The majority of our investments are in the form of convertible debt with a valuation cap. This is the most commonly used investment instrument for seed stage funding in the US. Like other investment instruments it has its advantages and disadvantages, but these are the topic of a later post. What I’m going to focus on today is the very high valuation caps which we’re seeing for the pre-revenue startups that we’re looking to fund in the US.
At its core, the valuation cap on a convertible note serves to compensate seed stage investors for the large risks that they’re taking by investing in companies at the earliest stage. It is used to determine the maximum valuation at which the note converts into equity at the first equity funding round. For example, if a startup were to receive a $10M valuation in its first equity round, a $2.5M cap would ensure that the note converts into equity as if the startup had been valued at $2.5M. This would basically give seed stage investors a 4X return on their initial investment. While this may seem high at first, keep in mind that the majority of seed investments are written off. As a result seed investors need returns similar to 4X between funding rounds to hit the home runs necessary for their portfolio to generate a meaningful positive return.
The problem arises when the valuation caps are so high that seed stage investors are not properly compensated for the risk of their investment. As an example, consider that the caps of the three most promising deals that we’ve recently looked into are $5M, $6M, and $10M. In other words, if the startup shows sufficient progress to raise an equity round, the note will convert into equity at a valuation between $5M and $10M depending on the startup. Applying a very aggressive 10X revenue multiple to this valuation implies that the company should currently be earning, or be fairly assured of earning, between $500K and $1M in annual revenue to deserve such a cap. This is inconsistent with the fact that the startups which we back are almost always pre-revenue.
The mismatch between the valuation caps which seed stage startups in the US are currently being offered and what their fundamentals deserve has a negative impact which extends beyond investors to the startups themselves. The negative impact for investors is clear. Knowledgeable investors find themselves unable to participate in the funding of promising startups because the terms simply don’t make financial sense. Since knowledgeable investors abstain from investing, funding rounds are primarily filled with those investors who have little ability or willingness to add value to the startup. This is a disadvantage for startups at all stages, but a particularly important problem for seed stage startups who can benefit greatly from the domain expertise and network of connections brought by the right investor.
Based on my experiences, it becomes clear whether a startup has the potential to scale its activities within a year after receiving its seed investment. Assuming that you invested based on proper research into the startup’s founding team and their target market, you can reasonably expect half of the companies you back to show the progress necessary to raise follow-on funding. At this time, it’s important for you to be able to participate in the new round. If you do not do so you will have sacrificed your hard-earned opportunity to share in the future upside of a startup which you supported when very few other investors were comfortable with its associated risks. In addition, not participating in the new round is likely to lead to the significant dilution of your stake. When an exit occurs, many seed investors who didn’t make follow-on investments are disappointed to discover that their final share has become too small to compensate them for the original risk that they took.
In order to participate in the follow-on round, you need two things. The first is to have the right to participate at the same terms as the other investors in the round. You can prepare for this situation by including a right of first refusal clause in your original seed investment. In addition to having the right to participate without offering better terms than a competing investor, you also need to have the capital to do so. This is why it’s important for seed stage funds to structure their fund so as to allocate sufficient capital for follow-on investments. Since the better performing half of your startups will raise follow-on funding in a round which will likely be two to three times as large as the seed round, it’s good practice to reserve between a half to two thirds of your fund for follow-on investments.
In addition to the clear benefits which follow-on investments have for seed stage investors, they are also advantageous for entrepreneurs. Earlier investors have an important informational advantage over later entrants in terms of their knowledge of the startup’s past activities. This makes them better able to evaluate the startup’s future potential. As a result, a follow-on investment by an existing investor sends new investors a strong positive signal about the startup’s prospects. This makes it easier for the entrepreneurs to raise new funding. By spending less time on fundraising, entrepreneurs are able to focus their efforts on where it matters most: improving the performance of their business and scaling.
As a fact check, I decided to review some of the most successful startups that we passed on at Romulus Capital. Since we invest in startups at an earlier stage than Bessemer, keep in mind that there is more uncertainty around the future of our investments than those made by later stage venture capital funds. While this is a caveat, it’s not an excuse for some of our biggest misses.
Perhaps our biggest missed opportunity is SixthSense. At its core, SixthSense is a wearable device which allows users to use their gestures to augment reality with digital information. Think about Google’s Project Glass without the glasses. Pranav Mistry of the MIT Media Lab showed a demo of SixthSense at a TED conference in 2009 and decided to make its underlying technology available open source following the mass appeal it gained there. We had the opportunity to invest well before the conference, but considered the idea too far fetched.
Another big miss is Sifteo. The company is behind Sifteo cubes, a set of interactive games where the players engage with physical blocks which sense each others’ proximity and relative motion. Think of digital dominoes and Lego blocks. The company is currently building educational games for children and adults, and has received over $10M in funding from the Foundry Group and True Ventures.
The final miss that I’ll address here is PeerTransfer. The company saves significant transaction costs for international students studying abroad as they make money transfers from their home country to pay their university tuition. While the company started with a focus on college payments with the US as a destination, it has the opportunity to cover other types of international transfers across the globe. PeerTransfer received $8.5M in funding from investors including Accel Partners and Spark Capital.
The reason why I’m going to stop here is not because there weren’t other great startups that we passed on but simply because these serve well to demonstrate my point: all venture capital funds forego great investment opportunities. While it’s not always easy to reflect on and disclose one’s misses, this shouldn’t be the case. Although you should probably question the abilities of someone who was presented with the opportunity to invest in but passed on each of Apple, Microsoft, Google, Amazon, and Facebook, most missed opportunities say little about the skill of a venture capitalist. If anything, for an investor to say “no” to a startup, they must first know about it. And if a venture capitalist knows about a company, that suggests that they’re either very good at finding promising startups or that they have a very strong network so that promising startups naturally come to them, or both. That’s a good situation to be in. The reason why even the best investors pass on great startups is simply because it’s very challenging to foresee the future potential of a team with an idea and perhaps some traction. As a result venture capitalists are not always right, and in fact can often be wrong. So if you’re an entrepreneur with an unwavering belief in what you’re doing, the next time that a venture capitalist passes on your startup, simply think how foolish he must be to not recognize the next Google.