In a prior blog post I discussed my views on valuing pre-revenue startups, more specifically my belief that in many cases the valuation debate is best delayed until the startup has progressed further and is at a revenue (or preferably profit) generating stage.

Chris Puttick, who is currently fundraising for his startup Two Ten, raised some valid points which have prompted this follow-on post.

First Things First…

What follows is a take on early stage investment from a purely financial perspective.

Clearly, angels and other early stage investors may have a variety of motivations for funding startups, including philanthropic aims.

However, I think it is fair to assume that at least some degree of perceived financial reward lies behind most investments of this nature, otherwise they could be structured in such a way as to minimise financial return to the investor (e.g. Oxygen Accelerator and their evergreen loans).

One Size Fits All?

The simple answer is that there is no ‘one size fits all’ solution.

Clearly, every fundraising situation will be unique, not only in terms of the fundamentals of the deal on the table, but also with regards to the risk profile and financial understanding of the investor(s) and founder(s) involved.

Investors vs. Founders

Straight Equity

Somewhat ironically, the solution that Chris proposes (investing straight equity) is weighted in favour of the investor, particularly when the various tax advantages of the Enterprise Investment Scheme (EIS) and its proposed sibling, the Seed Enterprise Investment Scheme (SEIS), for eligible UK investments are taken into account.

Convertible Debt

Equally ironically, my solution (convertible debt with no valuation cap) is actually weighted in favour of the startup founders, in that it enables founders to delay diluting their equity stake in the business until such a time as they can justify a higher valuation for their startup.

What is an upside to founders in fact leaves early stage, smart money investors (who use uncapped convertible debt to invest) in a bit of a pickle.

These investors will be actively helping their portfolio companies to achieve relevant milestones to increase the startup’s valuation. But in helping to increase the startup’s valuation in time for the next round of funding, they will actually be forced to pay a higher price when their debt converts to equity. Credit to VC Mark Suster for highlighting this argument here.

See also the blog post Angels: Don’t Use Convertible Debt to Fund Startup Ventures for further arguments against using converts as an early stage investor.

Other Forms of Consideration

There are a variety of other hybrid and derivative instruments that can be used to invest in businesses.

Examples include warrants and participating and non-participating preferred equity (which in turn have many derivations). Some of the valuation implications of participating preferred equity are outlined in this helpful blog post.

The issue with these instruments is that, whilst they can limit downside and increase upside for the investor, they typically require a valuation to be placed on the startup at the time of investment.

Why Establish a Valuation Prematurely?

From my perspective, it’s not establishing a valuation per se that I am against.

It’s more that it can be very tough to sensibly value a business from first principles at a pre-revenue stage, and relying on a ‘finger in the air’ methodology typically leaves founders and investors at opposite ends of the scale, unable to agree on a consensus.

Then, it boils down to the balance of power between the two parties.

If the startup is ‘hot’, then interest from other investors will drive the valuation up; definition of a bubble, anyone?

If the startup is struggling to raise funding, then the founders are either forced agree to a lower valuation (not the best of starts to a collaborative relationship), or the fundraising process fails altogether.

How do you Value a Pre-Revenue Startup?

Chris mentions in his comments:

The valuation of any company has challenges e.g. historical figures and trends are no guarantee of future revenues, particularly in tech companies and/or the longer term – additionally the revenue/profit multiplier used during valuation processes are essentially a best guess of future earning potential of the company and the value of the markets it operates in.

This I broadly agree with. However, with an established company you have a track record of financials on which to base your forecasts.

Sure, investors will take a view as to the future of the business, but this view is based on a solid foundation.

Without wanting to teach grandma to suck eggs, it goes back to the risk / reward equilibrium. Investing in a pre-revenue startup is a riskier game than investing in an established company.

Interestingly, the way that the early stage VCs I have spoken to appear to value startup companies is using more of a top-down approach. They will guesstimate the size of the market in which the startup is operating (which is a pretty big guesstimate if that startup is creating its market) and then backsolve revenues by guesstimating the proportion of the market that the startup will command at a later stage.

