One of the major issues very early-stage investors face is how to value start-ups with very little or no track record. Next round notes are an easy solution to this problem of valuation, because they effectively side-step the issue by basing the current round’s valuation on whatever number the next round of financing decides. The hope is that by the next round of financing, more information will be known about the start-up and a more accurate assessment of the company’s value can be determined. Thus next round notes function as a sort of convertible note.

Q. We all understand how venture stage companies get funded over multiple rounds, and often by different kinds of investors. How does a “Next Round Note” fit in?
A. This is a common technique for very early stage investment. It’s an answer to the most vexing question facing investors and entrepreneurs: what’s this company really worth? Of course, these startups usually have very big expectations for what they will be worth some day; but they are also very immature, so that traditional valuation metrics, like revenue or profits multiples, or even “comparables”, can’t really be applied. So there’s often a huge gap between how the investor and entrepreneur want to value the company.

Q. So, that explains the problem, but not the answer.
A. Indeed. Well, in this one very narrow way, Congress provides a good model for us: the answer is, kick the can down the road. The assumption is that there will indeed be future funding rounds coming in, at a time when a lot more is known about how successful and valuable the company might be. So what we can do today is say that my investment starts off as a note, for, say, $1mm; but that the note will convert into equity in the next round, at a predetermined discount – often, 30%– to that round’s valuation. Obviously, that’s what compensates me for the extra risk I’m taking by investing today.

Q. And I guess that, if the company isn’t so successful and there isn’t a next round, at least the investor has some protection because he has a debt position rather than just equity. Sounds like a neat approach to a thorny issue.
A. Right. But, as an investor, there are things to watch out for. The biggest one is that you want to negotiate a cap on that next round valuation for purposes of your conversion, because if you don’t, even though you’ll get a nice discount to that round, the percentage of the company you’ll wind up with might be so small that you’re stake isn’t worth very much. So you still have to do some math before investing.