AA 013: (High resolution financing) Different valuation caps for each investor?

Welcome to the thirteenth podcast of the Ask Alex show! Today the question is on high-resolution financing: “Can you negotiate different valuation caps for each investor, or does it have to be standard across the board when raising seed money?”

In this podcast, we get into a lot of details in the details of running a complex convertible note fundraise:

Discuss high-resolution financing
Why fundraising from investors is so hard (and why they are all sheep)
The benefits of a high-resolution financing structure (in theory)
6 tips from a company that successfully raised with this structure
Why this is a terrible idea (for the average founder)

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Transcript on high resolution financing if you prefer to read

Hello, 50 Folders and welcome to episode 13 of the Ask Alex podcast with me Alexander Jarvis. Today, we’ve got a little bit of a complex one. But I’ll try to explain it as simply as I can within means and it comes from Simon in London who asks

“Can you negotiate different valuation caps for each investor, or does it have to be standard across the board when raising seed money?”

Normally, you raise money in rounds or tranches. These are sequential steps. For example, angel, seed, then series A, series b etc. The valuation and terms for each round apply to all investors who invest in that round. It is the lead investor who typically sets the valuation or, terms, in the case of a convertible note.

What Simon is asking, in a round or tranche which is through a convertible note, can you set different valuations for different investors?

How do I know we are talking about convertible notes? Simon used the term cap. Priced rounds do not have such a term in the context implied. You might have a cap on a participating preferred liquidation preference, but a cap on those is fairly rare since you might possibly only see participation in later stage deals and when the company is doing poorly, or asking for a monster valuation.

Coming back to the question, you might see startups raise another seed (or call it that). It could be a seed extension. Maybe the seed is a pre-seed. In these cases valuation changes with each new raise. They are normally higher, possibly the same, and sometimes below that is called the down round. Ps, that’s really bad.

So normally each round has one valuation.

But what you are asking is if you are raising a round and you want to have different terms for each investor, can you? And the answer is yes, yes you can. It’s called high-resolution financing. That is effectively giving different valuations and terms to different people.

The important thing to bear in mind is we talking about within a round or a new round? Time and fundamental changes in prospects are what determine the difference. If the status of a company is different as it is derisked, I argue it is a new round, with separate notes for a tranche if you do another note. Yes you can do what is called a rolling note, but there should be a deadline on when you issue new notes in that round. There are also restrictions put in regarding how much you can raise on any given note.

Let’s talk about how high-resolution financing works. It was coined by Paul Graham in 2010 just when convertible notes were just starting to get popular.

You give different caps, or possible discounts to angels in a round, so that as the round fills up, the last people in, if they take their time, get a less favourable deal.

As PG writes:

“What you really need to get an angel round together are your anchor tenants. These are the people who make the early commitments to you to fund your round before having any social proof. You should seek to get people who are respected by others in your field and who will therefore make it easier to raise the rest of your angel round.” Thank you, PG.

Ideally those anchor tenant angels will help you get the full round done through their network, so they really are worth giving a discount. To me that’s totally reasonable and explainable to future investors.

Why do you want it? Well getting a round together is like herding cats. And no one wants to be the first one in a deal. ‘Who else is in a deal?’ is an incredibly common question and ‘Come back to me after you have a lead’ is the most common answer. Investors are sheep and constantly using social proof as a proxy for actual investment conviction. Nobody has an incentive to agree to write the first check. And no matter how rich people are – they still want a deal. That’s probably how they became rich in the first place.

So to incentivize someone to take the leap first you can throw them a bone. Incentivise them. You give the first investor up to a certain amount one number, and then the next threshold other terms, up till you close the round. This encourages people if they are interested to make up their minds.

How would you actually pitch this to investors? Mark Suster who is a great blogger gives a nice example:

“We’re going to be raising $750,000 – $1 million. We plan to raise at a $5 million pre-money valuation. We know how hard it is to get the first people committed. And we know it’s a challenge to herd cats. So we’ve reserved the first $150,000 at a $2.5 million pre-money.

We would be honored if you would consider being one of our first angels.”

Boom. Now when you pitch more investors you get to say “I’ve already raised $150k and looking to close another round.” and that’s definitely a whole lot more compelling, right? And if you tried to raise before I’m sure you know exactly what I’m talking about.

