Crouching Tiger, Hidden Terms

As markets tighten many look to valuation as the canary in the coal mine to indicate where the world might be moving. If valuations are still on the downturn then we still have a ways to go until bottom, and if valuations are starting to creep up then perhaps the worst is behind us. Or so the theory goes.

In actuality, there is a structural floor on valuations, as I highlighted in my recent piece “The Goldilocks Valuation Matrix.” As building a company has real fixed costs such as web hosting, technical build costs, etc. and there is an amount of time or runway necessary to find product market fit, and absorb sales cycles, the required amount of capital in the pre-seed looks like:

• Fixed Costs x Necessary Months of Runway = Real Money

Real money raised is traded for preferred equity, or ownership, in the business, but above a certain threshold of investor equity or the compensation provided for the risk taken, is an emergent new risk of over dilution, or cap table imbalance. Startups are a multi-year, multi-party game, and so early dilution risk that is too high sets the company up for failure or recapitalization later. In other words, if the necessary pre-seed capital raise is $1M and the maximum acceptable dilution before cap table risk emerges is perhaps 25%, then the structural valuation floor is a $4 million post-money (i.e. a pre-money of $3M + $1M of fresh new cash).

Therefore we might think that the absolute floor on valuations is $4M post money, but this ignores what I call “Crouching Tiger Hidden Terms,” which require a closer review of documents that are no longer “plain vanilla.” Investors have gone back to Basin Robbins 31 flavors of ways to get more equity without touching the sacred valuation numbers Y-Combinator, for one, loves to inflate. There are escape valves, and founder equity now slips out in creative new ways. The sticker price on any deal is no longer the sticker price. It’s MSRP with this discount, or that.

For example, we recently evaluated a deal where the valuation was $8M post-money, and all investors were pari-passu, meaning on “equal foot,” except for one thing; one investor was getting extra common stock for an “advisory” role. Another had a small warrant grant agreement whereby they were also getting bonus shares. So the effective valuation entry for these investors was not in fact $8M post-money because they were, for example, putting in $800,000 for 10% (800K/8M post = 10%) but then they were also getting extra shares as a kicker to their investment. In one case the firm was getting 6% common as an “advisor” and in the other they were getting 2% warrants for some other dubious reason.

In other words $800K was equating to 16%, so the effective valuation was not $8M post money, and it was not pari-passu. The effective entry valuation was 800K/0.16 or $5M post money. This was a case of Crouching Tiger Hidden Terms. Strikingly, however, while the founder was aware of the ask, they were not aware that their effective valuation had changed. They continued to speak about the round as though it was an $8M post-money SAFE without realizing that their side advisor agreements had lowered their valuation by 37.5% from 8M post down to 5M post. This sneaky VC ask was effectively, "can I have a 37.5% discount?"

The other ways you might see this expressed will be in increased interest rates on convertible notes under the auspices of inflation premium, or in how qualified financings are defined to convert SAFEs and Notes, and in time duration allowed before forced conversion to equity. In these conversions we’ll also likely see an increasing complexity around conversion prices, and anti-dilution clauses that aren’t just “weighted-average,” but rather “full ratchets” or more aggressive downside protections. If, for example, a qualified financing (that might now be inflated so as to become less likely) isn’t met within a timeline (that’s also been shortened), then anti-dilution provisions or more draconian conversions might occur, again usurping more equity. While not all of these provisions are nefarious, and investor downside protections are warranted compensation for some risk, founders ought to also realize that it's no longer all plain vanilla terms.

Things to look out for now include:

• Common advisor stock, and investment-adjacent asks
• “Studio” investments that come with common stock or warrant kickers
• Higher interest rates on Convertible Notes
• Shortened-duration conversion windows on SAFEs / Notes
• Anti-dilution provisions that aren’t weighted-average
• More than 1x liquidation preference
• How a “qualified financing” is defined to trigger conversion

And so far we’re only talking about the quaint land of Narnia that is idyllic early-stage venture capital where everyone plays nice. If you’re getting out into the tangled woods of Series A and B, terms can be significantly more aggressive as investors seek to manage the concatenation of risks in both survivability and price. At Everywhere Ventures, we’re seeing, in general, 10x revenue multiples hold up, meaning valuations that are roughly 10x trailing twelve-month (TTM) revenue for tech-enabled businesses such as Fintech, Health, and Vertical SaaS. With explosive growth, there might be premium paid on top of that, but for all but A+ teams with prior exits now “doing AI," we’re no longer seeing 20-100x revenue multiples being paid like we were at the top of the 2022 market. Forward valuations are now an endangered species, and to paraphrase Marc Andreessen, the bridge loans for credibility in return for future performance just got tighter.

So if you’re sitting at a $100M valuation and $6M of revenue, and you’re running low on cash, you have a few options before it’s time to face the music:

1. Cut burn, extend runway, and consider how to realign 10x revenue to valuation
2. Shore up your bank account with an inside round on the prior terms
3. Double down to grow like hell and hope your growth rate justifies the premium
4. Consider taking in more capital at the down-round, “fair market” price of $60M, knowing that if you wait longer you’ll have to swallow not only a lower valuation, but likely a lot of legal provisions that create additional headwinds

In this new world get out your sword, because you’re going to have to slay dragons, whether you’re a founder or a fellow investor merely watching your back. Beware, because plain vanilla is gone, and we’re back at Baskin Robbins where all 31 flavors are out haunting your legal docs. Get your favorite lawyer on speed dial, or give us a call if you need an extra pair of eyes. And if you want to talk more about this, tune in 9am PT Wednesday October 4, 2023 with Peter Walker, Carta’s Head of Data Insights, and I in a LinkedIn Live discussion.