Fundraising 1.02 – Deep Tech Valuations and Cap Tables

Tips and advice from deep tech investors

Anyone who has ever been through the fundraising process understands the complexity of getting to a sustainable valuation and setting up a healthy cap table. That usually goes hand in hand with a huge learning curve. Anyone who is about to fundraise will find themselves in a very hard-to-navigate jungle of information and advice.

This is particularly true for deep tech startups: not only is most available advice catered towards software startups, but also, how can you possibly estimate a company’s value when there are no customers yet, the markets are yet to be defined, there are various risks and there is a lack of other metrics?

In our series on Deep Tech Fundraising, we sat down with two seasoned VCs based in Europe and the US, and a deep tech founder. We gathered their insights on the valuation process and their tips on how to deal with other potential shareholders (universities, early-stage investors, key employees).

  • – Laurie Menoud is a Founding Partner at At One Ventures, a VC based in San Francisco that invests in deep tech companies that help build a future where humanity is a net positive to nature. She has been working for the past 8 years in the US, previously helping spin-off ventures at SRI International and as an investor with BASF CVC.
  • – Craig Douglas is a Founding Partner at World Fund, a €350M ClimateTech fund based in Berlin. They invest in tech that can save at least 100Mt of CO2e emissions per year in sectors like Energy, Food & Agriculture, Manufacturing, Buildings and Transport. Craig has 10+ years of experience as an investor in the clean energy sector.
  • – Robert Brüll is Co-Founder and CEO at FibreCoat. FibreCoat is a RWTH Aachen spin-out that produces new types of fibre coats with the aim of making high performance materials affordable, efficient and sustainable. In October 2021, they raised €3M in a Series A round.

Let’s start with the not-so-basic basics: How to calculate first valuations in deep tech?

The first valuation is not only the most difficult one to establish but also the most important one to get right as it will have a long-term impact on subsequent rounds.

Unfortunately, and let’s be blunt here: there is no magic formula.  In the earliest stages it’s all about potential, and as Laurie says: “it’s closer to an art than a science.”

VCs have the experience and general knowledge of both fundraising and the startup life cycle to practice that art. Early-stage, first-time founders do not. So keep an open mind and ask around.

To come up with a valuation, investors will use several strategies that are not mutually exclusive. One way to approach it is to look at comparables in the market, companies that are working in a similar sector, are at a similar stage and go after the same market. VCs will then come up with an average valuation, to which they will apply discounts or premiums depending on the trends, team, tech, market size and exit opportunities of a specific startup.

Another way to go about it is to look at the potential exit and try to work backwards from there. What is the potential for your product in the market? What is the potential value there? Looking at it that way is the easiest way for a VC to decide if the potential is large enough and will make a large enough return. Then you need to consider the key milestones – both technical and commercial – along the way to that desired exit. Looking at those, a VC will look at where you are today, how much money you are raising and where that is going to take you.

Craig’s additional 2 cents on it: Don’t do a discounted cash flow to calculate your valuation, it means nothing to VCs.

Don’t be afraid to ask for enough money… and to negotiate!

In general, don’t be afraid to ask for enough money. Don’t forget that not only will you have to show that you have enough traction for the next round, but you also need to take into account that every round will dilute your shares by 20 – 30%. Based on that, you can come up with a range of valuations that is probably going to make sense for you.

You’ll have to meet with a lot of investors who will not necessarily have the same opinion, will give you different numbers and have different thought processes. Learn from them, ask questions. Take all this feedback to forge your own opinion and don’t be afraid to negotiate. Think about what you need and how it impacts your equity story.

As Robert says: “It’s a long process going from the number you start out with to the final number, and this number will definitely change throughout the process”.

We know it’s tough, but the good news is: the next round is going to be easier to price than the initial one. Just make sure that your pricing today is not going to make a mess of your pricing tomorrow.

Of course, there are more factors that impact valuations. Market dynamics and cultural mindset also play a big role, especially if we compare the US and Europe.

Differences between the US and Europe

Valuations are currently much higher in the US compared to Europe. The US VC industry is well developed and mature and there is a lot of capital available at the moment. The basic law of supply and demand is leading to more competition among investors and thus resulting in increasing valuations. The European VC market is smaller (even though it is catching up) and is attracting US investors who are much less price sensitive than European ones.

