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La Escuela del Sur #6, The Magician’s Code: Terms and Valuation to Offer Investors

At least once a week, a disheveled Latin American entrepreneur comes to my office fresh off the plane with the same black Tumi backpack and the same question. “I am ready to go to raise capital.  What terms should I offer?”

In the world of magic, there is a code: a magician does not reveal the “secrets” of other magicians.  Well, I would have been a terrible magician. Here are the secrets that your advisors don’t want you to know.

What is my company worth?

That seems like an existential question.  At business school, there are exhaustive PhD-level courses exploring different ways to value companies.  Terms like “Black-Scholes” and “Discounted Cash Flows” get thrown around.  

You don’t need to go to business school to answer the famous valuation question.  For over 75% of early-stage Latin entrepreneurs with an initial MVP or some real industry expertise, venture investors value their companies at $750K-$2M. The valuation range for most early stage ventures incubated in Latin America will be $1-1.5M. This early-stage valuation allows a Latin entrepreneur to raise $250K-750K to prove the product/market fit.

If the company has over $100K (hopefully approaching $200K) a month in reccurring revenues, then venture investors will likely value them as “growth stage” around $8-15M, allowing the company to raise $2-5M comfortably.  In between those two extremes is the “Valley of Death” the subject of my earlier article-La Escuela del Sur #3.

What terms should I offer?

With a ballpark valuation set, the next consideration is what terms to offer prospective investors. This sounds like a daunting, open-ended question. My advice to entrepreneurs is: “innovate on your business model and product.  No need to innovate when it comes to legal documentation.” For most early stage companies from LatAm, there are only three alternatives for terms and 90% of the work for setting those terms has already been done.

If a Latin American entrepreneur is willing to offer investors equity, then she/he should insist that lawyers use the “Series Seed documents.”  Seven years ago, a group of brave lawyers led a project to open-source a standard set of early-stage legal documentation to allow founders to close  a Seed Round without incurring high legal fees. These templates contain a term sheet that uses the terms that most Latin American entrepreneurs raising a first round should expect to offer investors.

Note: If a company is raising more than $1M from institutional investors, it should consider the National Venture Capital Association form documents which are much more robust.

The problem with issuing equity is that the company and the investors have to agree on a specific valuation for the company at the time the equity is issued.  Often, the conversation around valuation gets complicated when the company is in early stages. Many entrepreneurs therefore explore the possibility of issuing a convertible note. There are standard terms to offer with this instrument, as well.

If the entrepreneur wants to offer investors a convertible note, he or she should use the TechStars convertible note.  This may not be the best convertible note template, but it is likely the most used convertible note in the world.  This broad acceptance makes it very functional for convertible note deals. As is often the case, “good & done” is better than “perfect & still working on it.”  

The terms for a convertible note are almost always the same: a two-year maturity date to either (i) pay off the note or (ii) complete a “Qualified Financing”- usually defined as $1M of new money invested into the company.  98% of the time these terms also include a 20% discount on the next round’s valuation and a cap on the valuation for the conversion. Often the conversion cap is between $1-3M for early stage LatAm companies.

An alternative to the TechStars convertible note is Y-Combinator’s SAFE, which is more founder friendly than a traditional convertible note.  A SAFE is like a convertible note without a maturity date so if the company never does a Qualified Financing, the SAFE never converts to equity.  

In a convertible note or a SAFE, the entrepreneur and the investors do not have to agree on what the company is worth to close the deal. Therefore, it is generally easier to close a convertible note or SAFE than it is to close a priced equity round.

“If you think I am expensive, wait until you see how much being cheap will cost you.”

I have seen several cases in which entrepreneurs try to use these templates to replace legal services and save money. I often see the DIY (do-it-yourself) or DWYLL (do-it-with-your-Latin-lawyer) methods, and these usually have negative repercussions. As my car mechanic used to say: “If you think I am expensive, wait until you see how much being cheap will cost you.”  

While the documentation in venture capital is fairly standardized, venture capital is very trend-driven. Only lawyers and advisors who are constantly working with entrepreneurs can advise on the most recent trends in venture. Like in the fashion industry, trends in venture change sometimes month by month. Terms that were “market” last year are not necessarily “market practice” this year.

A busy venture lawyer may advise 50-100 companies per year. At PAG.law we have advised over 400 venture backed companies in five years. A good corporate lawyer who does not specialize in venture might advise on two or three venture deals a year. A lawyer in Latin America who is offering to help might even be reading this article to figure out what agreements she should use. This goes to show that a specialized lawyer goes a long way.

There are lots of insights a lawyer or advisor not experienced in venture will miss. Ask yourself: if you were having to get eye surgery, would you try to find a surgeon who specializes in eye surgery, or would you try to save money and hire the surgeon who once did a similar operation a few years ago?   

When Y-Combinator posted the SAFE template, SAFEs were very popular for about a year until investors slowly began to realize that a SAFE is less favorable to investors than a traditional convertible note. Today, most Latin American entrepreneurs find they cannot raise money using a SAFE because the VC market prefers a more standard Techstars convertible note.  Only lawyers and advisors who live and breathe venture can provide these types of insights.

Now that you know what your company is worth and what terms to offer investors, move onto the fun part: go build a disruptive business that improves the lives of the emerging middle class in Latin America.

 

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