November 15, 2023

Investment Vehicles and Valuation

The Seedfunders Podcast
The Seedfunders Podcast
Investment Vehicles and Valuation

Show Notes

And we’re back.  Seedfunders podcast.  I’m Joe Hamilton joined by the co-founder of Seedunders, Dave Chitester.  Welcome sir. 

 Hey Joe.

I have to admit, I have the need for speed.  When I found out today’s episode was going to be about investment vehicles, I’m wondering – what kind of engines?  How fast are we going?  How high are we going?  Let’s rev it up!

We’re not talking about those kind of vehicles, Joe.

Oh no.

We’re talking about the ways companies invest – that investors invest in startups. In different types, whether it’s equity or a loan or another kind of financing.  That’s our topic for today.

When Angel groups invest in seed rounds, do they take control of a company like a private equity company does?

No, not at all. It’s best to explain this with an example. There are various ways to invest. I’ll start with equity, an equity investment. It’s called a priced round. What happens in a priced round is an equity investment where the investor and the entrepreneur agree on a valuation. Agree on how much a company is worth. For ease of math here I’ll say, say the company is – the agreement is the company is worth $1.8 million. That’s what we call pre-money valuation. Before the investment, the company is worth $1.8 million. If the investor invests $200,000, the post money valuation is then $2 million. The $200,000 gets added to the $1.8 million. Post money valuation is $2.0 million. Obviously, if the investor invests $200,000 in a company that’s worth $2 million, the investor receives 10% equity in that company. These terms are typically referred to as participating preferred. What that means is that when there’s an exit, and hopefully everybody makes money and there’s a high valuation investment, the $200,000 is returned to the investor. And then the investor receives 10% participation in the remaining distribution. Participating preferred is the name of that investment type. At SeedFunders we prefer equity investments on deals and any investment that we lead, we really want to see a participating preferred investment.

So, how do we determine valuation?

That’s the biggest question I get asked for every time I speak at a conference or anywhere is, how do you determine a valuation on a pre-revenue company? Basically, if you think about it, more established companies there are metrics. These are based on revenue or EBITDA which is Earnings before Interests, Taxes, Depreciation and Amortization. But a pre-revenue company obviously has no EBITDA. It doesn’t have any revenue. So how do you determine evaluation? It comes down to negotiation. I think somewhere along the line, someone told all these entrepreneurs if they have an MVP, they’re worth $3 million, because that seems to be the number that we see over and over again.

Typically, $3 million is the valuation that entrepreneurs are seeking. Well, it doesn’t mean you’re worth $3 million. We’ve seen valuations actually as high as 50 or $100 million which are really total of a fantasy. There’s no revenue in these companies. They can’t possibly be worth that amount of money. What it comes down to is, an investment is worth what somebody will pay for it. The company is worth what somebody will pay for it. Unfortunately, what happens a lot, the friends and family that come in – as I talked about the friends and family round – they don’t really know much about valuation. Often, we’ll see an entrepreneur say they’re worth $3 million, because they had friends and family that invested at that valuation.

A lot of them are very firm about the fact that because other people, people they know invested at $3 million, they expect professionals to invest at that valuation. SeedFunders however, we did a study actually in Florida of our investments and other investments. We found that a fair valuation for companies in this range, ranges between $1 million to $2.5 million. One million dollars if maybe they have an MVP, and they have some interest that we see maybe up to $2.5 million if they start to have some signed contracts and some early revenue. But basically, in Florida the numbers are between $1 million and $2.5 million.

California valuations however, and we’ve seen those. We’ve seen in Florida people give us what I call California valuations. And they are exponentially higher. Now, some have actually succeeded. I’ve seen some in Florida that have received valuation at those much higher valuations, but it is pretty rare. Not to say that it hasn’t been done. But we’ve also seen companies that refuse to lower the valuation and say, “We’re worth,” and I’ll use the example again, “$3 million.” In fact, two companies we recently talked to in the last year or two refused to lower their valuation. Said it was $3 million. I think one was $3 million and one was $5 million, refused to lower the valuation.

So, we did not invest, and within a few months both were out of business. If you think about it, they were worth then zero. So, founders need to be realistic on what their valuation is. And if you have a professional investor looking to invest at a reasonable valuation, then everybody wins.

What happens if you can’t agree on valuation?

Well, if you can’t agree on valuation there’s another way to do an investment. And that’s called a convertible note. There are two things or three things part of a convertible note. Basically, it’s a loan but it’s convertible to equity under certain conditions. And the long typically has what’s called a cap and a discount with interest. So, there’s three things: a cap, a discount and interest. It works like this. Say an entrepreneur says, “We’re worth $3 million,” and the investor says, “We don’t think you are, but we’d like to invest.” So, we will put together a convertible note with a three million-dollar cap. Now that’s not the valuation. That is the cap on the note.

