real business, right?

Generally, here are the problems I’ve seen targeting SMBs:

• They’re often overwhelmed, unsophisticated and squeezed for cash. SMBs are getting bombarded with tons of opportunities to leverage social media, SEO, and now location-based technology to help their business. How are they supposed to understand it all and figure out what’s best?
• Small companies aren’t necessarily any easier to close than big ones. And if that’s the case – if your sales cycle is too long but the price of what you’re selling is low (because you’re selling to SMBs) – then you’re in serious trouble.
• It’s not as easy to get leverage between customers. Close a giant enterprise deal and you hope to get a case study, press release, public coverage and generate buzz. Close a deal with a mom & pop shop and no one cares. Plus, that mom & pop shop doesn’t know any other businesses for referrals. There are ways of getting leverage between small businesses (think: virality built into your app between businesses) but it takes new, creative thinking.
• Startups don’t sub-target into the SMB space effectively enough. Really, there’s no such thing as an “SMB market”, unless you’re providing something that they all absolutely need (for example, credit card transaction services, payroll, etc.) Most startups aren’t selling products or services that are applicable across all SMBs. So it’s critical to target very specific markets within the great masses of small and medium size companies.

There have most definitely been companies that have had huge success targeting SMBs. Freshbooks, for example. 37Signals (although they went even smaller to individual consultants/contractors to start). But the sheer size of the market gives too many startups a false sense of security that it will be easy to access lots of prospects and punch a hole in the marketplace. And this makes startups lazy when defining their target market and how they’ll access that market successfully.

Things certainly feel frothier these days. More and more companies are raising money, and valuations seem to be skyrocketing. But even in stronger economic times (we hope!) and bubblier eagerness to put venture and angel capital to work it’s still extremely hard to raise financing. And in many cases the amount of money you’re looking to raise isn’t particularly relevant.

Often it’s just as hard to raise $50,000 as it is $5,000,000.

And this is true for startups as much as it’s true for VCs. When VCs are ready to get a new fund off the ground they have to jump to our side of the table and raise the money. Big money. Hundreds of millions of dollars. Alan Patricof of Greycroft wrote a telling article for Business Insider titled: You Think It’s Hard To Raise Money For A Company? Try Raising It For A VC Firm.

When raising early seed money, the requirements and demands from investors will be lower. Investors can’t look at significant traction, measure revenue growth and assess a lot of metrics. But you will invest a disproportionate amount of time raising early stage capital, even if the amounts seem low. And investors are still looking for key things across the board – early stage or otherwise: a kick ass team, unfair competitive advantages, market understanding and a clear roadmap.

Mega-trends are good. Investors like mega-trends. There are lots of opportunities that exist as a result of mega-trends. For example: The population of old people is going to massively overshadow the population of younger people that can replace them in the workforce. That sure looks like a huge opportunity in the recruitment space!

But be careful. Riding a mega-trend isn’t the same as solving a real problem. Big, bold statements are great. Startups can very effectively align themselves with mega-trends. But it’s equally important to peel away the big numbers, inevitable trends, and macro factors that seemingly drive opportunity — and get into the nitty gritty details.

It’s not good enough to say (for example): “There will be too many jobs for too few people in the next 5-10 years. Employers will have significant staffing shortages. Competition for talent is going to increase drastically. That’s going to cause all kinds of problems. We help employers reach job seekers and attract them more effectively.”

No one can argue with statement #1. Or #2, #3 and #4. When pitching investors (or customers!) it’s helpful to get them nodding in agreement, even if you’re stating the obvious. So from that perspective the mega-trend is important and the supportive statements too. But it’s the last statement that’s problematic. That’s where there’s too little meat on the bones and a lack of specificity. I made this mistake with Standout Jobs. The mega-trends were there (and still are) driving social recruitment, the need to hire young people, employer branding, etc. But those aren’t “solvable problems.” We needed to, and worked actively on, getting much deeper into the problems and understanding the “real” (not macro-trending) world our customers were living in.

Going from an undeniable mega-trend to a refined, core problem … and even more challenging, to a refined, specific and quantifiable solution is where many startups stumble. They latch onto a mega-trend and convince themselves that they now understand a very specific problem that they’re solving. Or they use a mega-trend as a justification for building a product or providing a service that doesn’t have a really clear problem. The mega-trend becomes the problem.

For many customers, mega-trends are too big, complex and in some cases too far into the future, for them to really care about, at least when it comes to making purchasing decisions. If mega-trends inspired action by themselves, we’d all be looking for old age homes (we’re going to need ‘em!)

