Why Your PreSeed SAFE Note Val Cap is ‘Low’ and Why You Want it to Be

One of the most difficult early conversations as a venture capitalist, especially a super early stage investor, is around valuation or valuation cap for a company that does not yet have revenue, or a product but perhaps has some intellectual property and spent a long time developing the technology.

The obvious reason this is tricky is because, well, how does one value something when it’s not even clear what it is yet, or it has no comparables? And often founders will say “but $15m million has been spent on developing this” as metric for setting a valuation, but as with any company, including public companies on the ASX or NASDAQ, value is not at all related to the amount of investment spent on building the company (*cough- WeWork -cough*).

Often the friction around valuation is rooted in issues that have less to do with the concept of market value — what it’s worth in an open and fair market, which is subjective — but about the concept of dilution and equity.

In my experience, valuation at the seed stage has little to do with intrinsic value, but structuring a partnership to set the company, the founder and the investor up for success. In that partnership, as an investor, you are buying into the founders vision and a desire to back that vision early when the risk is higher, as a founder what you are buying into the journey the investor needs to deliver on to provide you with the capital. When both of these are acknowledged and understood and they enable each other, often the friction falls away. And this is worth digging deeper into because there are nuances and factors that I think are often not said out loud often enough. Let me explain.

Founders often don’t want to give up large swathes of equity too early, for fear this will leave them with little to no autonomy or control. And this is a completely fair and understandable concern. They know that every time they raise additional equity they will be diluted further, and so feel protective of retaining as much equity as possible at the beginning to minimise it. I think most parties understand this. I also think sometimes founders feel pressure to negotiate the highest possible valuation at the seed stage, to prove to their potential investors they are ‘commercial’, and can hold their own. I definitely understand that drive, and I think at later stages this is important where there are clear valuation metrics and every dollar counts for later stage investors ROI. However, I think that can be counter productive at the pre-seed or seed stage as I’ll dig into further below.

What I suspect is less understood is what the seed stage venture investor is trying to solve for. The seed stage investor isn’t really trying to get he lowest valuation per say, what they are ACTUALLY trying to solve for is how to ramp up to the largest shareholding they can manage in line with their investment strategy, over multiple tranches or rounds, before the largest valuation uplift. After this, then the goal is to be diluted down as the company raises additional capital through later stages, before finally divesting and exiting. This is the playbook for a great VC investment which typically across the portfolio has to deliver on average a DPI (distributions to paid in capital) of 5 x.

The seed investor who wants to follow on, generally has no interest in owning too much of a company early on, because then the founder isn’t aligned, and it often can’t/doesn’t want to be the majority pro rata investor supporting subsequent financing rounds. The goal for the seed stage VC (particularly one who has the depth of capital to follow on) is a goldilocks equity position where it can, alongside the founder, benefit from the greatest valuation uplift before the larger quantum’s of capital are invested. Because success as a VC is a function of both time and returns.

Good VCs will help founders achieve this valuation uplift throughout these early rounds through advice, networks, blood sweat and tears etc, and the first part of helping this process is having the discipline to not invest at too high a valuation early on, to make the economics and process of multiple rounds of investment work for both the founders and the investors.

To illustrate this let’s look at two companies raising a $1.5M seed stage round and need an investor who can at least invest in the subsequent $10M Series A round. Both companies have spent $15 M in grants on R&D to develop some technology which is not yet proven commercially. Both companies need $1.5 m seed investment to support their commercial proof of concept and get first customers and the founder starts with 50% shareholding in each. One company demands and gets a valuation of $15M for its seed stage round, the other a valuation of $5M. In the first scenario, the investor gets 9%, the second scenario the investor gets 23%.

Assuming everything goes well, for the investor to make 5 x its money on that seed stage investment, the first company needs to achieve a valuation of at least $83m (without raising any further capital)…..which is a difficult task for most pre seed companies to achieve. 99% of companies will need to raise more capital to achieve the kind of value inflection milestones that would justify such a valuation, and this means more capital will be required of the venture investor in order to maintain their pro rata. Which then means a vicious cycle where an ever increasing valuation is needed for the investor to be successful for it’s cumulative investment. Boohoo for the investor, you might say, that’s why they pay them the medium sized bucks.

