I can’t tell you how many times I’ve walked away from deals where the entrepreneur insists on a start-up premoney valuation that is so high, no angel could expect to make a return upon the investment, even with a reasonable sales price for the company down the road.
There is always another attractive deal at the ready, and most have reasonable expectations of valuation. Why fight about valuation, or disappoint the founder at the outset? The real focus should be on smart planning, finding ways to launch and build the business with smart but frugal use of money.
Let me tell you two stories that are linked. The first is of a 2004 startup that I cofounded and led the investment group for several early rounds, then VC rounds. The company has grown to forty employees and a healthy eight figure gross revenue run rate, but has absorbed over $36 million of angel and VC money to do so, and without yet reaching breakeven.
[Email readers, continue here...] The second story involves a founder who is using outsourced development, support, outsourced customer relations and more. The total capital raise will have been under $600,000 if all goes as planned, and the founder retains majority control of his baby through this and even one optional future round.
For the first, company, the founder’s remaining portion is under 4% after all the subsequent rounds, and not yet at breakeven. The second company finds the founder with majority control even if the original raise is not enough. For the founder to see any return at all in the first company, the ultimate selling price must be above $40 million. In the second company, better planned, the founder would be made pleasantly wealthy at a selling price of $10 million. The chances of the latter occurring are much greater than the former. This founder was not hung up on valuation for the second company, just upon efficient use of capital.
Angel investors, particularly those in organized angel groups, are typically former entrepreneurs who have had successful liquidity events in their pasts, or executives of companies who’ve retired with the funds from their stock options. Occasionally, an angel is a member of a wealthy family, having little experience managing a business. But most often these angels are skilled at growing companies, calling on their past experience to evaluate and then help entrepreneurs in their early stages of growth. Several times in our angel group, one of the largest in the United States, we have queried our group as to their motives in being active, risking their money, taking their time to research, perform due diligence and then coach entrepreneurs of young companies. The result of these surveys over time is universally the same. Although
most every angel member joins a group to find great investments that will make money for the investor-member, all have other, sometimes more personally important goals. These include giving back to the community in the form of time and investment, or learning about new industries, new advances, and a generation of new ideas. Members want to socialize with those who have similar backgrounds and interests. And members want to participate in the creation of the excitement they universally once felt in the growth and ultimate liquidity event they experienced with their previous company. [Email readers, continue here...] Angels come from technology, real estate, medical specialties, and many other industries, bringing a wealth of experience to the table to help evaluate and then coach entrepreneurs. So how an angel responds to your pitch depends upon his or her background. You should try to find a way to get information about your audience before or even when standing in front of them. What industry specialties do they like, or where did their experience come from? Do you know any people in common? Are they interested in your industry either to be educated or to share their skills and experiences? Connecting with these people often requires a bit of effort. Networking events are great starting points. Although many of these angels will appear standoffish at the start, if you can find some information from one or more of them before making your pitch, you will be in a far better place to succeed when pitching your idea to an individual or a group.
If you seek funds from an organized investment group such as an angel fund, venture capital entity, or even an investment club, the first thing you want to do is to find one person to buy into your vision, become excited by your enthusiasm and be willing to become the internal champion for your fund-raising effort.
In some groups, if you cannot find such a person, you cannot even find the way to apply for funding, as some groups make it imperative that any introductions come from the inside, from a member or partner. In others, if you cannot find such a champion after initial presentations to a subset of the entire group, you will not be permitted to move from initial application to the next stages of due diligence and final funding.
And in all cases, simply sending in an executive summary of the business plan via email or filling in an application for funding on a website lowers the chance of success to near nil. If you cannot find someone on the inside, network with accountants, attorneys and bankers to find a name of an influential member or partner.
[Email readers, continue here...] You may have the most impressive plan in the world, but these organizations see tens of these each week, and often cannot be expected to understand the vision and potential of any at first glance at a document. I receive three hundred unsolicited executive summaries a year, and my investment group, Tech Coast Angeles, sees over one thousand. Together we fund, maybe, twenty-five of these. Although much more than half are disqualified because of geographical location, industry, or amount of money needed, that still is a small percentage of funding to applications.
