There was a lot of hype in the past couple of years about “unicorns” and “billion dollar valuations”. There is still a media overhang in 2017, but as Sam Altman notes in a recent Y Combinator blog post, the bloom is off the rose in the funding market, with a shift in investor emphasis on “doing a lot with a little” while resisting “the urge to seek validation by having a long list of impressive sounding investors”.
More and more VCs are “late stage” or “growth round” and the price of entry for a start-up these days in addition to the $1 billion + market opportunity, the “magical” product, and the seasoned team, is proven traction in the market – currently rated at $100K in monthly recurring revenue for SaaS issuers, ideally with no churn please. These filters help VCs avoid having to “kiss the frogs” along the way.
Canadian tech companies largely escaped the unicorn hype, given our more subdued early stage funding market. CB Insights, the most authoritative source for tech financing data every founder should know, counts only one – Kik Interactive (congrats to Ted Livingston for that awesome accomplishment, particularly after the former Blackberry crew tried to shut him down) – in its list of the 188 unicorns minted since the mid-2000s. In the Canadian market, along with Kik, already IPO’d Shopify will likely be one of the few exceptions – the true unicorn – that proves the rule (of inflated expectations), for this hype cycle anyway.
What does valuation have to do with cap tables? In this blog, we’ll explore a few of the more subtle ways they interact.
Size Matters; Smaller Is Better; Less Is More
As Altman observes, the shift of VCs away from irrational exuberance in early stage valuations may actually turn out to be a blessing in disguise. He observes that
“founders are often surprised about how choosing to raise less helps protect their ownership more than negotiating valuation does.”
But what does he mean? – What he means is that in virtually all cases, founders will likely do better in the long run by taking less money today to launch and grow their businesses.
The first and most obvious reason is that if your business is going to fail, you are better off failing earlier, rather than failing later. Many Silicon Valley startups burn bonfires of cash pursuing failed ideas before finally throwing in the towel. Raising less means you can move on sooner, and with more control. Perhaps not the way you WANT to think about things, but – hey – we’re lawyers.
The second, less obvious, and more important reason is that if you are truly ON to something, you don’t want to give up more than you need to, to get to your next hurdle. So having a clear, mind’s eye view of where you are going, and what you need to do to get there, supported by clear metrics and demonstrated traction, creates the focus and discipline you need to get there. If the threshold is $100K in MRR and with the results of a small round you find yourself tracking through $1MK in MRR you will have significantly boosted your valuation – and will once again need to remind yourself of the less is more rule. As Altman notes:
It sounds like a better deal to raise $5 million on a $10 million pre-money valuation (selling 33% of the company to investors) than $615,000 at a $2.4 million pre-money valuation (selling ~20% of the company to investors, which is what Airbnb did). But this is only true if you put the money to exceptionally good use. Otherwise, you may end up with a lower dollar value of the equity you keep.
Today, each percentage point of Airbnb is worth about $300 million. I expect them to be worth more in future. If you hope your company will one day be extremely successful, then treat your equity as such. (The one place I recommend not being stingy with equity is when it comes to giving it to employees—most founders’ instincts seem to be to give too much equity to investors and not enough to employees.)
The third, least obvious, and most important reason is that committed people can turn almost any very good technology idea into a viable business – if they get the market, product and people issues “approximately right”. But they kill themselves to do that, it is very, very hard, and only happens in 1 or 2 of every 10 companies. If you have signed onto a VC round with a large influx of capital, at a high valuation, in these (which are most) cases, you right the very real risk of getting very little of anything.
In concrete terms, and assuming standard rules of VC engagement apply, companies (like Thalmic Labs who closed a $175M round of VC financing in 2016 to much rejoicing) may raise tens of millions in venture capital at valuations of hundreds of millions, but the VC math never changes. “Last in, first out” at least as relates to founders. The economic reality of their situation is that the investors will need to see the safe return of that cash in a variety of exit scenarios – their so-called “liquidity preferences” – before the founders, employees and other common equity holders see a dime of upside.
Very seldom will the founders of the business be able to take money off the table early. The secondary was a popular tool for this in recent times, but it will likely be harder and harder to sell, particularly for cashed strapped companies.
The Smaller Piece of a Bigger Pie
The alternative perspective on financing and your cap table speaks to the value creation process, and the role of your team and early stage investors in making that happen, on an accelerated basis.
