Post Category → Funding

What a Valuation Cap Isn’t

Background Reading

In a nutshell, a “valuation cap” is a limit on the valuation that a convertible note will convert at upon a “qualified financing.” Seems simple enough, but there are a few serious misconceptions about valuation caps that I feel someone should clear the air on.  Here’s what a valuation cap isn’t. 

1.  A Valuation Cap is Not a Valuation

Sort of.  In the strictest technical sense, a valuation cap is not a valuation.  It relates to future valuations.  It also doesn’t (generally) require a re-valuation of the FMV of your company’s equity for stock grant purposes.  And if a Series A ends up happening at a valuation below the cap, it’s not exactly considered a “down round.”

But in practice, investors and founders often treat caps like valuations.  When you come across an AngelList profile saying a startup is raising $500K at a $4M ‘valuation’, the majority of the time they mean they are issuing convertible notes with a $4M cap.  This “sort of but not really a valuation” aspect of capped notes is seen by some as the best of both worlds: you get to price a round without all the costs of negotiating  a full set of equity docs.  Others see it as having removed the main benefit of issuing notes (instead of equity) in the first place: deferring a valuation discussion to a future date.  Both sides have good points.

2. A Valuation Cap does not guarantee investors a minimum % of the Company

This is the issue that really needs the most clearing up.  I’ve seen angels make the claim that a valuation cap guarantees an angel a specific % of the Company post-Series A. This is just not true.  In a theoretical sense, a valuation cap guarantees a minimum pre-Series A % of the Company, but the note-holder never actually owns that % because the Series A money comes in alongside the conversion.

Take the example in Joe’s post:

  • $5M cap, $200K in notes (assume no interest for simplicity), $2M in new money at Series A at a $10M pre-money valuation.

I’ve seen investors do the following math:

  • % Ownership Post-A = Investment / (Cap + Investment)
  • So: $200K / ($5M + $200K) = ~3.8%
  • Therefore, they say, the note-holder should own 3.8% of the Company after the Series A.

The problem, of course, is that the new $2M from the Series A is nowhere in this equation.  That 3.8% is a percentage of the Company without the new Series A money coming in.

When you do the math correctly for the full Series A (see Joe’s post), the noteholder’s % comes out to 3.22% of the Post-A company. That’s the number the investor(s) will see on the cap table after conversion. And it could be higher or lower depending on the economics of the Series A.

This kind of confusion shouldn’t happen if you’re working with seasoned angels who’ve done several investments that have gone on to raise a Series A.  But if you’re not (often the case in Texas), make sure they understand the math of their own investment so there aren’t squeals when conversion time comes around.

Don’t Ask Your Startup Lawyer for Investor Intros

Principle:  Nothing says “I can’t hustle” like a paid introduction.

A lot of young founders looking to raise seed funding for their startup go through the following thought process:

  • I need to get in touch with investors, but I don’t know any of them.
  • Well-known Startup Lawyers must know investors, and I need one anyway;
  • Therefore, I should ask the Startup Lawyer that I hire to make some investor intros for me.

The logic here isn’t bad. In fact, some startup lawyers emphasize their strong relationships with investors as a marketing pitch to companies.  Unfortunately, those relationships are sometimes too strong.

Yes, good startup lawyers do know many investors, and yes, they certainly can make investor intros.  The truth is, though, you shouldn’t want them to. Before I explain why, a bit of background facts:

  • Startup investors, particularly VCs, receive hundreds, maybe thousands of pitches every year.
  • There are very few areas of investing that carry as much uncertainty/risk as startup investing.
  • Therefore, investors rely on as many signals (shortcuts) as possible for filtering out founders that can’t build a successful business.
  • The ability to hustle (related to and including networking) is extremely important for a startup team, or at least the founder who will play the CEO/business role of the startup (investors will excuse a technical co-founder who sits in a closet all day coding); and
  • Finally, VCs often intentionally make themselves difficult to get ahold of as a way to test (find a signal for) the networking skills of founders.

As a sidenote: cold calling/e-mailing VCs almost never works, for the above reasons.