Banks and lenders often are the same way. Although anyone can walk into a bank and apply for a loan, those who are recommended by a trusted source are treated much more personally and have a greater chance of success.
Spend time finding your champion. Create time to network with members of these groups at their public events. Seek out names from your trusted sources.
It is rare when one person starts a company, supplies all the funding, and shares no management tasks or equity with others, and still grows the company to any significant size, worthy of a multi-million dollar opportunity to cash out at exit.
We should think of the creation and growth of a high valued company as the sum of three parts, with three distinct classes of participants helping to make real value out of a raw start-up.
First, there is the entrepreneur, the visionary, and force behind the venture from start to finish. The reward for the entrepreneur, after years of effort, time and sacrifice, is measured by what portion of the total pie s/he retains at exit, how much the person continues to participate through that time, and how many other resources are brought in to get to that point. Most importantly, the reward is measured by how much added value the total process creates over time. It is the old story of “100% of nothing is worth far less than 10% of a large number.”
[Email readers, continue here...] Few entrepreneurs can do it alone, with subordinate hired help and no expert management to share the burdens, skill sets and efforts involved in growing the enterprise. So co-management is the second group to share in the bounty upon a liquidity event. Often, if not co-founders, this group is rewarded through issuance of stock options from a pool of available options that usually totals 15-20% of the total company’s equity divided among all employees. Those who receive options but leave the company before a liquidity event may either purchase those shares represented by the options upon exit from the company, or lose the right to those shares, often 60 days after their exit.
The third group is made of the total number and types of investors, other than the founder(s). From friends and family early on, to angels that are not related to the founder(s), to venture capitalists for larger opportunities, these investors have risked their money in the venture for only one reason – to eventually profit from a liquidity event.
It is normal for the first round of organized angels to expect to purchase between twenty and thirty-five percent of the company with their investment. Second rounds, if needed, often drive the founder(s) into a minority position, unless the company has grown significantly by that time and can command a higher pre-money valuation, giving less stock for the same amount of investment. Investments in small companies involve a much greater degree of risk than investment in public companies, which provide immediate liquidity if needed and a ready measure of value at any time. That risk deserves reward if there is a profitable sale or even an initial public offering, rare as that event is.
So remember that there are three slices to the pie to consider when creating your company and again when considering a sale or liquidity event. All three deserve recognition for the risk, time and effort in driving the company to its ultimate value.
Think of it as the rule of the thirds.
Dave’s note: Popular Bill Payne returns this week with a thoughtful take on valuations.
By Bill Payne
One entrepreneur has a company which appears to be scalable to a $30 million exit value in five to eight years, and a second entrepreneur’s venture seems to be scalable to $200 million in exit value in the same time frame. Yet, at the pre-revenue stage of development, angel investors price both companies at a pre-money valuation of $1.5 million.
It doesn’t seem right, huh?
But, it is… and here is why. It is possible to grow a company to a valuation of $30 million on one or two angel rounds of investment. But, the working capital and management team necessary to grow a company quickly to sufficient revenues to justify a $200 million valuation will require raising lots more capital. So, the angels who provided the most valuable and risky financing for the gazelle that can grow to a $200 million valuation quickly are going to get diluted by subsequent investors, probably by three to five-fold. They may own 30% after the first round of funding but will probably own less than 10% at exit. So, angels simply must value both ventures at about the same price.
[ Email readers, continue here...] Scalability is a critical factor for angel investment. Because of the risk inherent in funding pre-revenue companies, angels are unlikely to invest in any venture that cannot demonstrate the potential to scale to a $20-30 million in valuation in a reasonable time period (5-8 years).
So, angels won’t fund a deal that doesn’t scale sufficiently to justify investment, and they tend to value all pre-revenue stage companies at about the same valuation, which is currently about $1.5 million in most parts of the US. Although there may be some variation among business sectors, this is essentially true for software companies, medical device companies, life science ventures, electronics companies and alternate energy deals, regardless of the long term potential.
Bill Payne has been actively involved in angel investing since 1980, funding over 50 companies and mentoring over 100 more. He is the recipient of the coveted “Hans Severiens Award form the Angel Capital Association, its highest honor.
