Thanks Leo for the detail response. The problem with this analysis is that you're comparing a priced round to an uncapped note, but using totally different and arbitrary parameters (ie. 20% discount).
I agree 20% discount is not an accurate assessment of the risk and potential increase in value from seed to A, which is usually 3x. Also, the original purpose of a note is to solve the problem of inaccurately pricing an early stage company. If that's not a problem then there's no point in not pricing. But if there's great variation in the potential of a company, then it makes sense to use a variable pricing model, which a significant discount (30-60%) better accounts for. Add in a cap and a floor (something like $4m - $40m) to protect founder & investor in extreme situations like you described.
Obviously a fixed price is better for you, the investor. But is it better for the company? Is it the best way to model the uncertainty of valuation? You argue for not dissentivizing the investor. What about the founder who raises $1m seed at $5m valuation, then raises Series A at $30m? They mispriced their seed round, and the likelihood of the A investors finding a way to diminish the value of the seed investors greatly increases.
Just an alternative view of things from an outside.
I appreciate the follow up. I think where we disagree is that a priced round is a disincentive to the founder. Instead of a disincentive, I think a priced round is "fair." A few quick comments:
- are there any other areas where, as a buyer/investor, you buy at a discount to a future price instead of an estimated current price? For example in places where houses appreciate quickly, people still buy houses at a fixed price. No seller ever says "this house might be worth $2m-5m in 10 years, so instead of buying it for $1m today, which don't you buy it for a 20% discount to when you sell it 10 years from now?" Same thing with paintings, stocks, etc.
- the $5m -> $30m mark-up is not a mispricing. For public stocks, pricing is based is based on expected cash flows. For example, if a company is expected to make $10m/year for 30 years, it might be worth $300m today, minus an adjustment for inflation (so maybe it's only worth $200m today). For startups, the valuation is based on "% chance of a huge outcome." So when a company goes from $5m to $30m in valuation, that doesn't mean its revenues jumped 6x. What it really means is investors think the company made enough progress so that instead of a 1% chance at a $1b exit, there's now a 6% chance at a $1b exit. In that regard, the company is worth $30m today, but it was also not worth that at the seed round.
I agree 20% discount is not an accurate assessment of the risk and potential increase in value from seed to A, which is usually 3x. Also, the original purpose of a note is to solve the problem of inaccurately pricing an early stage company. If that's not a problem then there's no point in not pricing. But if there's great variation in the potential of a company, then it makes sense to use a variable pricing model, which a significant discount (30-60%) better accounts for. Add in a cap and a floor (something like $4m - $40m) to protect founder & investor in extreme situations like you described.
Obviously a fixed price is better for you, the investor. But is it better for the company? Is it the best way to model the uncertainty of valuation? You argue for not dissentivizing the investor. What about the founder who raises $1m seed at $5m valuation, then raises Series A at $30m? They mispriced their seed round, and the likelihood of the A investors finding a way to diminish the value of the seed investors greatly increases.
Just an alternative view of things from an outside.