However it does affects the founder. Assuming a Series A round of $10m capital is needed to continue to scale market traction, and the market comparables suggest the appropriate pre-money valuation at series A is $40m, the seed investors pro rata obligation is only $900,000, meaning the founder needs to find other investors to stump up a further $9.1M. And as anyone who has raised money knows, fundraising and bringing on new investors is time consuming work especially when the existing investors are contributing less than 10% to the round. Furthermore, the seed investor has to now go to the investment committee to tell them that they need to approve a further investment to help them make their target 5 x on the original investment which increases the risk profile of the entire investment. As a result, the company needs to achieve a valuation of approximately $125 m for the seed investor to make 5 x its accumulated invested money. Putting an ever increasing pressure on the business along the way to hit a difficult valuation and potentially needing to raise increasing quantum’s of capital to get there.

Contrast this with the company that raised their seed round at $5m valuation, and the investor only needs to see that company increase its valuation to $30 m in order to see a 5 X return. Which increases the chances the investor will see their target returns even within one round, and makes the ability to raise a second round much easier, because the burden isn’t on the company to achieve a valuation that is ‘out of market’ relative to its performance (given the series A comps suggest a premoney of $40M is fair). The pressure on the founder is lower, the investor is happy, they have a much easier time committing to their pro rata in any subsequent rounds because they can tell their investment committee that the investment has met expectations and is in line with market comparables. Then if series A round of $10M is raised then the original investor has to commit a larger quantum to retain their pro rata — in this case $2.3M, meaning the founder has to raise less money from new investors and can confidently tell new investors that existing investors have already filled almost a quarter of the round. You want an investor who can invest in multiple rounds and to take a material slice to make your task of subsequent fundraises easier. Trust me. The seed investor still only needs to see an exit valuation of $82m to make 5 x its money on the cumulative investment and the company has still managed to achieve the same milestones with the same capital, but with far more ease and more wiggle room if things don’t go entirely to plan.

Its important to understand that in the two scenarios, the perception of the success of company is also very different. This is unfair, but its a fact of behavioural economics that every founder must grapple with, especially when statistically most companies trending toward the mean eventually during their life cycle. When a company raises its first round of capital at too high valuation or a valuation that is higher than average, the market expectations are set higher. If it doesn’t deliver, by performing better than the average, it will be penalised in subsequent rounds — either through valuation or lack of interest. Additionally, the more a company can see big lifts in valuation between rounds, the greater the perception of strong momentum, the more excitement will be built around investing in a company. The smaller the valuation delta between rounds, the lower the perception of the company’s momentum and the harder it is to raise capital. The easiest way to see big jumps in valuation between rounds, is to start with a relatively low valuation base and then hit or out perform milestones. The easiest way to set yourself up for failure is to start with a high valuation base, expecting everything will go well, and then not hit milestones.

For deep tech companies, the same structural aspects outlined above apply, but the issue is amplified because of the need of deep tech companies to raise larger quantums of capital at each round. Valuations for deep tech companies at most stages tend to be higher than say software companies — this is not necessarily because they are more valuable inherently, but because space needs to be created to absorb larger rounds of capital over subsequent rounds. To build into their capital strategy, enough space in the valuation strategy to absorb these large rounds of capital is critical. Thus, bigger valuation deltas between rounds are needed when the capital needs are increased and yet they also need to be alive to the fact that the valuation needs to be within market for an eventual exit strategy, so some pragmatism is needed along the way.

That’s all very well and self serving you might say, but how does this really work out for the founder except to take the pressure off and make the process easier? Well, lets unpack that. The founders shareholding in the second scenario definitely has greater dilution. If the founder starts with 50% it will be diluted to 36.4 and 30.8 after series A respectively in the two scenarios above. However, that ~6 % difference in shareholding can be substantial when a company goes on to raise larger and larger rounds of capital and that’s certainly not something to dismiss as trivial. So how do responsible investors who want everyone to win solve for this? Thats where refreshed ESOP pools come in….because there is an acknowledgement that founders can often get diluted over various rounds such that their shareholding no longer aligns them with investors over the longer term. As such that 6% difference at Series A can be remedied through refreshing the ESOP pool in subsequent financings to allow founders to earn back equity, and good investors will look at this closely when investing and make sure all parties are aligned. Personally, I have found this a much better tool, to manage risk and alignment, than starting with a valuation that is too high and sets all parties up for a difficult journey for the next five years.

While I’m a venture investor and so, utterly conflicted, I do think its important to set out why these structural terms are often sought at seed and preseed stages. It’s not (necessarily) to be predatory — of course, its a free market founders are able to take capital from whomever they like if they don’t agree with them. When used by investors who invest across multiple rounds, it is often genuinely designed as a structural element, to mitigate risk, to ensure investors can back the company throughout multiple rounds, and maximise the opportunity for success for both the founder and investor. Good investors will explain this, and find alternative ways to ensure that all parties remain aligned along the journey, and smart founders will be open to these options.