Don’t Make the Same Investment Mistake as Me!

Even long-time angel investors tend to think of company valuations as a single number: $10 million or $25 million. But there are two numbers: the valuation before and after the investment called the pre and post-money valuations.

If I invest $1 million in a company that we’ve agreed is worth $10 million before my investment, once my cash hits the company’s bank account, the company is worth $11M.

For the purchase of equity, the calculation is simple: a $10M pre-money valuation with a $5M investment becomes a $15M post-money valuation.

But when we look at valuation caps on SAFEs and convertible notes, the situation can get messy, especially with multiple rounds of notes and SAFEs that convert to stock at the same time.

Until now, I’m ashamed to say, I didn’t pay attention to the valuation details, and a good investment I thought I’d made turned out to be a bad one.

Those details I’ve realized are important for both investors and founders to understand to avoid getting burned like me.

The Difference Between Buying Public and Private Shares

Buying stock in startups is different than buying public stock on Nasdaq. When I buy a share of Apple stock, I’m purchasing it from another person who’s selling theirs, not from the company itself. It’s more like buying a used car than a new one. Buying public stock doesn’t change the number of shares, and the money doesn’t go to the company.

When I invest in a startup, I’m buying stock from the company. This increases the total number of shares that the company has issued, and my money goes into the company’s coffers to help build the business.

So far, so easy, right? Good. Hold that thought.

When I consider buying Apple shares, I look at the price per share. The price today is about $150. To invest $1M in Apple, I’d buy 6,667 shares.

When I invest in a startup, I have no idea what the price per share is. Startup investors think in terms of company valuation and chart the increase in valuation in each funding round.

However, when I hand you a check to invest in your startup, I’m actually buying shares. After agreeing on a valuation, we need to convert my investment that into a number of shares and a price per share.

In theory, that calculation is simple: The price per share is the pre-money valuation divided by the total number of shares.

If your startup is valued at $10M and there are 10 million shares, I buy the shares at $1 each. To invest $1M, I purchase 1 million shares. After my investment, there are 11 million shares at $1 each for a post-money valuation of $11M.

Complicating that calculation is deciding what to include in the total number of shares. It includes all the shares that have been issued, but whether it includes unissued or unvested options, the new options pool authorized in the funding round, and the shares needed for the conversion of convertible notes or SAFEs depends on the fine print of the contract.

Depending on what’s included in the total number of shares, I can end up paying a very different price per share for my investment. It’s a detail every investor and founder should be aware of when negotiating the investment terms.

SAFE and Convertible Note Valuation Caps

Most of my investments in startups are seed or pre-seed, occasionally even a friends and family round. In those investments, I’m usually not purchasing stock directly but using a convertible note or SAFE to invest now and deal with the stock documents later. TL;DR details on the differences between SAFEs, notes, and preferred equity here.

SAFEs and notes usually include a valuation cap, which differs slightly from a valuation. When the investment is converted to equity in Series A, the valuation used is the pre-money valuation of Series A, up to the limit of the cap we’ve agreed on.

For example, if I invest in a note with a $10M valuation cap, and the Series A valuation is $8M, I purchase the stock at the $8M valuation. If the valuation is $20M, I get the stock at a price per share based on my cap of $10M.

Sounds simple enough. But I’ve made the error again of thinking of the valuation as a single number. It isn’t. Are these pre or post-money valuations? And what stock is included in the price per share calculation?

Here’s where things get complicated. These details make a huge difference in the price per share, and therefore how many shares I’m buying and the percentage of the company I’m acquiring.

The current SAFE document uses a post-money valuation. Convertible notes (and the original SAFE document) use a pre-money valuation, so let’s look at them separately.

The Post-Money SAFE

The original SAFE document created by Y-Combinator was modeled from the convertible note and used a pre-money valuation cap. But as the YC folks realized, startups were using “SAFE-based financings as independent seed rounds capable of providing multi-year runways, rather than shorter-term bridges to priced preferred stock rounds.”