Startups need to find the acutely painful problem that customers suffer from and target that with a laser beam. The mega-trend provides context, but not the specificity of definition to drive real understanding of a meaningful problem that requires a solution.

Companies with the best record and most success at hiring top people don’t sit around and wait for those people to show up. They go out and grab them by the throats. OK, it’s fair to say that grabbing someone by the throat and dragging them to your office for a job isn’t going to work, but sourcing talent is extremely important.

Sourcing talent means actively recruiting. It means going out there, finding prospects, reeling them in, and getting them on board. Sure you can wait around for the top candidates to find your crappy job descriptions on crappy job boards and somehow be miraculously incentivized at that very moment to eagerly apply … but that’s like sitting around in a ghost town watching tumbleweeds roll by. Yawn…

And FAIL.

Without great people a startup cannot succeed.

Startups generally do a very bad job of sourcing talent. There are two simple (but inexcusable) reasons:

• They don’t know how
• They’re too busy

Those are both poor excuses, but I hear them quite regularly. The worst is, “I don’t have time to spend on recruiting, but I need people!” I’d argue that startup CEOs need to spend anywhere from 25-35% of their time recruiting (if not more!) It depends on the stage of the startup, but even as it scales and additional people get more actively involved in the process, startup CEOs and founders can’t delegate the responsibility. It might make sense to bring in a recruiting firm, but the ultimate responsibility and investment of time and energy must be made by the startup CEO and founders.

So how should a startup source talent?

Here’s how I’d go about it:

Build a Target Company List

1. Make a list of competitors. This probably already exists, which is great. If not, put a list together. Make it broad. Things you need to know per competitor include: size (# of employees), location (relative to yours), how well it’s doing (track stock prices for publicly traded companies, or record anecdotal evidence), who you know there.
2. Make a list of similar, local startups. Using the same criteria as above, make a list of similar startups in your area. “Local” might mean just within your city, but you could increase the geographic range as well. “Similar” means startups working with the same technologies, in the same area/space/industry, or those that have many of the same types of roles.
3. Make a list of bigger, similar, local companies. See #2 above, but instead of the companies being startups, make a list of all the bigger companies that have similarities of interest.

In rank order from most valuable to least valuable, you now have a pool of potential companies to poach from. That’s right, you’re about to go out and steal people from other companies! But think of yourself like Robin Hood, robbing others for the greater good! At least your greater good…

Leverage Friends

4. Assign someone to manage the lists. This could be a great job for an intern, or someone else within the organization. Tracking companies isn’t the key component of this process, it’s just for laying the groundwork. If there’s no one you can delegate this to, then you have to do it yourself. The lists need to be constantly updated and refreshed.
5. Leverage friends outside the target companies. With a target list of companies, you need to find friends that don’t work at those companies that can provide you with intel and introductions. You’re now starting to build a list of potential prospects.
6. Leverage friends inside the companies. Go right to the source. Find people you know within the target companies and see what you can find out. You’re looking for intel and introductions. Friends within the target list of companies may have loyalties to their existing employers, and that’s fine, you can respect that. But remember: You’re not doing anything wrong. Poaching talent is the name of the game.

One of the best questions you can ask friends is, “Anyone entrepreneurial there?” You’re looking for people that might have an entrepreneurial spark; the types of people that won’t ignore startup jobs, but may actually jump at the opportunity. Your friends can at least tell you if there’s ever been any watercooler or after-hours chatter about startups and entrepreneurship amongst the people they recommend.

Create a Target List of Prospects

7. Do your own research. Don’t rely exclusively on friends; do your own homework. LinkedIn is a great resource for this. It’s becoming easier and easier to find people, how they’re tied to specific companies, similar people to the people you’ve found, etc. Use Google too. And Twitter. Facebook has some interesting data as well.
8. Create a list of prospects. First off, it’s important to think of these people as prospects. Just like you would selling your wares to someone. That means it’s most likely going to take a few “pings” before the prospect is receptive, and you have to make sure the value proposition to the prospect is clear. Sell benefits, not features. In the case of recruitment that means you have to sell the benefits of the job, not the job requirements.

   Next, you need to decide what information about someone you want to collect. Name, email address, phone number — that’s fairly obvious. Social network participation could be worthwhile (so you can follow prospects on Twitter, Facebook, etc.) Their resume may be online, or at least they have a LinkedIn profile. Save that URL. I also like to take note of their career path and how long they’ve stayed at various jobs, especially the last one. Startup people tend to hop around, so after 2-3 years they may be getting antsy. That’s potentially the perfect time to pitch someone on switching.