The fundamental premise of taking on capital is to achieve the market product fit, and critical mass needed, to demonstrate a commercially viable business opportunity. In this case, having 100% of nothing – and that includes having an “idea” (which basically is nothing in virtually all cases) – needs to be weighed against the value of having 75%, 50%, or even 25% of a company capable of actually executing on the idea. And that pie slicing process usually involves skills and cash.
In crafting your cap table at this stage, and in anticipation of subsequent growth rounds, your cap table and supporting documents will typically have a number of moving parts to be taken into account. Below are a few examples:
- Founders – The founders and others who have been engaged in building the business may have “sweat equity”, or advanced funds to the business to help fund growth when external sources of funding were not available. All of this needs to be documented, as does the very real likelihood that your founder team may fall apart at some point. What is the deal on founder ownership; are founder shares fully vested, subject to vesting requirements, or subject to reverse-vesting (cancellation). When can they be bought back, and at what price, or under what circumstances.
- Employees and Other Option and Warrant Holders – you may have established a stock option plan or granted options to a portion of your shares to an advisor, or given an equity kicker to a customer or lender, decided to donate a portion of your future upside (like we did at Organimi) to a charitable group like the great folks at the Upside Foundation [link]. Whether or not you have a stock option plan is a big issue on its own, and one worth some thinking and planning. But once you take the plunge – whether you have voting equity, non-voting equity, or simply a “participation right” linked to future liquidity events, you need to put appropriate agreements in place – not only from a cap table perspective but to ensure the company is able to protect itself in all of the same circumstances described above, as your employees turnover, as they inevitably will.
- Convertible Instruments– many early stage companies will do seed round investments involving convertible notes, debentures or SAFEs [link]. These instruments usually provide for a conversion mechanism, triggered in the future, if there is a subsequent financing (a “priced round”). Showing these securities, and reflecting their conversion entitlements, is useful for both founders and investors when you are thinking about raising additional capital, and the relationship between your valuation and what new investors will get in that process, or thinking about an alternative liquidity event such as a sale of the business. Most importantly, mindlessly “stacking on” follow on convertible security rounds with forward pricing can create nightmares for your cap table, your investors, your lawyers, and you! Do not do this!
- Preferred Securities – the medium term goal for many early stage companies is to get to a VC round for investment. This (the so-called “Series A Round”) is typically a watershed moment for the business since once the VC investment has been completed, the company is likely on the path for further growth and additional (Series B, C etc) funding. The cap table needs to reflect these rounds as well. Preferred share rounds have their own nuances, including the likelihood of a preferred investor minimum return (reflected opaquely in the concept of the “original issue price” and its priority ranking over other securities), and the range of conversion outcomes resulting from subsequent financing rounds (reflected in the conversion price formula and adjustments in it).
In our last blog, we told founders to think of their cap table as a “ladder”. As the founder and common equity holder, you are on the bottom rung – you get what is left when all the other claims on the company – the people on the higher rungs of the ladder, such as preferred holders, note holders, lenders – are taken care of.
In the best case scenario, you are taking care of them by converting them to commons when you get to the liquidity events that drive these conversions – you have achieved your objective of having a “smaller piece” of a (hopefully much) bigger pie. Think Google, Facebook, Uber, RIM or Shopify.
In the worst case scenario, if you have the people on the rungs above you leaning down on you, it is always good to know where they sit, where you are, and what kind of negotiating room you have in dealing with them.
As valuations inflated upwards state-side US VCs developed (belatedly) slightly higher interest in Canadian market opportunities. This increasingly familiarity with Canadian companies will likely prove to be a good thing, for funders and founders, as the wheels come off many of their US investments. More choice and competition for funding. More strategic value adds in helping their businesses grow. The Canadian policy environment is good. The Canadian startup zeitgeist is good. We’re still punching below our weight, and have room to go in getting to US capabilities in scaling global businesses, but we are getting there, and you are getting there. So it makes sense to get prepared on the financing side for the hard work ahead.
A well organized, up to date cap table – that clearly deals with these issues – helps at the top, at the bottom, and everywhere in between.
Aluvion’s Bay Street In A Box™ solution has a new Seed Financing Module – our next in the series – that provide you with samples of all of the key documents you will need to explore your financing options.
You can check out a sample cap table here. If you need help figuring out what your cap table should contain, or completing the documentation you need to make your cap table reflect your business reality, we’re happy to help.