“(Valuating early stage startups) really is an art. Entrepreneurs (and professors) would love for it to be something that we just throw an Excel spreadsheet at. But there is no perfect methodology to establish the pre-money valuation of pre-revenue ventures.”
– Bill Payne, Seasoned Angel Investor.
Valuating early stage companies is hard. Justifying the value to the investors is harder. The early stage companies typically have not made sufficient progress for traditional startup valuation techniques to apply. For example, revenue multiplier or EBITDA (Earnings before interest, taxes, depreciation, and amortization) multiplier are useless for the valuation of a pre-revenue company.
“Revenue multiplier or EBITDA (Earnings before interest, taxes, depreciation and amortization) multiplier are useless for the valuation of a pre-revenue company”
The early stage companies need to be evaluated on the basis of what problem is being solved, size and growth of the market, company strategy, strength of the management team, early product or prototype, and user validation. Most of these are very subjective parameters that make it very difficult to determine the value of a seed stage company and to justify it to early investors.
Challenges for Entrepreneurs:
After a difficult journey of incubating a business concept and getting to a stage where they ready for initial seed funding, valuation is one of the biggest dilemmas the entrepreneurs face when dealing with angel investors.
- How can I valuate the company so that it is not ridiculously overvalued and would not turn off the investors?
- How can I valuate the company to ensure that the co-founders and early employees are not shortchanged by grossly undervaluing the company?
- How can I avoid spending critical business cycles in trying to justify the company value to the investors instead of focusing on my business?
Challenges for Newly Accredited Investors:
Per JOBS Act (Title II), the accredited investors are individuals who make over $200K annually or $300K as a household or have a net worth of $1 million dollars excluding primary residence. These newly accredited investors, who generally did not invest in startups, are now in a position to do so. Once they like a deal/company, there are several issues that become inhibitors to move forward:
- They are unable to determine the valuation of the early stage companies since they do not possess previous startup investing experience.
- Majority of them are not super wealthy and investing is not their full-time job. As a result, they do not have the bandwidth to get involved into deep due diligence.
The disconnect between the investors and the company founders about company valuation either slows down or derails the financing process. Even when the investors like the deal and entrepreneurs need capital, they are unable to move forward since both parties often can’t come up with mutually agreeable valuation swiftly.
“The disconnect between the investors and the company founders about company valuation either slows down or derails the financing process.”
SAFE resolves the valuation gridlock:
A SAFE (Simple Agreement for Future Equity) is a relatively new instrument that has become very popular to raise capital for early stage companies. It is being used by early pre-revenue stage startups that are difficult to valuate using traditional multipliers. SAFE allows an investor to invest capital in a company in exchange for a promise to issue equity in the future that would be priced at the valuation determined by professional investors (such as Venture Capitalists) while raising (typically Series A) the first institutional round.
SAFE allows an investor to invest capital in a company in exchange for a promise to issue equity in the future
The question in the seed investor’s mind – if I am getting the same value as the Series-A investors, what is my reward for the risk of investing at a much earlier stage? SAFE allows following provisions to reward the seed investors and to compensate for their risk:
- Discounts: An entrepreneur can offer the seed/SAFE investors a discount off the price paid in the Series-A round while converting the SAFE into equity. The typical discount rate can vary from 10% to 20%. For example, if the Series-A investors pay $10 million in exchange for 10 million shares of a company, a seed stage investor who invested $10,000 at the earlier stage (at 25% discount rate) would get 13,333 shares (at a price of $0.75 per share) instead of 10,000 shares at the Series-A price if there were no discount.
- Valuation Cap: An entrepreneur can offer the seed/SAFE investors capped conversion price so that the seed investors can realize upside if the company makes a lot of progress with the seed capital and secures a very attractive valuation for its Series-A round. For example, if the valuation cap in the SAFE is $10 million and the Series-A investors end up valuating the company at $20 million pre-money, then the seed/SAFE investors would get the lower valuation ($10 million) while converting the SAFE into equity and thus benefit from the significant appreciation of their investment.
Several startups offer either discounts or valuation cap to compensate for the risk of seed/SAFE investors. Some companies make it further attractive by offering both discounts and capped valuation.
“SAFE is a contract where the seed investor invest their money now and agrees to take the terms the next institutional investors (Series-A) receives with additional benefits of discounted price and/or capped valuation.”
Difference between a SAFE and a Convertible note:
- SAFE is a relatively simple instrument with a simple 5-page agreement while the convertible notes could be very complicated
- Unlike convertible notes, SAFE is not a debt instrument and it does not carry an interest rate.
- Unlike convertible notes, SAFE is not a debt instrument and it does not have a maturity date. The entrepreneur does not have to pay principal and interest back if the conversion to equity is not very attractive for investors.
In a nutshell, SAFE provides an increasingly popular instrument for seed stage investments in pre-revenue companies where the investors and founders agree to let the institutional (typically Series-A) investors determine the valuation while ensuring that the SAFE investors get compensated for their risk and the company is able to raise money faster and execute on its business plan.
DISCLAIMER: The information contained in this blog is not legal or investment advice and it is for informational purposes only. You are advised to consult your legal and/or investment advisor for getting expert advice.
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