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when you speak to early stage founders
they often don't understand
how they can either determine a
reasonable valuation for their friends
and family
seed or series a round or judge if an
offer they receive is
fair and reasonable there are a lot of
moving parts to valuation
and things vary across rounds so let's
get into the details and also cover what
typical numbers look like
for these types of rounds i'll talk
about valuation issues in the order
things come up
so we'll talk about valuation and other
factors at play
during a friends and family angel seed
and series a round
as you go further in the capital stack
and as investors
tend to be more professional valuation
and deal terms can and do change
and i'll make sure to point out the
differences and pros and cons for both
founders
and investors
typically friends and family investors
are writing checks of ten thousand to
two hundred thousand dollars
often their family members or close
personal connections
who feel an attachment or affection to
the founders and or the problem the
startup wants to solve the normal
valuations you'll see
at the friends and family stage are
about a half a million to a million
dollars typically the range is pretty
tight
and the valuation is low the reason the
valuation is so
low is that the risk is enormous many
people know that over 50
of startups fail so this is an extremely
high risk investment
sometimes you'll hear these rounds
termed triple f rounds
friends family and fools while you may
have a great idea
the common expression you'll hear is
that ideas are a dime a dozen
and it's all about execution you very
well could have a great idea
but that's just the beginning and it's
the execution that's the hardest part
founders usually think their idea is the
next big thing and there's little chance
of failure
but this just isn't the reality and most
investors know that
even friends and family when friends and
family investors put money into your
startup it could be structured as a
convertible note which converts to
equity of the later stage
or could be done as equity by using a
convertible note you can delay
the valuation discussion about what the
company is actually worth
again a typical valuation at the friends
and family idea stage is around a half a
million to a million dollars
and often money is raised as a
convertible note or safe i'll get into
convertible notes and safes in more
detail in a bit
as well as their interplay with
valuation so after you've raised your
friends and family round
you'll typically raise your angel or
seed round angel investors usually write
checks
ranging from about fifty thousand
dollars all the way up to two million
dollars
but more typically the check size will
be somewhere between fifty thousand
dollars and two hundred thousand dollars
with some variation higher or lower
often angel investors don't have a
personal or family connection to the
founders
but they may have an attachment to the
problem being solved or
have worked in the domain valuations
you'll see at this stage are typically
between one million and three million
dollars and that's usually for ten to
twenty percent of the company
again like a friends and family round
often times this is a convertible note
or
safe type structure that converts at a
later round
a later larger equity round that
triggers a qualified financing or qf
when you hit a funds raised threshold
i've now mentioned convertible notes and
safes several times
so let's get into those as they have a
very strong interplay with valuation
you're about to see that valuation
does not live in a vacuum a point i'm
going to come back to
several times a convertible note or
convertible debt is capital that begins
as debt and converts into equity
upon a next qualified financing round at
whichever is
less the discount rate or the node's cap
discount rate and cap are super
important terms to make sure you
understand
convertible note investors are offered a
lower price via discount rate
to the next round than other investors
this is when the convertible note
investors funds turn into equity at the
next financing round
the most common discount rate you see is
20 this discount
compensates investors who came in
earlier in the company's life
for the highly increased amount of risk
they're taking on
we then have the valuation cap which
puts a maximum
not to exceed valuation on the company
for the next
equity round valuation caps offer
dilution protection to an investor
the lower the cap the better the deal
and investor gets
for the investor this prevents a runaway
valuation where in the very early stage
convertible note they took extremely
high risk
and they want to make sure that they can
convert into a meaningful portion of
equity in the next
equity round there are other important
terms to understand about convertible
notes
but cap and discount rate are the most
important ones
when dealing with convertible notes and
taking that back to the subject of this
video
often times that cap we've been talking
about is a tell
on valuation if a startup says they're
raising a seed round of one million
dollars via convertible note with a 10
million dollar cap
they're implying a valuation of about 10
million dollars that's a
not to exceed number but it's definitely
a tell and the higher that number goes
the less interesting it is to an early
stage investor
so keep that in mind to drive that point
home this is why many early stage
investors won't invest in
uncapped notes because they have no idea
what that valuation could be in the next
round and if they're going to get
diluted to almost nothing
there's one other very important and
more flexible structure to talk about
and that's a safe or simple agreement
for future equity this is a convertible
security not a convertible note
a safe convertible security has no
interest rate
no maturity date and no repayment
requirement
safes are more founder-friendly since
it's not debt if the company would go
under
the funds are not owed to investors and
similar to convertible notes
safes have discount rates and caps
so you can still defer the full
valuation discussion
so now let's think about the interplay
of convertible notes and safes and the
topic of this video
valuation think about this if you
received a term sheet
for one million dollar convertible note
with a five million dollar
cap and then we're lucky enough to get
another term sheet from another investor