The sale of equity in private companies is regulated by the Securities Act of 1933, which requires that the company either register with the SEC or meet one of several exemptions (Regulation D). A Private Placement Memorandum (PPM) is a special business plan defined to meet an SEC exemption. In most cases, those entrepreneurs choosing to raise capital using PPMs retain specialists (many of whom are lawyers) to write their PPMs – a rather expensive undertaking. I don’t fund new companies that have prepared PPMs for investment. I am an angel investor, that is, an accredited investor who is assumed by the SEC and others to be sufficiently wealthy to afford to lose the investment and supposedly experienced enough to make good choices on fundable companies. Angels, as group of accredited investors funding startup companies, are assumed to meet a Regulation D exemption for purchasing equity in private companies.
Like most angel investors, I have preferences for the terms and conditions of investment and intend to negotiate with entrepreneurs on those terms, such as valuation, company structure, the makeup of the board of directors, liquidation preferences and others. I have yet to read a PPM written for a startup company that meets the parameters we angels generally establish for funding new ventures.
[Email readers, continue here...] If I don’t like the terms offered in the PPM, why don’t I insist that the terms be changed to accommodate my partialities as an angel investor? Sounds simple, huh? Unfortunately, upon completion of the PPM, the first thing that entrepreneurs tend to do is sell shares to friends, family, friends of friends and other acquaintances. Then, only after convincing these “unsophisticated” investors to sign up and write their checks, the entrepreneur may approach an angel or group of angels.
The entrepreneur may have already raised half or more of the cash required in this round and is eager to top off the round. The PPM does not meet the investing terms and conditions of the angels. The valuation is too high, or the PPM is written to sell common stock when it really should have been a preferred stock deal, or other critical terms are not present in the PPM. Since many unsophisticated investors have already funded part of the round, it becomes too complicated to renegotiate the terms of the deal.
It is only fair that all capital sources in a given round should invest under the same terms and conditions. There should not be one version of terms for the early set of investors (the PPM terms) and a second version of terms for later investors in the same round. In the long term, different term sheets for investors in the same round leads to unhappy investors. We angels could insist that the entrepreneur go back and renegotiate the terms of the PPM with all the earlier investors, but the earlier investors may or may not agree to the changes. From a long history of angel investing, we have learned it is just easier to pass on PPM deals and move on to the next opportunity. We see many startup investment deals every year – too many for most of us to fund.
Regarding PPMs, my recommendations to entrepreneurs are:
- Don’t prepare PPMs to fund startup rounds of investment. It is expensive and may preclude sophisticated investors from funding your deal.
- Pursue smart money, that is, sophisticated investors who will negotiate a fair deal with you and help you grow your company.
- Limit your offering: Only sell shares to accredited investors. In the long run, this usually works best for startup entrepreneurs.
By Basil Peters
After being an active angel investor for about fifteen years, I realized that many of the discussions I was involved in were virtually identical to ones I’d had many times before. A good example was during the negotiation of a term sheet. These usually involve a handful of angel investors, and a few entrepreneurs, who all want to build the very best term sheet for their exciting nascent enterprise.
Unfortunately, the previous experiences, and depth of knowledge of the individuals are almost always very different. To finalize a term sheet, everyone involved must come to an agreement on some fundamental principles which will have a profound effect on the future of the company. Just a few of these terms include vesting, corporate structure, governance principles, financing strategy, valuation and exit strategy.
Each one of these terms includes aspects of fairness, ethics, law, business, entrepreneurship, psychology and investing. Very often, the initial opinions of the people around the table are radically different. In most cases, these are well-meaning, intelligent people who all sincerely want to find the best solution.
[Email readers, continue here...] Angel investing today is similar to where venture capital investing was in the mid-1980s. Back then, there was no consensus on best practices in that industry. As an example, twenty five years ago, most VCs used common share deal structures. It was not until the later 1980s that the preferred share structure became popular.
During those times, VCs had lots of conferences where thought leaders gathered to discuss term sheets, deal structures and fund strategies. As a result, there is tight agreement today on the form of VC term sheets and definitive investment agreements. Angel investing is rapidly evolving to the same state of development, as a result of networking, industry associations, and deal sharing between angel groups.
