This article was originally published in Forbes.
By: Doug Bend
We have helped dozens of startups raise their seed round of financing. Most of these companies have used the template Simple Agreement for Future Equity (better known as a SAFE) with a valuation cap that Y Combinator has open-sourced here.
One of the best attributes of the SAFE is the S, which stands for “simple” because only a few terms typically need to be negotiated with an investor. This helps to decrease the amount of time that the founders and the company’s attorney need to spend on negotiating terms.
The most important of these is often the valuation cap, which provides the investor with a ceiling valuation for calculating the number of shares the investor will own if the SAFE converts. The valuation cap, therefore, provides the investor with the peace of mind of knowing that even if the company is valued at a much higher amount, the investor will still have a floor ownership percentage in the company if the SAFE converts.
Determining the amount of the valuation cap is more of an art than a science, but there are typically six key factors—let’s take a look at them.
1. The Overall Fundraising Market
The first factor is the overall fundraising environment for early-stage startups.
For example, the current market for raising capital for startups has cooled off in recent months and is more pro-investor than it was in 2021.
The second factor is how much traction the company has. Investors are more likely to invest with a higher valuation cap if the startup can demonstrate that it has product-market fit. For example, does the company have any contracts that generate revenue? If so, how much revenue and who are those contracts with?
Another indicator of product market fit is the amount of user and revenue growth. For example, investors are more likely to invest in an early-stage startup if it has at least 20% in month-over-month revenue growth or steady, significant increases in the number of users.
3. The Prior Financial Returns Of The Founders
If the founders have a proven track record of prior exits, they are more likely to have a higher valuation cap.
Investors are more likely to invest with a higher valuation cap if the founder has previously provided the investor with a solid return. If the founder has done it before, they are more likely to do it again.
4. The Experience Of The Founders
Founders are likely to have a higher valuation cap if they have experience that is relevant to the startup, particularly if that experience is helping to grow and scale other startups in the same industry.
Investors are more likely to invest with a higher valuation cap not only if it is a great idea, but also if the right team is implementing that idea.
The industry the startup is in can also impact the valuation cap for the SAFE. For example, software companies often have a higher valuation cap because they can quickly grow and scale.
Lastly, the valuation cap will likely be higher the more leverage the startup has. For example, the more interest there is in the investment round, the higher the valuation cap the startup will likely negotiate.
In contrast, if the startup has a short financial runway, the investor might use that as leverage to negotiate a lower valuation cap or not invest at all if they believe the startup is not as likely to be financially solvent.
As you can see, the valuation cap for a startup’s seed round is based on several variables. Founders are best served working with their company’s CPA and attorney to gauge what valuation cap amount is market and fair for both their company and its investors.
Disclaimer: This article discusses general legal issues and developments. Such materials are for informational purposes only and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.