The way you actually structure up a deal is to decide on a total amount you are raising. So if you are raising $500k then that is written in the note as the minimum amount required to close the note in the first round. You also can add that the note can raise a larger amount say $800k in total up to a specific date. 90 days is reasonable for some people will say 60 days. This way you can do a first close but have the option to do more if you get more investors and the second close you can also have a third, fourth or a fifth. That’s why they call it high-resolution financing. That second close date needs to be relatively short so investors who did commit on the previous close, don’t feel cheated, unless of course, you are looking to do a larger close over time, but also worse terms.

We’ve got an example here which I’m sure you’d be interested in hearing. This comes from a company called Chameleon that raised 1.9M seed round in 4 weeks which is cray cray.. with high-resolution fundraising. They progressively raised their valuation cap to break the deadlocks and get investors to a decision point as quickly as possible.

In their words “What made high-resolution fundraising so powerful was that we were able to align incentives and reward the investors who had supported us the most. That helped set the foundation for us to succeed with our investors for the long-term.”

They share 6 basic steps they took. There’s a lot of detail missing here, but you may find it interesting:

Start with a relatively low valuation cap: You need to make the deal look attractive to angels, so the investors who take a chance on you that early should get a good deal. If all goes well, this number will go up.
Let investors know how long that valuation cap will stand: The time frame for the terms provides the forcing function to encourage investors to make a decision quickly. This saves everyone time.
Prioritize your list of investors: Once you have an idea of who is interested, you need to prioritize your prospects. This will help you find a lead investor and land a champion to close out your seed round.
Follow-up after meetings: Answer any questions that investors have and get the yes/no decision.
Get docs signed and funds transferred: Making palpable progress will raise your spirits rather than doing a mega-close of everyone at the end.
Raise the cap for the next round of investors: Increase your valuation cap with confidence knowing that you brought in the previous set under comparable terms. Let outstanding potential investors and new contacts know of the increased valuation cap.

I’ll put a link to their blog as well as the other required reading if you want to dig into this topic in more detail.

Now two other notes.

Firstly, you can do this high resolution financing structure in a priced round which is when you effectively set a valuation and actually issue the shares. You do this by issuing the early investors warrants. Secondly, high resolution financing shouldn’t apply when you’re actually raising from VCs, only angels. Why? You’re using a structure to go directly to angels who are possibly going to make a really rapid decision and give you the cash to give you the social proof that you need. VCs on the other hand are going to have a nice long process. So back on VCs, it doesn’t make sense that a lead investor gets a discount either for being the first one in. It sets a pretty bad precedent.

However, before you leave me thinking holy shit balls Batman, this is awesome… my recommendation is that you don’t actually do this.

Here’s why (Now, this is where reality sets in):

You don’t know what you’re doing. Trying to be too smart and you’re going to be the one who gets bit in the behind. For perspective… I know a little about this topic I’m talking about it but I’m not necessarily sure that I’m knowledgeable enough to pull this off properly.
Legal costs will be higher at the next round as you probably going to need to clean up your cap table and this is going to look like a shit show. And do you even know how to set up a basic cap table? If you need a cap table, by the way, I have two on my site, one is free and one is the pro-version. Depending on what you need, feel free to check them out.
Investors will get confused by your cap tableat the next round when your raising from VCs unless you clean up the cap table and thinking is bad. It’s always bad and no investor wants a messy cap table, it’s just way too much work.
It creates a hell of a lot of issues at the qualifying financing round. Most people do not understand how conversion happens with ‘simple notes’ to start with, so what you think it’s going to happen when you make things 10 times more complicated? As I wrote, someone is going to be pissed off, only this way you’re likely to aggravate more people
If you do a poor job of explaining how the process is being run and why certain investors are getting different terms, this will sound like it is you want to give different valuations to different investors in a similar time period for some unknown reason. Everyone has an ego and will not understand any rationalization you invent, especially if they get a sense you think someone is more valuable
It’s far better to have slightly more dilution and happy investors. Some of the reasons for this are 1/ you get a round closed faster if it looks oversubscribed, 2/ happy investors will pro-rata, 3/ you grow into valuation better and mitigate down round risk etc

Thanks Simon! That was a bit of a monster of a podcast on high resolution financing!

If you have a question that you don’t have the answer for, feel free to reach out to me at www.alexanderjarvis.com/askalex and I’d love to feature it on the program. Thanks, guys! Have a super time! Bye!