There’s a startup raising capital right now that seems like a slam-dunk investment.
It has groundbreaking technology, backing from prominent VCs, and $1 billion in orders. Investors are piling in. And I was about to join them — until I noticed something.
As a result, I won’t be investing in it. You shouldn’t either.
Let me explain.
An Impressive Start
The startup I’m referring to is called Alef, and it’s built a flying car.
To be clear, this isn’t a concept car, or a computer rendering.
It’s an actual vehicle that can be driven on the street — then it can take off vertically and literally fly over traffic
To see it in flight, click here »
Alef already has significant traction:
- The FAA is allowing it to do flight tests. It’s already done 1,000 of them.
- It’s received more than 3,500 pre-orders, representing nearly $1 billion in sales.
- And it’s backed by venture-capital firms including Draper Associates and Splash Capital.
It’s no surprise that investors are excited to get in while the company is still on the ground floor.
But when I dug into the deal terms, I quickly realized there was a dealbreaker…
The Investment Terms
When raising capital, some startups set a valuation for their funding round. For example, they set the valuation at $5 million, or $10 million, or $50 million.
But since it’s difficult to determine what a company is worth at its earliest stages, other startups decide to fix the valuation later. Specifically, they’ll let a professional investor determine the valuation in the future — and investors in today’s round will get a discount to that valuation, since they’re taking more risk.
The thing is, such deals typically come with a valuation cap. The cap determines the maximum valuation for today’s investors — i.e., the highest valuation you’ll pay.
For example, if the valuation cap is $50 million, that’s the highest valuation at which your shares will be issued. So if the company raises funds next year at a $100 million or a $1 billion valuation, you’ll still get your shares at the $50 million valuation cap.
In other words, you get a nice discount.
But here’s what I noticed about the deal for Alef…
There’s No Cap!
Alef’s funding round is “uncapped.”
In other words, there’s no maximum valuation at which your shares will convert in the future. There is a 20% discount, but unlike a valuation cap, that discount doesn't limit the valuation at which your investment will convert.
So if Alef’s next funding round takes place at a $1 billion valuation, that’s the valuation you’ll invest at, too (less the 20% discount).
Suddenly, your investment looks a lot less promising. Earning 10x your money — our target for any private-market deal — would mean Alef would eventually need to be worth roughly $8 billion to $10 billion.
Such an outcome is possible — but it’s much less likely than if you’d gotten in at a $50 million valuation.
By investing earlier, you’re taking on more risk. You deserve to be compensated for that risk. And a valuation cap is how you get compensated.
Without a cap, the risks/return calculation changes — and not to your advantage.
Keep Your Investor Hat On
This doesn’t mean Alef is a bad company. It may turn out to be a great one. If you’re interested in exploring its current funding round, click here »
But great companies don’t necessarily make great investments.
As Matt has been pointing out with SpaceX in recent weeks (here and here, for example), deal terms matter just as much as the company itself.
Bottom line: when looking at startup investments, stick to deals that have set valuations or valuation caps. This is how you protect your upside!
You’ll find plenty of such startups on our Deals page right here »
In the meantime, happy investing.
