Yesterday, my friends @sonofsarah, @dunkhippo33 and others had an interesting discussion on Twitter about multiple caps and founder dilution in the early-stage rounds.
Here is what Isaac and Elizabeth said:
Hey vc twitter, I have a proposal and would love your take.
For early rounds on a note/SAFE, if the round oversubscribes there should be some “float” to the cap written in the term sheet to manage dilution and reward founders for nailing the raise.
Scenario/context below…
— Isaac Souweine (@sonofsarah) December 15, 2020
Why wouldn’t you just raise the cap as you go along?
Ie if you’ve raised $500k at $4m post with ease, then raise the remaining at $6m post.
From a (biased) investor perspective, because we do intros for a lot of our founders, this helps align incentives.
— Elizabeth Yin (@dunkhippo33) December 15, 2020
This is a super timely conversation and something that has been top of mind for me and 2048 Ventures this year.
The idea is essentially to raise the capital in tranches using multiple valuation caps, to minimize founder dilution, and to reward the earliest investors who aren’t just willing to commit but are willing to wire the capital too.
Before we dive into the details of the mechanics of such raises, let’s talk about how the early-stage rounds were done historically.
The old pricing dynamic of Pre-Seed Rounds
Historically, pre-seed rounds have been done using convertible notes, pre-money SAFEs, post-money SAFEs, and equity.
With equity financings, the founders needed to find the so-called “Lead Investor”. Typically a lead is a VC or Micro VC who conducts the diligence and then issues a term sheet. One of the items in the term-sheet is a pre or post-money valuation, which determines the price per share.
The key thing is that everyone in the equity round gets the same price – that is, the price that the Lead Investor offered in the term sheet. So whether you are an angel investor who soft committed before the lead or you are a top-up investor who comes in after the term sheet has been negotiated, everyone gets exact same price.
In this system, the early angels who soft committed to the round before the lead do not get a discount, they pay the same price.
The key thing here is having a lead is viewed by other investors as a major reduction of the risk.
That is angels, weren’t willing to invest and wire the money without a lead. The reason is that there is no price and also, if I, as an angel, am putting in $50K into a $1.5M round, I am not willing to wire this money right away — I want to see the full round come together.
A similar dynamic exists when founders raised non-equity rounds using convertible notes (which are terrible for the founders and should not be used), pre-money SAFEs (which are dated and replaced by post-money SAFEs), or post-money SAFEs (in my opinion the best early-stage instrument after equity).
The difference in these rounds is that there may not be an institutional VC lead, and so the natural question of the price arises. Who sets the price?
Historically, in these circumstances, the price would be agreed upon half way through the round by the largest check and the founders. That is because at the beginning of the round there is no momentum, and for the earliest commits, it is not even clear if the round would come together – why bother setting the price?
From the founders’ point of view, they don’t know how much demand there will be, and hope that if the round goes quickly, and they can generate a lot of demand, then they can get a better price.
Once 1/2 or 3/4 of the round is committed, the dynamic is clear and the founders and committed investors agree on the price.
This process is cumbersome and uncertain for both sides so in the last few years we’ve seen a clear shift in the dynamic here – founders just set the price out of the gate.
The new pricing dynamic of Pre-Seed Rounds
In the last 12-18 months, we’ve seen a shift in how some of the early-stage rounds get priced — the founders just set the price themselves.
They pick a cap, whether they are raising on a convertible note or a post-money safe, and present the price to the investors.
We’ve seen this very clearly in the last two YC batches, where each company announced a cap, ranging from $8-$15M, clearly suggested by a YC partner.
I like this system a lot because it simplifies things.
When the price is too high, the first investors have a chance to counter, and the founders have an opportunity to adjust — this is a market pricing in action.
However, if the price is too low, then the founders get more diluted, and that is not ideal for them.
There is another nuance here – in the new model, the founders often ask the investors to wire the money immediately. This is a crucial difference because the first $100K in a $1.5M round takes significantly more risk.
So naturally, IF the earliest investors are wire the money immediately, BEFORE the round comes together, the system is not fair to them because they take way more risk, but have the same upside as the investors who come in towards the end of the round.
A Fair Pricing Model for Pre-seed Rounds
So with all this context, how do we create a pricing structure that is fair to the founders, and rewards the earliest investors?
A structure that would fairly capture the risk and reward is this.
-
The founders announce or agree with the earliest investor, that the round will be raised in tranches
-
They are willing to take up to $X1 on a cap $Y1, up to $X2 on a cap $Y2, and maybe up to $X3 up on a cap $Y3
-
The amount and caps should be set upfront, and there should be no more than 3 to make sure it is not a perpetual raise
-
There is an official term sheet that captures all of this so that there is clarity on what will happen in advance
-
Use standard post-money YC SAFE to create clarity on all the actual equity that founders are selling and investors are buying
Benefits
Less dilution for the Founders – The founders end up with less dilution than if they raised all the money on the $X1 cap (obviously they would have less dilution if all capital was taken on $X3 cap, but that’s not the point here).
Reward earliest investors for committing and wiring – Early investors, the absolute first check, are rewarded with a discount for doing the work and being in early and, crucially, wiring the money while there is massive uncertainty about the rest of the round.
Scarcity and a forcing function – This a market dynamic that creates scarcity – only $Y1 is available at the lowest cap, so if you really want the discount as an investor you need to jump in quickly. Scarcity is a great tool for founders and always helps get investors to move faster. For example, if only $300K is available on a $3M cap out of $1M round, the first investor will feel a lot more pressure than if there is $1M available.
Problems
Is this really fair? – One can argue that the price of a company should be based on milestones and the actual progress they made and is roughly fixed during the fundraising period. Are we starting the company on the wrong foot, not treating all early investors equally? I personally don’t think so because this is a classic market dynamic, and that early-stage rounds are priced based on the market demand, but I can see why some people may argue with that.
The risk for early commits and wires – What if the rest of the round does not come together? The earliest commits on $X1 cap are stuck with the under capitalized company. This is critical in my opinion, there SHOULD NOT be any way for the investors to condition getting money back if that happens. The reason is that if such a clause is to be inserted, that would unfair to the founders. The only reason to reward the earliest commits with a lower cap is exactly because of this risk.
So is this needed and appropriate for all pre-seed rounds? No.
This strategy only makes sense if the founders are early, and are not able to immediately raise capital on a higher cap. The tranches help get the round going and minimize the dilution for the founders while also rewarding the risk that the first check would take for committing and wiring the money.
At 2048 Ventures, we have seen and participated in several rounds with this new dynamic —where the founders were willing to take initial capital on a lower cap and then increased the cap for subsequent tranches.
We like this dynamic a lot and feel like putting in more structure around it, like declaring the total raise and the caps upfront can make this type of round even more attractive and popular.