These notes typically will include a 20% discount. And what happens when there’s a subsequent raise which is called qualified financing, if the valuation in the subsequent round – the qualified financing is an equity round basically – if it’s $3 million valuation then the note holder gets a 20% discount which is $2.4 million. Even though these new investors are coming in at three, the early investors holding the note would come in at the same round at $2.4 million. If however the valuation is higher then $3 million say $4 million. Then the investors come in at the three million-dollar cap on the note.

So, basically it’s a way to hedge the bets that the investor feels like. If the company is worth three, I’ll get a discount on that. If it’s worth more than three, I’ll get it at three when there’s an equity round qualified financing. Now, you don’t get the discount and the cap together. You get one or the other. So, either the discount for the cap as in the example I just pointed out. These convertible notes also include a timeframe. Typically, something like two years. And they’ll be an interest rate of typically 8%. That all then gets rolled into the financing, the future financing.

The other difference is typically on a convertible note, the note holder can foreclose on the assets of the company if it’s not paid back. But realistically, if the company can’t pay back the note, they’re probably not succeeding. And they’re not going to be in business very long. There’s really probably no value in foreclosing. There’s not much of the assets that are worth anything for foreclosing. Now, SeedFunders we don’t prefer convertible notes, but we have done deals on convertible notes when they’re led by others or there’s additional terms that can be in a convertible note.

So, you can always add terms to satisfy everybody in addition to the cap, the discount, the interest rate and the term of the note. We will talk about these in term sheets, and probably a future podcast, because you get pretty involved.

And another vehicle I hear a lot about are SAFEs. What’s SAFE?

Well, that’s funny. One investor I talked a year or two ago when SAFEs were first coming out said, “And now there’s this new thing. What the hell is a SAFE?” obviously, it’s a California thing. Y Combinator, an accelerator in California came up with this idea in 2013. A SAFE is a Simple Agreement for Future Equity. What it is, it kind of works like a convertible note, but it doesn’t have the security and the foreclosure rights. It’s very flexible, because basically there’s one document. It’s one document. Typically one, two, three pages. There are numerous terms like there are in the term sheet to negotiate.

It really saves a lot on legal fees. It reduces the time that an investor and an entrepreneur will get funding. The only thing that needs to be negotiated in a SAFE is the cap. So, it does have a cap but that’s all it needs to be negotiated. There is no expiration date. There’s no maturity date. There’s no interest rate. Now, Y Combinator says these terms are balanced. And they can be used in most situations without any modifications, but as I said that’s California. In Florida things are a bit different. I haven’t seen much use of a SAFE in Florida. Particularly, I haven’t seen any investment firms in Florida leading a deal with a SAFE.

So, I haven’t seen it when people lead deals in Florida. So, in Florida SAFE is regarded as not really investor-friendly. Here is one example of a SAFE. Since a SAFE has no interest rate and no maturity date, and no end date, if a company gets investment from a SAFE. And say it’s $100,000 or $200,000 and uses that money to become very successful. And never needs to raise additional funding, there is no mechanism in a SAFE to ever get it repaid. So, technically an investor can invest in a company with a SAFE, the company becomes very successful. And the company never has to pay back even the principal on a SAFE. Now, I haven’t seen that happen, but legally and theoretically it’s certainly possible.

So, in Florida SAFEs are not viewed as investor-friendly. SeedFunders has however participated in two SAFEs, but both of those were out of state investment firms, well-known investment firms out of state who basically negotiated the SAFE with the entrepreneur and said to us, “Take it or leave it. If you like the company and you want to invest, these are the terms.” Now, in both of those, we did due diligence. We liked the deal and we did invest. So, we have done a SAFE. We’ve done a follow on when the round was syndicated, but we have not led any deals with a SAFE.

One of those, by the way did lead to a priced round after one year. And the SAFE, I believe had a cap of $3 million on. The priced round was $4 million one year later. So, we got to convert our SAFE at a three million-dollar valuation and basically made about one third increase in value in one year. But the other investment is relatively recent. And I don’t have any stats on how that will turn out.

So, what’s the breakdown on how often seed investors use equity versus a convertible note or a SAFE?

Well again, the Halo Report which covers the whole southeast basically said that 47% of deals are equity and that’s preferred equity. Forty six percent of the deals in the southeast are convertible notes, and 7% are common stock or a SAFE or some other method of financing. So, basically when you look at the two most common ways of funding these companies; equity and notes, it’s about 50-50 use of equity versus notes.

Well Dave, it wasn’t exactly the kind of vehicles I expected, but it was a great ride.  Any final thoughts?

Sure – as always, we covered a lot in a pretty quick time today.  We talked about equity, we talked about convertible notes, we talked about SAFEs. I know I go pretty fast sometimes, outside the vehicle, not counting in a vehicle – if anybody has any questions on anything – again everything is written down in text on our website to review. Follow up with me at any time.

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