You can then expect higher valuations from US investors, even if you’re not based in the US.

But it’s not all about market dynamics, there are fundamental cultural differences between the US and Europe in both how entrepreneurs sell the vision of their company and what investors look for. US entrepreneurs will usually pitch a big vision with huge market opportunities and potential exit. “Especially in Silicon Valley, people are really well trained in pitching ideas to investors, if you manage to pitch a big vision for your company, a big opportunity, and a potential exit, it is going to drive the valuation up”, explains Laurie. This approach of selling a big vision is also what US investors are expecting and are used to.

In Europe, it’s quite the opposite. “[The European European VC market] is getting similar, but the selling nature is fundamentally different”, says Craig. There is a tendency for founders, particularly in deep tech, to undersell and openly discuss the shortcomings and challenges of their company early on, while in the US there is a tendency to oversell and possible difficulties and problems only become visible halfway through the due diligence process. “The other thing is that European investors are more conservative, they’re less driven by super high returns”, adds Craig. “It’s a history in Europe where the failure rate is lower, but the super success rate is also lower”.

There is no right or wrong in this. It is just important to keep in mind that the culture around that process is very different and you need to adapt your pitch accordingly. Bonus: make sure to also adapt details like metric systems and currency in addition to the order of your outline. Often, small things can go a long way.

FibreCoat’s Experience – Fundraising in the US vs Europe

Robert raised money from both sides of the Atlantic for FibreCoat and couldn’t agree more: “We made exactly that mistake, where we were very open and honest and explained all the errors of our startup.”

But not only that, in Robert’s experience, European investors also asked early on about the details and the technology, while in the US investors wanted to hear about visions, potential and “how are you going to change the world?”.

These first lessons quickly led Robert to adapt his pitch to the local mindset and structure it completely differently. In the US, he would start with the vision and expect discussions around technical details much later in the process, whereas in Europe he’d swap it around by 180 degrees.

Despite these differences in the approach and interactions with investors, extensive discussions led to a final common valuation for FibreCoat

Besides founders and VCs, who else could be at your cap table and what should you look out for?

Business Angels

Typically, angel investors are high net worth individuals that want to engage with the entrepreneurial community and help founders. In most cases, they invest either through convertible notes or through SAFE (simple agreements for future equity). There are many benefits to these types of financing, as the documents are usually quite short without having to negotiate many legal terms and therefore easy and fast to execute. However, it is important to understand the nuances and to ensure that they are according to the industry standard and don’t include any tricky terms that might fall on your feet later. You can check the industry standard at the European VC Association or the North American VC Association websites. Another thing to note is that there are regional differences (tax system is one example) that might impact angel investor behavior and make them more or less price sensitive. If they are less price sensitive – which they often are – and offer a high amount, be aware as it can cause problems later on! You might be too expensive for where your company is at for some investors to invest in or in the best case, they will invest but a significantly lower amount – and that can be quite demoralizing for the founders.

Key employees

Are company shares a good strategy in order to incentivize employees and if yes, who should get how much? Here we have once again geographically dependent answers.

In the US equity and stock options are common. “Equity should be for all employees, because it’s the best compensation for recruiting, motivating and retaining employees at a startup company with a vesting period” is Laurie’s take on that. That means around 1-5 % for key employees and less than 0.1 % for all other employees. It ensures everyone has a stake in the company and growing the company is tied to personal financial benefits.

In Europe, company shares and stock options are not as common due to a different financial culture. Sometimes they are not even as financially beneficial as it might first seem depending on the local tax system. Craig thinks that good C-level people should always be incentivized with options, anything between 0.5 – 3 %, the same way the shareholders are. However, for a general employee, it’s really dependent on the country. In the UK, it is normal for employees to get options and it is something they expect. In Germany, not so much because benefits like that are taxed in the same way as the salary which makes it complicated and potentially expensive.

Founder hack: speaking of expensive, in some cases it can be a good way to pay very expensive employees early on when your funds are still low.

“Motivating [employees] through rewards or punishments isn’t really working. Ownership is [a] much stronger [tool].” – Robert Brüll, Co-founder & CEO, FibreCoat

If stock options is something you’d like to offer your employees, make sure you understand the local tax system and look into the different options on how this can be done, for example through virtual ESOPs. This is how FibreCoat solved the issue of the taxation disadvantage for their employees of regular stock options in Germany.