Chris continues:

Traditional investment valuation says I’m happy to give you £Xm or pro rata thereof because I believe the company’s value will be more than that in the future; but an EIS/SEIS investment (assuming the income tax relief can be realised in full) is a range of values; firstly 50% relief from SEIS reduces the investment risk and thus to a degree the initial valuation; then the CGT relief on the sale makes for an additional effective increase in the future value by the equivalent tax you would otherwise have paid.

I think that the first sentence is true for early stage investors. They are seeking capital growth and not income.

However, later stage investors may well be seeking an income from their investments (typically in the form of dividends for an equity investment), or capital growth, or a mixture of the two.

Valuation, and in particular forward valuation, is a tricky game, even in the public markets. Valuing an illiquid investment in a pre-revenue startup is nigh on impossible.

As regards the use of SEIS and similar schemes, this has got to be an upside to the investor and not one that is shared with the startup in the form of an increased valuation. The main reason for this is that the tax benefits of these schemes can be clawed back if certain conditions are not met. An investor would, in my eyes, have to be pretty naive to significantly alter their valuation based on a tax benefit that is not fully locked in.

Happy to be persuaded otherwise, however!

Does Issuing Convertible Debt Imply a Valuation?

Chris makes the following point around issuing convertible debt:

A convertible note is in a sense a form of valuation, it’s just a hidden one – one wouldn’t issue a convertible note of value X to a start-up without believing that (a) the company will in the future raise capital of an amount considerably greater than X and (b) that the company’s long term value will be such that your converted note will make your investment worthwhile.

Enterprise Value vs. Equity Value

I agree in part, although in my mind it’s important to recognise that issuing additional debt (albeit in the form of a convert) simply adds to the Enterprise Value of the company, and does not (whilst the debt remains debt) affect the equity value.

When deployed effectively, the debt can of course be used to increase the equity value of the company through value-enhancing initiatives. This, after all, is the primary financial reason that early stage investors seek to invest (capital growth), and that startups require external funding in the first place.

Downside Protection

As debt is senior to equity in a company’s capital structure, assuming that there are no other loans out to the company that are senior to the convert, all the investor needs to reassure himself is that the company will remain worth at least the value of the notes he has invested, in order for him to be able to recoup his investment.

Liquidation preferences are another way of achieving this.

Cashflow Considerations

The convertible debt will usually not have a cash coupon, so no cash interest payments will pass from the startup to the lender. The reason for this is that a startup will either be cashflow negative, or else be expected to utilise its free cash flow to drive growth and development in the business.

The debt might be structured as a Payment In Kind (PIK) instrument, where the interest element of the debt rolls up on to the principal. This would only be redeemed in cash when / if the debt matures. More likely, this would give the convert holder additional capital to convert to equity when a trigger point is hit.

So, unlike a traditional debt investor, an investor in a convert is not likely to be worried about the near-term cash flow profile of the business.

Similarly, an equity investor in an early stage company would be unlikely to seek dividend payments. That cash would be greater served by being retained in the business and put to use growing the equity value in the company.

Dilution

The other important point to note is that early stage investment is just that.

In and of itself, a seed round is unlikely to get the business to a stage where it is sufficiently cash flow generative to fund its expansion from internally generated funds.

It is highly likely that a further round (or, more likely, several rounds) of funding will need to be raised before the business gets to the stage where an exit can be achieved.

This means that, unless a seed investor follows on his investment with further investment at each subsequent funding round, he will get diluted (i.e. his percentage stake in the enlarged company will fall).

Luis Villalobos has written about what he terms valuation divergence far more clearly and concisely than I’d be able to manage. Well worth a read.

Essentially, it is important for founders to recognise that investing in a seed round for a minority stake in the startup does not imply that the investor will still hold that same percentage stake when it comes to exiting the investment.

As such, investors will either look to take measures to minimise the risk of dilution and/or to minimise downside risk.

Conclusion

I don’t pretend to have all the answers – far from it! In fact, I readily admit to being new to the world of early stage financing.