   The health of their current company is also a potential indicator that a prospect might be ready to jump ship. There are lots of ways to track that information.

9. Rank the prospects. Using the criteria above (and maybe some of your own), you want to rank the prospects. This doesn’t have to be a superbly scientific exercise, but it’s going to be helpful from a time management perspective for yourself (and your existing employees.)

Work the List

10. Follow the prospects. Follow your prospects on Twitter, Facebook, etc. If they have blogs, add them to your RSS Reader. You want to get a feel for people over time, which will impact how you rank them.
11. Deploy your staff. You shouldn’t be the only one sourcing for your startup. Get others involved as well. They can follow some of the key prospects, especially if it’s in a shared domain space. Get your system administrator to follow and track the system administrator prospects.
12. Find multiple routes to the prospects. One introduction might be all it takes, especially if it’s a very strong one. But if you can only get a light introduction, look for other ways to connect. In some cases you can do this through social networking alone – a prospect might reciprocate a Twitter follow action, for example. But you also want to look for more people and stronger connections through your social graph. Who do you know that the prospect knows? What are the relationships? How can they be strengthened and leveraged?

Go for the Sale

13. Make your intentions clear. You can’t wait forever or be sneaky with a prospect about the recruitment process. Make it clear, pretty quickly, that you’re interested in speaking to a prospect about a job opportunity. You’re not offering a job at this stage; just trying to get to know the person better. You may have broader intentions too: Interested in sharing startup war stories, building your network, talking “shop”, etc. And those are great reasons for constantly building and nurturing your network. But I wouldn’t hide the fact that you’ve got job positions you’re looking to fill.
14. Get them hooked. As you build relationships with prospects you do want to move them into the recruitment funnel as quickly as possible. Sure, dating is fun, but you need to get married. Remember: Sell the benefits. By this point in time you should know what makes a prospect tick and you can tailor your pitch appropriately.

This is neither a quick or easy process — nor should it be. Plus it’s ongoing and essentially never stops. Recruiting great people is very hard. Doing it on a consistent basis is almost impossible. It takes more work than most people realize, and definitely more work than most people are willing to put in. But if you’re running a startup and not actively tapped into the talent market you’re going to lose out on the best people. Someone else is putting in more work, being smarter and more aggressive about recruiting people, and that leaves you in a dangerous spot. Without great people a startup can’t win.

For more information, check out these posts:

• 8 Things to Look for When Hiring Startup Talent
• 10 Steps to Successfully Sourcing and Recruiting Startup Talent
• How to Turn Your Company into a Recruiting Magnet
• The Key to Startup Hiring: Build a Magnet
• The Future of Recruiting is Inbound

This isn’t about stinky startups or startups that give you bad breath. But it is about startups that might make you cry.

Recently I’ve spent a lot more time meeting with entrepreneurs and listening to their pitches. It’s not in any formal sense, but I’m happy and eager to provide 30-minute or 1-hour blocks of time to startups, get to know them, listen to their stories and help out if I can. (Tungle me to book an appointment!)

And something I’ve seen a lot of late are startup onions. These are startups (or just ideas) that have many, many, many layers. The ideas are big, the implementations complex. And there’s a lack of clarity around what’s really important. This doesn’t mean the entrepreneurs and startups can’t be successful. It just means there’s a lot of work to do.

If you think of a startup or a startup idea like an onion, then you need to peel away many of the layers before you get to the true essence of things. During the process you’re going to cry. Peeling things away is hard. Peeling away the vision is hard. Peeling away features is hard (often for many people this is the hardest thing for them to do!) And the overall exercise of getting to the core of things is very hard. But it’s absolutely necessary.

Entrepreneurs need to work a lot harder and focus much more on the core components of their startups or startup ideas. Get rid of everything and go right to basics: What problem are you solving? Why will people care? How do you know if people have the problem you’re solving? How do you know how painful the problem is? How will you acquire users and/or customers? If you can’t answer these core questions, you haven’t gotten to the middle of the onion. So keep peeling!

image courtesy of Shutterstock

When I launched Standout Jobs I didn’t know much about the HR / recruitment industry. I could clearly identify problems in the space, and I was passionate about fixing some of those problems, but I lacked a real appreciation for the industry itself. This led to numerous challenges, and without a doubt had a negative impact on the company.

I was able to overcome some of those challenges, but my lack of domain knowledge, experience and expertise gnawed at my ankles like a crazed ferret. And in some cases I over compensated as a result.

