Ask TBD Angels: Discounts and Valuation Caps
As an angel investor, how should I think about discounts and valuation caps in early-stage investments in startups?
Most startups raise their early rounds using a SAFE or Convertible Note, contracts which specify the terms associated with an investment but do not establish the company valuation. BUT…if there is no valuation, how do you know how big a slice of the company pie your angel investment will receive? The investment converts into equity in the company’s next funding event in which the valuation is set.
By way of example, let’s assume you invested $10K in AcmeCo’s pre-seed round last year. AcmeCo recently closed a Series A round with a post-money valuation of $1M and a VC invested $200K in that round.You walk away with 1% ($10K divided by $1M) equity and the VC owns 20% of the company. Wait, that’s not fair! The VC swooped in a year later and her investment earned her the same relative % of the company as your money, despite your taking a huge risk by investing early, perhaps before there Acme had customers, a product or even a team?!?
To “compensate” the early investor for the opportunity costs and mitigate the risks taken by investing early, valuation caps and/or discounts are often part of the SAFE or Notes governing the angel investment.
- The discount defines the reduction in the price used to calculate your percentage equity in the company. For example, if the discount is 20%, then when it converts, your portion of the $1M company is calculated using $800K (80% of $1M). Your $10K yields 1.25% ($10K divided by $800K) rather than 1%.
- The valuation cap defines the maximum price for the calculation of the investor’s portion. If the valuation cap is $750K, then even when this round closes at $1M, your portion will be calculated using the lesser of valuation cap and the valuation in the round…so $750K. Your investment gets you 1.33% ($10K divided by $750K).
When the terms include both a discount and a valuation cap, only one is triggered and your investment converts using the one that is most beneficial.
The following scenarios outline how things play out for a $10K pre-seed investment with a 20% discount and $750K valuation cap.
Discounts and valuation caps are common terms in an angel investment and the impact of each can vary from deal-to-deal. Investors and founders should think about how these might make sense for their particular scenario.
Jason Burke is one of the founding members of TBD Angels and founder of All Stage
