In the startup world, convertible instruments have long been used to avoid the significant difficulty in valuing early-stage companies. However, what happens when these instruments become part of the solution?
Convertible instruments, such as those used in early-stage transactions, are now equipped with valuation caps. These ceilings limit the amount of capital that early-stage investors can borrow and convert into stock ownership. These caps are designed to protect them from sudden and unexpected growth.
Unfortunately, the use of valuation caps as the proxy for valuing a company during the investment time is becoming more common. This can create unnecessary complexity for both investors and inexperienced founders.
Despite the efforts to prevent the use of valuation caps, many founders and investors still resist the temptation to discuss the value of a company when the takeover is happening. This happens to be more true in situations where the cap “ceiling” values the investment at the time of conversion. For instance, the old pre-money type of valuation cap for SAFEs issued by Y Combinator and the newer post-money cap for SAFEs issued by other companies both expressly values the investment at the time of conversion.
There is a better method to value early-stage companies. It is the interim RoR (rate of return), which takes into account the various factors that affect a company’s value. Despite the intentioned nature of these caps, they have brought back valuations to the negotiations involving early-stage convertible instruments.
Various factors make it difficult to value early-stage companies, and there are many steps that entrepreneurs and investors should take to make it easier to do so. Some believe that it is difficult to value early-stage companies due to their lack of revenue, and limited assets.
However, these arguments don’t take into account the most important factor that investors and entrepreneurs should consider when it comes to valuing a company. Most of the time, early-stage investors are investing in a stock ownership structure that will only fully exist once the founders’ vesting schedules are completed. Despite the intentioned nature of these caps, they have reintroduced valuations to the negotiations involving early-stage convertible instruments.
Dil Bole Oberoi