Mark Suster points out that domain experience brings relationships. I recognized early on just how important it was to establish myself in the HR / recruitment space. I began blogging, networking, connecting with people on Twitter, attending conferences. With my experience in brand building and positioning, I was able to fairly quickly and successfully get some level of recognition in the space. But in hindsight, I probably spent too much time doing that, and overvalued those efforts. Without question there was value in establishing myself and Standout Jobs as leaders and innovators in the HR / recruitment space, but if I had gone in with domain knowledge and experience already, I would have started in a much better position.

One way to compensate for a lack of domain knowledge is to hire someone from the field in question. Logically makes sense. But there are risks as well. One of those risks is losing objective control and decision-making abilities to the “hired expert”. If that person is executing, so be it, but if not (and in some cases it’s hard to judge because there’s a lack of information), there can be serious difficulties within the startup.

Another tempting approach may be to outsource sales responsibility through channel partners. Be very careful about doing that. Channel partners may have a ton more domain knowledge and existing customers to up-sell to, but they require tons of effort and pose plenty of challenges on their own. Plus, without your own domain expertise it becomes difficult to judge partners, figure out how to motivate them, and drive success through them.

Mark MacLeod suggests that domain knowledge and aggression are the two startup founder traits that stand out. Is domain knowledge really one of the top two traits that define successul founders and startups? I’m cautious about over-estimating its importance, even in light of my own experience, but I do think domain knowledge provides a clear advantage.

The Lean Startup Methodology and Customer Development can most likely counter (somewhat) a lack of domain expertise because these strategies are driven by engaging customers, discovering key problems and then implementing solutions. Their systematic approach to building startups, finding product/market fit and scaling through information gathering & assessment help remove errors that might be caused by not knowing an industry. So you can “learn the market”. But even here, without true domain knowledge, you may not be asking the right questions when speaking to prospects, and you may be approaching things incorrectly (but simply be unaware).

In the world of startups there’s no such thing as perfect information. CEOs have to make decisions all the time with imperfect data. You can’t know everything. But those founders that have domain knowledge (versus those that don’t) have a clear advantage in terms of the amount and quality of data they possess. That makes it easier for them to make better decisions on a consistent basis. And generally that leads to winning.

When entrepreneurs are so driven by passion that they’re blind to the realities around them they often find themselves in big trouble. But what we see quite regularly at the early stages of startups is not too much passion but misplaced passion.

Ask yourself this question, “Are you more passionate about the problem you’re solving or your solution?”

It needs to be the former — the problem you’re solving — because there’s a very, very good chance that your solution isn’t the right one. Or at minimum, it’s going to change significantly through many iterations.

Entrepreneurs at the beginning stages of their startups fall too in love with their solution (and their ideas), and that passion drives them down rabbit holes. That passion, which every entrepreneur needs to succeed, has to be directed towards the problem or problems that the startup is intending to fix. If the passion is focused on the problems, it will drive entrepreneurs to make better decisions, focus on customers, and keep an open mind about the solution, and the likelihood for other solutions to emerge.

Startup founders need inordinate amounts of passion to succeed. Passion is the self-created drug that inspires startup founders to press on during tough times. Since the startup roller coaster goes from incredible highs to suicidal lows in a matter of moments, it’s important to leverage passion as a driving force. But when is there too much passion?

It’s absolutely possible to be too passionate. Startup founders get blinded by their passion all the time. Passion blinds us to reality.

Passion impairs our judgment. When things aren’t going well, and money is running out, startup founders have to make tough decisions about staff. Who do we fire? When do we fire them? How many employees do we fire? Passion delays tough decision-making. Compassion too.

That’s bad.

Passion compels us to launch startups and build products even if we’re not ready. Founders often say, “I’m doing it. No matter what. I’m building this thing.” Oh ya? Why? Are you sure you’re solving a super-painful problem? Have you validated anything with anyone?

Startups can’t succeed on passion alone. Startups are built in the current reality of our times (with an eye to the future.) Startups succeed with validated markets, a focus on key metrics, super strong teams, co-founders that get along, aligned investors, active customer service, etc. Startups can’t escape those realities.

When founders recognize the importance of focusing on metrics, markets, business models, user acquisition strategies, etc. — things based in reality — and they can successfully overlay an absurd level of passion on top, to drive their initiatives and intensity, they can succeed. That’s the balance. Passion driving reality. Sometimes passion pushes us past reality, and that’s fine, but we still need to find a balance.

Don’t lose your passion. But don’t let it blind you either.