Having said that, I do think that my experience working at later stages in the business cycle gives me a good grounding when looking at investment opportunities, preventing me from making mistakes that less sophisticated investors might fall into.

On the flip side, it’s easy to over-think and to over-complicate matters.

Using an extremely complex hybrid instrument is unlikely to be the best way to progress with an early stage investment, but that’s not to say that relatively straightforward hybrid instruments should be altogether overlooked.

For me, the most appropriate use of convertible debt is in the context of a pre-seed or seed funding round. More specifically, a round that exists to give the startup sufficient runway to get to proof of concept stage, or to get to a product launch stage and achieve an element of traction within the market (and preferably revenue).

Of course, for some of the reasons Chris and I mention above, this type of instrument is far from perfect.

Therefore, I will continue to explore alternative solutions, with the aim of keeping the terms as simple as possible whilst giving all parties the various protections and access to valuation upside that they seek.

Any suggestions appreciated.

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2 Responses to Forms of Consideration for Early Stage Funding

  1. Some points I’d like to respond to…

    Dilution and convertible notes
    Dilution also happens with a convertible note, hidden away, but there.

    Taking the nominal £2m (post money) valuation start-up; our seed investor invests £50k as equity, getting 2.5%. An additional round of funding is sought to purchase a US competitor (for example ;) ). This round values the company post-money at £5m, with a £1m investment. This dilutes the seed investor’s % stake down to 2% (although the value of their holding is now £100k, and assuming SEIS income tax relief, means an effective 4-fold increase in the value of their stake).

    Same company, no formal valuation. The seed investor comes in with their £50k in the form of a convertible note with a 20% discount. An identical funding round is undertaken, this time with the investor converting their note at the discounted price. Now their investment is worth £64k, and their holding is 1.28%. Isn’t that a worse dilution? Additionally, their money already being in the business means the funding round raises less new money to grow the business with.

    Ok, so if you change the discount rate the final holding increases, but then if the valuation increases the final holding decreases – but either way there’s still less new cash in the business.

    And come to think of it I want my investors incentivised towards promoting the company’s maximum growth and valuations; it seems to me the convertible note could have the opposite effect.

    And on the convertible note and S/EIS
    This takes the form of a question… Does the existence of a convertible note preclude an S/EIS investment taking place at the same time? So if you have a seed investor who’s just spreading their investment money around i.e. a mixture of investment types, from ISAs and bonds to property and start-ups, they are likely to prefer an S/EIS investment because of the tax reliefs. Can the two types be included in the same round of investment?

    And finally… SEIS reliefs and valuations
    Everything that you can take into account should have an impact on a valuation; if there are tax benefits that benefit the company, like a special rate of VAT or R&D tax credits you take them into account, even though they can be withdrawn easily in the future. The SEIS benefits cannot easily be withdrawn; presuming the investment subscription could be written to prevent the company acting in a way that renders existing investments ineligible. Thus the benefits can be sensibly taken into account in valuing the company, as a contributor to the valuation range.

    • Mike says:

      Chris, you raise several points in your response.

      I think the big issue for me is the valuation debate, and this is what got me started thinking about alternative ways of financing a deal in the first place.

      The long and short of it is that founders want capital to help grow their business, and angels want to invest capital to support the business and achieve a return on their investment.

      However, in cases where the founders’ valuation expectations widely differ from investors’ valuation of the company, there are three possible outcomes:

      1) Enter into and resolve the valuation debate there and then. One party will likely feel hard done by.

      2) End negotiations. Neither party achieves their respective objectives.

      3) Delay the valuation debate. Use an instrument that rewards the early stage investor, whilst also injecting ‘runway’ capital into the startup.

      I agree that convertible notes (at least those with no valuation cap) may not be the best way of achieving this.

      Another option, which might be S/EIS compatible, would be to inject straight equity, but to award early stage investors with additional warrants.

      I would be interested in hearing others’ views on the matter. Maybe we are missing a trick here?

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