Hustle Deficiency

So here’s the big issue: if you type a well-known investor’s name into LinkedIn, there’s a 99% chance that you’ll find 100s of different “paths” to get an introduction to that investor. Twitter also often helps, as do AngelList, Accelerators, etc.  Now, of all those paths to a warm intro, what do you think it signals to the investor if the only person you could find to introduce you is someone you’re paying?  The first thing that will run through that VCs mind will be something like “huh, well, putting aside the actual business idea, the founder clearly sucks at networking.”  That’s not a first impression you want to make.

A second thought might be, “maybe they’re not bad at networking, but just couldn’t find someone to sincerely recommend them.” You get the idea. Having your lawyer introduce you to investors isn’t too far off from having your mom write you a reference for a job.

What good is my Startup Lawyer then for helping get investment?

Does this mean whom you hire as your Startup Lawyer is irrelevant as far as finding investors is concerned? No, it still matters, just in different ways.  A knowledgeable startup lawyer can help with (i) how to approach particular investors, (ii) making recommendations as to which investors would be better targets, and (iii) signaling to investors that there’s been some “adult supervision” in the Company’s development to avoid legal land mines.

Because reputable startup lawyers are (often) selective as to whom they represent, a good startup lawyer can also signal that, by representing you, he/she at least thinks your startup has good prospects.  Granted, a lawyer’s business judgment isn’t exactly on par with Warren Buffet’s or Paul Graham’s (obviously, he wouldn’t be lawyering if it was), but it’s something.

Nutshell:  Ask your Startup Lawyer for suggestions on whom you should seek intros to, and on how to do it, but don’t ask him for the intro itself.  It’ll just make an investor think that, because you resorted to a paid intro, the company lacks a competent hustler. Nobody wants to invest in a hustle-deficient startup.

SAFE: How Founders Should Paper Their Own Investments in Their Startups

YCombinator has made a splash over the fast few weeks regarding its new SAFE (Simple Agreement for Future Equity) security that it will be using for investments in YC startups. It accomplishes everything convertible notes do, without the “hammer” of a maturity date (i.e. the money coming due if another financing never happens). Open question how far the document goes in the broader investment community. It seems everyone took to their blogs to comment on SAFE’s provisions, so I’m not going to repeat that here. Instead, here are some links:

I’d like to establish a point that (I think) hasn’t been touched upon by the startup bloggerati: that, regardless of whether SAFEs get much traction with investors/startups broadly, SAFE appears to be the perfect way for founders to paper their own capital investments in their startups.

Background Reading: SHL – Founder Convertible Notes

  • At the inception of a startup, founder stock should generally be issued at a very low per share value: typically $0.00001 per share.
  • Issuing the stock at a higher per share price (for, say, a founder’s investment of $20,000) potentially establishes a Fair Market Value of the stock that will make it much more expensive for future employees to receive equity in the company, which negatively impacts hiring.
  • “Founder Notes” are a way to (i) issue founder stock cheaply, but (ii) still paper a founder’s investment of serious money (aside from sweat) in her/his startup. And (in my experience) later investors like to see the extra “skin in the game” from a founder.  They’re not happy about it being reflected in a debt instrument, but it’s usually a net-plus for the founder.
  • But one downside is that, in the case of multiple founders, by issuing founder notes you’ve just handed a co-founder a very sharp object to use against the Company (and other founders) if things don’t go as planned and the note never gets converted. Founders sometimes end up hating each other. Better to keep the weapons in the closet.

Solution: SAFE – The “Discount, No Cap” Version

  • 20% Discount should be fair
  • I suggest the uncapped version because founders shouldn’t be setting capped valuations at the formation/early stages of the Company.
  • SAFE is also a bit more digestible to those Angels who may have a problem with Founders having a debt claim on the Company.

Founders now have a standardized security to paper their personal investments in their startups, (A) without screwing with the Company’s FMV and, more importantly, (B) without giving disgruntled co-founders a way to blow up the Company at a “maturity date.” 

Nutshell: Founder Notes were a way to paper a founder’s investment of personal funds without messing with a startup’s FMV, but “maturity” created a problem in a multiple founder context. SAFE resolves that problem. While it’s an open question how much SAFEs will be utilized by investors, they should be strongly considered for papering founder investment.