If you want to raise capital for your business, part of getting it right is structuring your deal and getting the valuation in the right place.
I have recently seen a number of deals where the valuation was just too high and I thought to share some insights on this as I have found myself repeating this advice.
My VC fund invests 20% of our dollars into later stage seed rounds that we define as financing rounds where the startup has raised a minimum of $500k of non-founder cash financing, but is not quite ready for the VC series A round of $3m to $10m. 80% of our fund invests in series A, B, C and beyond, but as you can see we are very active in this early stage of funding and see valuations not only in the Valley and NYC where we live, but all over the US and Europe.
These early financings are often structured as convertible notes. I get into lots of detail on this in my book, but at a high level a convertible note is a typical way early stage financing rounds are completed where there are many angles and institutional investors like my fund and angel group participating.
The key components of a convertible note are 1) the cap, 2) the discount rate, 3) the interest rate and 4) the conversion feature of what happens if the company is acquired in advance of a priced round.
When an investor wires funds or writes a check investing on a convertible note, the money is accepted by the startup as debt with a document known as a promissory note or convertible note (different terms for the same thing). Then when the startup eventually completes a priced round such as a series A with a VC or any investor where equity is sold for cash financing, the debt from the previous financings converts to equity at the time of that future financing.
With a typical convertible note the debt converts at the lower of a) the specified discount rate to the next pre-money valuation or b) the cap specified in the note. For example, a convertible note might have a cap of $5m, a discount rate of 30% and an interest rate of 6%. In this case the startup could raise money from many angels and seed stage funds like mine under these terms and have zero legal costs for closing the financing. We can give you the legal docs you need for free to do this.
Then after some time goes by and the startup puts this money to work making progress they might close a series A funding round from a VC fund like mine and that series A would typically be a “priced round” where investors buy equity in the company rather than put money in as debt. In this example, if the pre-money valuation were lower than the cap, so for example if the VCs invested $2m on a pre-money valuation of $4m buying 33% of the company then the total amount of money invested on the convertible note would convert at a 30% discount to the $4m pre. So the angels or seed investors get 30% more equity in the startup dollar for dollar than the VCs who came in later when the risk was lower and the company was that much closer to an exit.
If the pre-money of this next priced round were higher than the cap of $5m, say a pre of $10m, then this would trigger the cap. So rather than the debt converting at $7m, a 30% discount to the $10m pre, the debt would convert at the cap of $5m.
OK, you probably already knew all of that; so here is the interesting part.
I am seeing startups ask for a cap of $10m or $7m when they only have a drop of validation revenue like $10 or $50k per month. Or even worse they are pre-revenue all together and talking about what they did at their last startup.
I think the founders think that this last convertible debt round or even priced round priced at $10m pre is the last seed money they need to get the company to that coveted series A of $3m or $10m of cash funding that will really let them hire a big sales team and add all the bells and whistles they think will be required to totally delight their users and customers.
BUT HERE’S THE PROBLEM. Shit happens and this current bridge round may burn up and the traction will not be there to enable the startup to secure that big series A funding and the startup will very likely return to their existing angels and get the knee pads out to meet more angels and need to raise yet another angel round before going to the VCs with success.
So if they completed their last financing at a valuation of $10m and 6, 9 or 12 months later the numbers are up but not enough to get to a series A the “Obama Hope” of this shinny object may begin to fade and to get the next round of cash it the door they will need to drop their valuation.
This may spook many of the inexperienced angels that initially supported the company. Some of these angels may think of this like buying shares in the public markets and think, “Gee I bought shares in startup X at $100 per share and now they are raising a round at $50 per share; so I am down 50%. I lost $100k or $500k – not good! I will not put good money after bad.”
SO HERE’S THE GEM OF ADVICE FOR STARTUPS!
Complete this next round at a cap or pre-money valuation of $3m or $5m. If the numbers fly off the hook and this brings the company to the series A then great. If not then the company can point to the progress it did make with the product, team and numbers and raise the next angel round at a valuation of $7m and then another one at $10m. The incumbent investors can tell their spouses that they invested first at $100 per share and now are investing at $150 and $200 per share and it’s going up like Twitter. They may double the amount of money they put in at the next higher valuation compared to what they first invested.
If you listen to bad advice and go for the $7m or $10m valuation when your revenue is only $10k or $50k per month then you are putting the entire ship at risk. What are you going to do when something goes wrong? Do you think you will go back to your angels and oversubscribe your next financing round at pre of $20m or $40m?
There are enough challenges with bringing a startup to the finish line of success that it just does not make sense to cut your legs off by making it that much harder to complete your financing rounds as a result of stupid valuations and being greedy and worrying too much about dilution. God help you when you need to raise more money and all you have are good explanations why this is proving slower than you expected to hit the metrics that justify your next or previous valuation.
I know a company that raised a $500k seed convertible note every 6 months for 2 years and then closed a big Series A with BlueRun. Yup, that was 4 angel rounds before the VC round. That company is now in play for M&A at $350m+ and everyone will make money. One thing that did not happen with that company was that it did not run out of cash. The CEO of that company was actually a General Partner at a big VC fund before becoming CEO of that startup.
Also keep in mind that a VC like me needs to see and believe in a very realistic 10x return when we invest early and a minimum 4x return when we invest in later stage deals. So if I am investing in a later stage company now and it is going for $9bn, I need to be convinced that this company can exit at a minimum of $40bn. If I am investing in a Y Combinator company with a cap of $10m I need to believe that I can sell the company in 1 to 3 years to Facebook, Google, Yahoo or Twitter for at least $100m. If that company at demo day had a cap of $3m I might feel very confident that with my help I could sell it to Yahoo or Google for $30m and I can get comfortable with a minimum 10x return for my fund and I’m ready to get my shoulders behind that company.
And please do not dismiss this as a VC that is a bottom feeder looking for a bargain. I am in this to make a billion dollar exit and not leave any dead bodies on the beach that can be avoided. The reason I wrote this blog post is to make sure startups don’t stall when they have no option to raise an up-round for angel funding and they run our of cash and die. May you all be funded and prosper!