In other words, it had all the problems we’ll get to below with the pre-money convertible note, but worse. Where a convertible note is intended to provide a year or so of runway and includes a maturity date by which it must convert to equity, SAFEs are often used at the earliest stages when it may be many years and many separate investments before the SAFEs are converted to equity in the first preferred equity investment round (Series A).

Consequently, in 2018, YC revised the SAFE to switch from a pre-money to a post-money valuation cap.

But what exactly “post-money cap” means isn’t obvious. It uses the post-money valuation after all the SAFEs and convertible notes have converted to shares at the time of Series A, but does not include the investment of Series A itself. It includes the options pool that exists at the time of Series A, but does not include the additional options usually authorized as part of the Series A.

As an example, if I invest $1M in a SAFE with a $10M post-money valuation cap, 5 years later when the company completes its Series A at a $50M pre-money valuation, my price per share is based on a post-money valuation of $10M. In other words, I’ve acquired 1/10 of the company’s shares, before the issuance of additional shares for the Series A investors and the expansion of the options pool.

Got all that? Now let’s look at the pre-money cap in a convertible note.

Getting Burned by a Pre-Money Convertible Note

A convertible note is legally a loan where the full amount (including interest) is applied to the purchase of stock at the next equity investment round. Unlike the current SAFE, the valuation cap on the convertible note is usually based on a pre-money valuation. The original SAFE also used a pre-money valuation, so this discussion applies to it as well.

With a pre-money valuation cap, all the stock that will be issued to convert the outstanding SAFEs and convertible notes are not included in the total stock used to calculate the price per share. And in that little bit of fine print for the calculation of the “company capitalization” hides the problem.

As an investor, I have no way to know how much money will be raised before my investment will convert to stock. This means I have no way to know how much my stock will eventually cost at the time I make my investment.

If mine is the only investment that will convert on Series A, then the post-money valuation is known, and it really doesn’t matter whether I use a pre or post-money valuation. If I invest $1M and that’s the only investment, it doesn’t matter if we use a $10M pre-money or $11M post-money valuation.

I can and should ask how many other SAFEs and notes have already been raised that will also need to convert. If $4M was previously invested in the company in SAFEs and notes that will convert at Series A, my post-money valuation is not $11M but $15M. I often forget to ask this obvious detail, but that’s my own mistake.

Here’s the problem: even if I’m careful to consider all the SAFEs and notes raised before or at the same time as my investment, I have no way to know how much additional money the company will raise afterward.

After my $2M seed investment round following the $4M pre-seed, the startup decides to raise an additional $10M on another convertible note instead of opening a Series A equity round. But that means a $26M post-money valuation for my $10M pre-money investment. That’s not what I thought I was investing in.

Sound absurd? It did to me until it happened recently.

I invested in a company at a $6M valuation that I thought was fair given their stage of development and the small size of the market. The company was raising $1M so I thought I’d invested at a post-money valuation of $7M. I was wrong.

By the time they reached Series A, they’d raised another $9M on notes and SAFEs. So the post-money valuation used to calculate my stock price was $15M.

At a $7M post-money valuation, this was a good investment. If I’d known I was investing at $15M, I wouldn’t have invested.

I can only hope the company does especially well with all the cash it’s raised. If they reach an eventual exit, my gains will be less than half of what I expected when I invested. If the business is acquired at $20M, I’ll have a 25% profit instead of close to 3x. If the business struggles and is acquired for $10M, I’ll lose 1/3 of my investment instead of achieving a 43% gain.

So I’ve learned my lesson: invest in equity or a post-money SAFE or make absolutely sure I understand the startup’s complete fundraising plans before investing in pre-money convertible notes.

Thanks to fellow Tech Coast Angel member Joe Gatto for his lucid explanations of the fine print in my investment. Any mistakes are mine and mine alone.

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