Interim rate of return: A better approach to valuing early-stage startups

Convertible instruments, whether in the form of convertible notes, simple agreements for future equity (SAFEs) or otherwise, have long been used in the startup world to avoid a fundamental issue: the extreme difficulty associated with valuing early-stage companies. But what happens when the very mechanisms designed to address this problem become a part of it?

Valuation caps, for instance, are now employed in most early-stage convertible instruments. By imposing a ceiling on the price at which a convertible instrument converts to future stock ownership, valuation caps were intended to protect early-stage investors from extreme, unexpected growth (and, consequently, equity positions deemed excessively small by such investors).

However, valuation caps are increasingly being used as a proxy for the value of the company at the time of the investment — creating the very problem they were designed to help avoid, while adding unnecessary complexity for inexperienced founders and investors.

It isn’t surprising that founders and investors struggle to resist the lure to discuss present value when using valuation caps, despite efforts to push back against that use. This is especially true in contexts where the valuation cap “ceiling” expressly values the investment in a pre-conversion exit event (e.g., both the old pre-money valuation cap SAFEs and the newer post-money valuation cap SAFEs made available by Y Combinator).

Fortunately, there’s a better approach: the interim rate of return method.

The problem with early-stage valuations, or the crystal ball

Before we get to the solution, it’s useful to provide additional context on the problem — namely, why it’s so difficult to thoughtfully and rationally negotiate the value of early-stage companies.

Some will say that such valuations are difficult because early-stage companies don’t have meaningful (if any) revenue, have limited assets or are just an idea. Yet, while these arguments identify real issues, they miss what may be the most important one: Investors at the earliest stages are investing in a possible ownership structure that will typically only fully exist in the future upon completion of the founders’ vesting schedules.

Let’s say you’re an early-stage investor writing a $500,000 check for a startup at a stated pre-money valuation of $4.5 million, where 100% of the existing equity is held by a single founder and subject to a 4-year vesting schedule that just started.

On its face, that would entitle you to a 10% ownership in the company (i.e., the post-money value would be $5 million, with your capital representing 10% of the value). But your stake and the pre-money valuation at which you effectively invested depends on how much of the founder’s vesting schedule is actually completed, as shown by the following table:

In our example, the company was effectively valued at $0 on the investment date; its value was otherwise implicit within what the founder would be able to build over the life of the vesting schedule (presumably without outside capital, on a fully bootstrapped basis).

When founders and investors are looking into their respective crystal balls to value the future, already difficult negotiations become nearly impossible.

Current approaches

As noted above, convertible instruments were intended to skirt the difficulty of early-stage valuations by deferring the issue until the value being created by the founders could more readily be predicted (or until such value had been realized), and a priced equity round could occur. These instruments have generally evolved as problems were identified and addressed — an incremental approach that has led to today’s overly complicated and counterintuitive pricing mechanisms.

For instance, in years past, convertible instruments avoided the valuation issue by applying a flat, non-discounted conversion, with early investors rewarded with warrants that enabled them to receive additional preferred shares in the future round. A problem arose, however, due to certain adverse tax consequences related to the warrants, and so conversion discounts were created in an effort to avoid those consequences while still providing investors with the benefit of warrant coverage.

With conversion discounts, the convertible instrument converts into equity in a future financing based on a discounted price per share, indirectly reintroducing valuations in the convertible note context. Generally, these discounts are static, meaning that the same discount applies whether the instrument converts in six months, one year or two years, although discounts rarely have step-ups at various intervals (a more complicated and less intuitive version of the rate of return approach outlined below).

Yet, as companies became increasingly adept at using convertible instrument capital to create significant value, early investors became concerned that they were not always being adequately compensated by discounts. And the valuation cap was born.

However well intentioned, valuation caps directly reintroduced valuations to early-stage convertible instrument negotiations. They have also shown, especially when coupled with discounts, to be unnecessarily difficult for first-time founders and investors to fully understand and negotiate, which has exacerbated the pull to simply use the cap as a proxy for current value.

A better way: The interim rate of return method

Thankfully, there is a simpler and more intuitive way that’s easy to negotiate, doesn’t slip into conversations about value and still rewards investors for a truly unpriced investment without being detrimental to the company’s interests.

With the interim rate of return method, you simply negotiate a rate of return (like an interest rate) that applies to the convertible instrument investment solely for purposes of future conversion or the amount payable in a pre-conversion exit. Rather than directly (via a valuation cap) or indirectly (via a discount) discussing valuation, this method simply agrees on the appropriate rate of return that will accrue on paper until the investment can be priced in the future while avoiding the unnecessarily complicated approach often taken with discount step-ups.

Importantly, to avoid various debt-related legal issues in the same manner as current approaches, the negotiated rate of return is not an actual interest rate (in a convertible note, the interim rate of return is separate and distinct from the interest rate) and is not recognized in a pre-conversion, pre-exit liquidation and dissolution.

Using our example from above, rather than investing $500,000 at a nominal pre-money valuation of $4.5 million, let’s say that the investor instead invested via a convertible instrument with an interim rate of return of 25% compounding annually.

If the instrument converts in 18 months, it would convert into approximately $700,000 in securities in that financing round. If the company is sold in 18 months, the investor would receive approximately $700,000.

In either scenario, the investor would receive the negotiated 25% rate of return and be compensated for their risk. What’s more, the interim rate of return addresses the risk that the company will defer a priced round using additional convertible instrument capital until a higher valuation is achievable, thereby addressing the issue valuation caps were designed to solve and better aligning the investor and company’s incentives.

In sum, the interim rate of return allows convertible instruments to get back to basics, avoiding discussions of early-stage value and providing a simple, intuitive mechanism to reward early-stage investors.