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Changeable devices, as it were In the form of convertible notes, simple agreements for equity futures (SAFEs), or otherwise, have long been used to avoid a fundamental issue in the startup world: the enormous difficulty associated with valuing early-stage companies. But what happens when the methods designed to solve this problem become part of the problem?
For example, price offers are now employed in most primary exchange instruments. By placing a ceiling on the price at which a convertible instrument can convert into future stock ownership, valuation allowances are intended to protect early-stage investors from extreme, unexpected growth (and, consequently, equity positions perceived by such investors as too small).
However, valuations are increasingly being used as a proxy for company value at the time of investment – creating the very problems they were designed to avoid and adding unnecessary complexity to inexperienced founders and investors.
It’s no wonder founders and investors struggle to discuss present value when using equity capital. This is especially true where the valuation cap “ceiling” clearly values the investment in a pre-conversion exit event (eg, both the old pre-money valuation cap SAFEs and the new post-money valuation cap SAFEs are available at Y Combinator. ).
Fortunately, there is a better approach: the temporary return method.
The problem with early stage reviews, or the crystal ball
But while it’s well-intentioned, they’ve introduced an array of equipment that automatically shifts the valuation cap prices to the first tier.
Before we get to the solution, it’s useful to provide more context on the problem—namely, why it’s so difficult to negotiate the value of early-stage companies thoughtfully and rationally.
Some say such valuations are difficult because early-stage companies have no meaningful (if any) revenue, limited assets or ideas. However, while these arguments identify real issues, they miss the most important point: early-stage investors are investing in an ownership structure that will exist entirely into the future as they complete the founders’ program.
Let’s say you’re an early-stage investor writing a check for $500,000 to a startup at a stated pre-funding price of $4.5 million, with 100% of the existing equity held by a single founder and subject to a 4-year vesting schedule. It just started.
On the face of it, that gives you 10% ownership in the company (ie, the post-money value would be $5 million, with your capital representing 10% of the value). However, your share and the pre-funding value that you have effectively invested will depend on how well you have completed the Founder’s Certification Program as shown in the following table:
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