The most challenging task in building an early-stage investment deal together is for the investors and the funders to a degree on the deal valuation. In many cases, it becomes a deal-breaker not because the investors did not like the deal, or believe in the company, yet the economics of the deal need to work out for both sides.
The startup founders always have a tendency to overvalue the company, and investors are always looking to “low ball” so they can get larger pieces of equity. In the past few years, and especially in the recent uncertain economic conditions, the challenge becomes even more significant in the founder’s ability to raise capital.
We recently created a balanced way to bridge that gap. We called it the “Flex-Value” methodology. In early-stage investments, most investors have to rely on projections and guesstimations of what the company’s future performance would look like. By offering a “Flex-Value” method, it can allow investors to mitigate the risk that will lead to a quicker investment decision.
This approach takes into consideration the founder’s financial projections as a baseline for the term sheet. If the founder is able to perform, and deliver on the financial projections, they will be able to maintain the baseline valuation. In the event, the company performs below financial projections the investors get a deeper discount/lower valuation. This approach creates a balance that diffuses the tension by establishing a fair and balanced benchmark.
It is specially applied to early-stage investors, i.e. first money in the deal after FF, which will not be the last round of funding. Typically, startups will raise at least two more rounds of funding at much higher valuations, which by nature, the early-stage investors always get diluted, although early-stage investors are the most important money in the life of the company. So in order to allow the early-stage investors to be treated fairly, the “Flex-Value” is the answer. In other words, it is basically to say to the Founder; “put your money where your mouth is!” Instead of taking a leap of faith, it allows the investors to establish a benchmark of trust, where there is none in order to move forwards.
Let’s say that the founders think that the company is worth $2M, or the market cap on a convertible note type of a deal, and the financial projections indicate that the company will produce $3M dollars in revenue within 18 month – than baseline equation is:
$3M in revenue = $2M company value and or market cap
If the company ends up producing $2.52M dollars in revenue, then the baseline equation is:
$2.52M in revenue = $1.6M company value and or market cap
if the company ends up producing $3.52M dollars in revenue, then the baseline equation is:
$3.52M in revenue = $2.34M company value and or market cap
The reality is if the founders have a high level of confidence that they can meet or exceed the numbers then it’s a better deal for the startup, because the investor will convert at a higher valuation, and the founders get to keep more equity. On the other side, it’s a way for investors to mitigate the risk in the event the startup does not perform. It also creates a fair value for the next round of funding. Inside the conventional wisdom start-ups always want to raise at a higher valuation in order to create a benchmark for future rounds. Although we are in completely different market conditions than we’ve ever seen before. As the saying goes; “extreme circumstances require extreme measures”.
The truth is that it is a tricky situation. These methods may not be applicable for a straight forward deal. It can be a very creative solution that creates a common ground instead of walking away, both from the founders and the investor perspective. We know it’s not a traditional approach, to say the least, yet we tested this several times in the last year and we found that he can work. It is an alternative worth pursuing when both investors and the founders want to make a deal yet, there is still a gap.
From my perspective, both as an investor and as a founder, this approach creates a measure of accountability on behalf of the startup to prove to the investors that their financial projections can hold water. It takes away the investor’s need to make a blind faith decision, which most investors are not comfortable with. At the end of the day, the only thing that matters in business is a bottom-line financial result. This is why the founders got into the business and this is why the investors want to put the money, to make as much money as they can, as fast as they can long for as long as they can.
As an investor, I also find it very interesting, almost like a “Tell Tell” to see what is the level of confidence the founders have in their own ability to deliver the numbers. If you, the founder, are absolutely convinced and confident that you will deliver or exceed \ the numbers, why not go for it, it will work in your favor.