Convertible notes or the Y Combinator valuation formula are approaches to avoid price negotiation at the early stage of a startup. Through these methods, early investors can wait for the seed stage institutional player to set the price (valuation) and convert their equity at that rate, opines Peter Relan, head of Silicon Valley early stage incubator YouWeb.
Some of these valuation models, used in the US, might work in Southeast Asian startup ecosystems as well.
In an interview with DEALSTREETASIA, Relan detailed his incubation investing methodology after his address at the Vietnam Silicon Valley Accelerator’s Investor Bootcamp earlier this month.
YouWeb’s portfolio companies have been acquired by the likes of Google, Facebook and Japan’s GREE. Relan has also led a lot of incubated startups through later stage funding rounds. He has invested in US-based, Vietnamese-founded edutech startup GotIt!, which closed $9 million funding outside of YouWeb last year.
Let’s talk about your incubator. Why do you choose nine months for the programs?
Every time we take a new batch, we give it a name and theme. The first batch was Mobile Social while the second batch was 9+. We typically like to give one year to our founders. Most incubators in Silicon Valley do three to six month programmes, but we’ve got to be different. Most important of all, what the founders like is the mentorship – the knowledge they get on how to succeed, build the technology and team, bring the products to market and raise funding.
That was the beginning. We had good success with four companies, having incubated about 10 companies. 9+ – the second batch during the last four years – incubated 20 companies.
We have finished the second batch. GotIt! is one of the stars and I am happy to help them.
A lot of accelerators claim to have broad networks of partners and investors to help startups raise further funding outside of the programme. But that is not what is actually happening for a number of incubators. What are the reasons?
For early stage incubators, we take every risk because the startups are so young. There are three risks: team, product and market. We will not see every startup make it through. External investors do not want to take so many risks. Seed investors, the next investor after incubator, would like to reduce at least one of the risks. Most would want to see product risk or market risk gone. They would want to see the market love the product.
Then the next investors would want to make sure the team, the product and market risks out. With GotIt!, we got the incubator out (exit) before the $2.5 million seed round. It raised $6 million in its Series A round. Now we are getting to raise Series B. Each time we get more, the bar is higher.
There have also been debates about whether to take minor stake in a startup and exit to a VC investor, or to get a majority portion then help the startup get acquired. Which one do you think is better?
It depends on the idea. If it’s a big idea, then it is important for the founder to take control and to be able to go big and then attract later funding. In that case, minor stake is better. If it is a small idea, which is still workable, it’s alright for an acquisition. We had four companies acquired by Google, Facebook and GREE. I don’t think anybody should ever take majority stake of more than 50 per cent. But 30-40 per cent is okay. For the early stage, take 10-12 per cent maximum if it’s a big idea because you need other investors to come in to get cash for the startup to get big.
US incubators often take convertible notes, which is not a normal practice here. What is its advantage over equity investment?
Convertible note is more unusual. But, in the US, we are very comfortable with it. The reason we use it is because in the early stage startups, it’s not easy for the early investor to come up with the valuation for the company. So, it’s better to wait for the seed investor, who is more institutional and experienced in investing in startups, to set the price. We will convert into equity at the price (seed stage) with some discounts. That’s an easy way to do it.
However, one of the approaches used in many countries is SAFE (Simple Agreement for Future Equity), invented by Y Combinator. With SAFE, they take 7 per cent of a company at a preset valuation of about $1.7 million. That creates a standard that nobody would judge that you’ve got too low. It allows a startup not to require convertible notes but still have a standard. Otherwise, you will have to negotiate a price every time.
The whole point of both approaches is to avoid price negotiation at the early stage. Here you can use Y Combinator’s SAFE.
As an angel investor, have you invested in Southeast Asia?
Even though I haven’t gone to invest in the region, I am now thinking that YouWeb should be here. But it will require a lot of support from the local region because I am full-time committed to GotIt!