When In Doubt on Pre-Money Valuation, Smart Guys Procrastinate
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2002-08-02
If there simply is no way to get a handle on the pre-money valuation in an angel round, the trick is to postpone the valuation/pricing decision until a future event, typically the first professional (some times called the Series A) round of financing, when the company is more mature, professional VCs are investing and perhaps competing to invest, in which case the price is fairly, established by definition through an informal auction.
A typical structure entails a security which is labeled a bridge loan, convertible into either common or preferred stock at a price per share (or in the case of preferred stock, a conversion price) tied to the price of equity in the forthcoming Series A round. Usually the angel round price is discounted off the hypothetical Series A round price, the discount running from 20% to 30% in most cases. If the Series A round is not closed by a date certain in the future, then the default option is a price which is quite favorable to the investors and penalizes the entrepreneur. It is usually not contemplated that the bridge "loan" can be called and the holder or holders demand repayment.
A new development in this area is a "cap". This is a misleading term. "Cap" means: on conversion, the note holder can convert into the round rate at a discount. This means the conversion price is 10% to 25% lower than the conversion price of the other players or at a negotiated pre-money valuation. This number produces an up round but protects the investor if the Series A round is so elevated that the investor's $500,000 converts into a trivial percentage, even without a discount. Assume the pre for the bridge is somewhere between $1 and $4 million, this is too big a gap so the price is discounted 25% from the next rounds price. The cap will protect the investor if the pre for the Series A is $25 million. The cap, therefore the price is $10 million.
The virtue of this structure is that it postpones the pricing decision until (i) the company has made progress and the indicia of value are easier to ascertain and (ii) the pricing is established by professionals who have a keener sense of market conditions. The defect, of course, is that, if the Series A round does not take place in a timely fashion, the angels are taking, in effect, pot luck. However, in the early stage universe, pot luck is more the rule than the exception.