There are several ways to finance a startup at inception. The traditional route is your own pocket and sweat equity or a “friends and family” round. Seed investors like angels and angel groups come next along with seed funds.
Typically these rounds are no longer priced rounds but are valued as debt or convertible debt. I have written about convertible debt in the past. There are different kinds of notes. The primary ones are capped and uncapped notes.
A capped note basically says to the world what you want your valuation to be. VCs that come in next rounds will look at that cap and immediately anchor on it. It’s not a smart way to fund a business over the long haul but I know they are in vogue.
An uncapped note is free money for the entrepreneur with all the risk being borne by the investors. I never have, nor will I ever invest in an uncapped convertible debt note. Our fund will never do it either. It’s bad financial management for a fund manager to do it on behalf of their LPs.
Even if it’s a bridge round between financings, there should be a hearty valuation discussion. A note might not be the best way to do that bridge. Maybe selling straight equity at a valuation is better.
However, I was thinking there might be some middle ground.
What if an entrepreneur said, “We are doing a delayed cap convertible debt note.” What do I mean by this? We all know the song and dance that is played when pitches happen. Entrepreneurs say it’s a market that is trillions and trillions of dollars and they only need a 5% slice to create a multi-billion dollar company. Their expected sales look like the hockey stick graph Al Gore used to show global warming. First two years they lose money. The third year they break even, or maybe lose a little or make a little. The fourth year they make a lot. Fifth-year they are off the charts.
Of course, if you didn’t think they could build a blow out company you wouldn’t invest.
Here is a different idea that might work for some businesses.
- Investors put money in with NO pre-agreed cap. All they get is 20% discount to the next round plus some interest rate like 8%. If it’s a SAFE, no interest.
- Investors and entrepreneurs agree on some metric to base the cap of the instrument on at some point in the future. For example, “We will take the average of the first (xx number) months of sales and multiply it by 5x to get the cap.” If you are hitting $100k per month in sales, cap would be $5M. This is totally negotiable. Negotiations can happen around the length of time, multiple of top-line revenue. Maybe the revenue should be averaged, maybe not.
- Entrepreneur proves out their business and gets a pre-agreed fair price to give up equity in the business. The investor gets a cap based on actual performance and not a crystal ball.
I have done capped notes, straight equity and a deal like I describe above. I don’t mind the above because it’s based on the execution of the business. It’s objective and agreed to by the entrepreneur and investor. It might even work with bridge financing. Suppose my company’s last financing was a $15M post. I need a little more to get to where I need to be to get next round financing. Why should this round go off at a higher valuation when I haven’t proved it-yet I have made progress so $15M seems low? The above structure bases value on actual value the company pulls out of the marketplace.
What do you think?