for a safe
so convertible security not a note or a
loan
with a five million dollar or maybe even
four million dollar valuation cap
which offer would you take if they were
the same cap and all things being equal
you would want the safe since it's safer
for you no pun intended but if the
valuation cap were a little bit
lower on the safe say four and a half
million dollars you may still want to
consider the safe
so if things go sideways there is no
debt liability
valuation does not live in a vacuum
before we go on
let me share a few more things you
should seriously consider
as you think about valuation for your
startup for example
what happens with your employee stock
option pool does it come before or
after the financing comes in so do just
you the founders only get diluted when
the stock option pool is replenished
or does the stock option pool get
replenished after the funds come in
so everyone gets diluted this has an
impact
on what your effective valuation will be
what other things are at play that are
tied closely to valuation but are not
directly
called valuation how about what
additional rights or restrictions is the
investor
putting on the startup for example if
your startup wants to write a check or
sign a contract over twenty thousand
dollars
maybe the investor has to sign off on
that you're giving the investor
much more day-to-day control over your
startup you
thought you were running the show but
maybe not so
based on other terms that are baked into
the agreement another big factor in deal
terms to think about
liquidation preferences for example is
the investor asking for a 2x liquidation
preference
meaning if there's an exit the investor
gets back two times the money they put
in
before anyone else gets their money back
by the way the typical liquidation
preference you should be looking for
is a 1x liquidation preference so you
might get an offer or term sheet with a
slightly
lower valuation but with more favorable
terms regarding the employee stock
option pool
liquidation preferences and other rights
so the slightly lower valuation
may be a better overall deal for the
founders
and the startup the last big issue i
want to point out that we've seen by
founders in the ass
and caught them off guard founder
vesting let's say you and your
co-founder own 100 of the company
you're about to raise a seed round and
investors are going to write a check for
1 million
investors want to make sure you're going
to stay around so they're going to ask
you to vest into the equity of your own
company
otherwise they could write you a check
for a million dollars one of you
walks out the door and now owns a large
percentage of the company that they're
no longer working for
thanks gents for the cash and equity let
me know how it all turns out
not something an investor ever wants to
let happen what's typical
investors will ask you to vest over a
three to four year period into the
company
some investors may say you get a four
year vest but you also get a 25
credit for the time you've already put
in for time served
like i've said many times before the
terms and negotiations can get fairly
complex when working on deals like this
bring your a team and your a game
surround yourself with great attorneys
or accountants
who've done this before or other
entrepreneurs or advisors
who are highly experienced in these
issues and by the way if your aunt is a
personal injury attorney or your uncle
or friend is a divorce attorney and says
hey i'm a lawyer i'll help you do this
and get it structured and done
politely decline their offer and bring
in that a team
that has a ton of experience on these
particular types of issues
okay as we get closer to your series a i
want to talk about how valuation
becomes more mathematical based on some
pretty standard ratios
that are usually tied to one key thing
how much
are you raising in a recent dream of
dose we talked about how to figure out
how much to raise often this is a
confusing topic for founders
and they're not exactly sure how to
figure this out anyway
for early stage companies moving into
seed and series a rounds your valuation
is usually going to be
a ratio based on how much you're raising
typically an investor at this stage
wants to own about 20 percent of the
company
so if you tell me how much you're
raising i'll tell you based on this
ratio
what your valuation is if you're trying
to raise a two million dollar seed round
i'm going to tell you that your
valuation is going to come in at around
10 million dollars
20 of 10 million dollars is 2 million
now that's just a rough rule of thumb
could you get a higher valuation sure
let's say this is your third startup the
other two have been
huge hits that drove great investor
returns and you're working in a hot
space with an amazing team and
great early stage traction could you
raise two million dollars at a 20
million or even 30 million dollar
evaluation
sure it's possible not probable but
possible what you're working with here
is fair market value and what the market
is willing to bear
what's the price a reasonable buyer and
reasonable seller come to
if you go too high on your valuation and
no one will meet it
you won't get a deal done further you
could try to get a bidding war going
and get more than one investor offering
a term sheet so there is a chance the
valuation gets bit up
but what we typically see at the seed in
series a stages
is that the 20 rule mathematically
determines
your valuation now the final point i
want to reemphasize here is that
valuation is just
one of the many knobs and levers in a
deal unfortunately
it's valuation that seems to be the big
issue that most founders fixate on they
almost get
tunnel vision around valuation they're
almost thinking about
how their tech crunch headline is going
to read but be super
careful here otherwise you can get taken
to the cleaners on many
other terms founder investing employee
stock option pool
liquidation preferences and other
investor rights keep in mind that at the
end of the
day investors will typically set the
capper price not
you you can try but you may not be
at the fair market value and you may
over price
or under price your round over price and
the round won't close
under price and you may have sold more
than you needed to
the more investor interest you can
generate the better deal terms you'll
get
i hope you found this valuation
discussion helpful and if you did
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