A Cap is not a Valuation

When we raised our last fund, our largest to date, we told our investors that we wanted to run two experiments. The first was what became Indie.vc, the second was to test the waters around, what was then termed, the Series A gap.

Our hypothesis then was that with the huge surge in the number of seed funds getting raised and deployed, the number of Series A focused firms had stayed relatively constant. Few follow on options from larger firms and fewer firms able to write $2M checks seemed like an interesting window of opportunity to explore.

So explore we did!

As we hunted for those overlooked gems or misunderstood breakthrough ideas a common theme emerged among the founders stuck in the Series A gap.

Most had structured their seed rounds as bridge notes (a fancy term for a loan) that would convert to equity when the anticipated future round of funding closed.

Many of the companies with notes we evaluated had valuation caps on them; meaning, if the new investor priced the round higher than the cap the seed investors would reap the benefits of a lower valuation given the earlier risk they’d taken.

The problem we began to run into was that founders believed that these caps were actual valuations. Instead of their intended use of kicking the hard conversation of setting a valuation down the road, founders had come to believe that setting a high cap today meant that they must clear that cap to sufficiently reward themselves and their seed backers. Anything less than the arbitrary cap they’d set at their seed was believed to be a down round.

And in the rah rah days of 2014 and 2015, those caps were inching from $10M to $15 and even up to $20M for a seed note. As you might imagine, convincing a founder to take a valuation lower than the cap became a series of painful, and ultimately, unfruitful conversations.

At the time, it was staggering to me that founders didn’t recognize that caps were aspirational and something they needed to grow into over time. By losing the plot on the cap, many believed that the future value they were aiming for had already been achieved and that anything less was admitting defeat to themselves and their investors.

In the end, we closed the chapter on that experiment and moved on but it is still a refrain I hear all over the valley.

Caps are not valuations, they are aspirational and are designed to be grown into. Closing a termsheet below the cap is a better deal for your early investors not an admission that their investment is less valuable than the day they wrote the first check.

Something to keep in mind going into a constricting and competitive 2016 funding environment.