Universities / Research Centers / Venture Studios

Spinning out of a university (or research center) is quite common in deep tech but it also brings its own set of challenges. Some of the questions that you need to sort out are who owns the IP, who are the stakeholders involved that you need to negotiate with and who should be included in the cap table. Let’s be straight here: there is no clear manual as it depends highly on the university, the people involved and the realities of your company.

You should aim for a maximum of 25 % of equity for the university. If the university asks for 50% equity or 10% revenue fees, it’s a huge red flag for potential investors and you may end up at a Series B stage where you own less than 10% of your company. Late-stage investors might think that founders do not have enough incentive to grow the company anymore.

But worse than that, the startup’s probability of failure is increasing (and everyone, including the university, would end up with nothing).

  • Weighing your options: Buying the IP

In the case of FibreCoat, which spun out of RWTH Aachen, they managed to keep the university out of their cap table entirely. “We were fortunate enough to be able to make a lump sum payment to the university and then another success fee down the road”, says Robert. Which means they now own their IP fully and pay for every hour of access to university resources that they use. This makes the boundaries very clear and allows for high flexibility (not to mention, it simplifies explaining the current setup to investors). But don’t be fooled: “As nice and clean as this sounds, getting there was a long process”, Robert emphasizes. His advice: start the negotiation process with the university as early as possible.

Okay, that didn’t sound too horrible, did it? But let’s think this through a little more. FibreCoat was quite lucky in how smooth their negotiations went and that they had the funds to afford buying the IP. But let’s be honest, that might not be an option for most startups. So what other options are there?

  • Weighing your options: Licensing agreements and royalties

Another way of setting up a clear structure to use the IP is coming to a licensing agreement or an agreement to pay royalties to the university. It’s a common practice and the university most likely will already have standard licensing terms in place. However, make sure to read the terms well (as with any legal terms) and again – don’t be afraid to negotiate.

The problem with royalties is that it’s going to hit your cash flow and your runway, resulting in you needing to raise more money much sooner”, warns Laurie. This is going to dilute your ownership in the company, which is unfavorable for several reasons. She advises to ensure that the royalties are not too crazy high.

Try to negotiate lower than 5% royalties on your sales, very little or no minimum annual royalties and ideally, a cap on the royalties that the university can take every year. Alternatively, try to make sure your royalties only kick in once you hit a certain revenue threshold. This is going to save your company’s life.” adds Craig.

If all this didn’t seem complex enough, keep in mind that negotiations usually involve not only the university itself – and this is where it can get quite complex – but other stakeholders such as professors or external partners that you might have worked with, or regional funding agencies. How do you manage to get all of these on board and aligned into one agreement – whether that is licensing, equity or a lump sum payment? It can take a lot of time, communication, negotiation and patience. For FibreCoat it took more than a year.

When negotiating with these stakeholders, it is important to be confident, explain clearly what you envision, where you’ll take the technology and the startup and be concise in what you want and need.

You have to stay confident, and you have to know what you can do, the more freedom you get from the university, the better. – Robert Brüll, Co-founder & CEO, FibreCoat

Fixing unfavorable terms – is it possible?

If it’s too late and you already negotiated unfavorable terms: there are solutions to fix it during the fundraising rounds. Typically, the investor will put in money at a low valuation and create a massive (30 – 40%) ESOP pool and hand that to the founders. This happens especially when the universities can not follow on on their investment (which is quite often the case in Europe). However, it is definitely a problem that you would want to avoid as you need to find an investor who understands that this is possible, who is willing to go through with it and get the universities on board with that dilution. Both Laurie and Craig confirmed they walked away from deals because of a bad initial cap table.

“Better take your time and negotiate well and early. You should especially look out for any terms regarding revenue fees as these can break your neck further down the line.” – Craig Douglas, Founding Partner, World Fund

Remember: No matter what your strategy for the IP situation with your university and other stakeholders is: Negotiate, negotiate, negotiate.

As we can see, once again, there is no one solution that fits all and it is all about finding out what works best for your company and your team but we do hope that some of these insights and advice will help you make this journey easier.

If you want to learn more about how to identify the right VC, how to make your first meeting a success and much more, make sure to check out our first article on Fundraising 101.

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