Basil Peters is perhaps the best known name in the world of early stage company exits. His groundbreaking book, “Early Exits” has become a textbook for angel groups and entrepreneurs throughout the world. His Strategic Exits Corporation provides M&A advisory services, and he is much in demand as a speaker at angel and entrepreneur events worldwide.
First, here’s a link to my recent TEDx talk, “Smiling at success; laughing at failure.”
I am chairman of a company that, as I write this, is twelve years old and has not yet taken a dollar of outside investment. The company has been funded entirely by grants from the National Institute of Health, amounting to millions of non-dilutive dollars in all. The company has created a product that can be delivered as a service to medical clinicians anywhere in the world, enhancing their ability to understand their patents’ problems and needs in less time, using the expertise built into an expert system created by the best minds in many medical specialties.
[email readers, continue here...] In general, grants are made to individuals, companies, businesses, organizations or institutions that are working toward serving the greater good or a greater cause. These grants include funding to educational institutions, researchers, research centers, colleges and universities, or private companies that are researching or developing leading edge solutions in several categories including agriculture, education, energy, health, medical, space, science and technology to name a few.
Grant writing takes skill and immense amounts of time. Often, grants require that you partner with other organizations to deliver the results, or measure the effectiveness of your special project. And often, grants come with detailed accounting and reporting requirements. If you can finance your enterprise through grants rather than equity or debt, you retain control and when it is time to sell your interest in the business, a lower sales price will create a higher return on your personal investment.
There are some grants available even for one person shops, from cities, corporations and even non-profits for just your type of business, especially if you support a social cause, can employ more people, or help turn around a geographic area in need of upgrade.
Let me tell you the story of how I raised $100,000 to fill a gap needed to purchase a new home for my young family years ago. I had located a beautiful home that would be a stretch to finance, and had arranged for a first mortgage from the bank, and a second from the seller. Home values were rising so fast that I knew I had to move quickly.
So I went to visit a number of customer CEOs, told them my story, and asked them to advance some amount against their future billing from me. In return, I said, I would give them more time than originally contracted for, and certainly would treat the relationship as special from that moment on. Corny? Every one of the CEOs said “yes.” And I closed escrow on a home I could not otherwise afford, and which I continue to live in, after its value shot through the roof during the subsequent years.
I sometimes counsel CEOs to consider consulting to their prospective customers or in their industry while they are simultaneously developing their product for market. Consulting fees pay the bills, reduce the stress, and give people confidence in the business.
[Email readers, continue here...] If you are already purchasing raw materials or services such as development or programming, consider asking your supplier to be a paperless partner, showing confidence in you and your future business by granting you deferred payments. You might be surprised at the positive results, if your needs are real and you treat the relationship well by following through on your promises.
How about offering prepaid licenses to your product or a package of prepaid hours, or a discount for prepayment of purchase? All of these create special relationships with your customers, who show their faith and trust by advancing money to you before receiving products or services. Just remember that you must deliver as promised, and you are eating your meal before its time. You will have later expenses to pay when the revenues have already been received and presumably spent.
Strategic partnerships with suppliers, customers and others sometimes are an attractive way to share the risk and fund an operation. Creating a new company to do this is often a time and money drain, even if it seems easier to do this than to create a relationship within existing organizations.
These are just some of the ways to creatively raise funds without offering equity or taking on new debt. Since some entrepreneurs are completely adverse to sharing equity, and some greatly fear taking on any form of debt, creative fund-raising is certainly worth considering.
Often I see executive summaries from entrepreneurs who have never managed any form of business, or even managed employees in their past life, and who don’t know the first thing about business formation and managing for growth. I used to tell them to find a partner with knowledge in business creation and management. Although that is still a good idea in many cases, there is a recent alternative available to some entrepreneurs on a competitive basis that seems most attractive and positive.
Accelerators are organizations that selectively accept entrepreneurs into a program of intense coaching in a physical environment sponsored by the accelerator that also provides seed funds for the startup to begin its business.
[Email readers, continue here...] Accelerators are popping up in college towns, urban cities and near existing technology hubs. Some have become well known in the entrepreneurial community as benchmark operations for others to emulate, including TechStars and Y-Combinator. Others have a more local flavor, catering to single audiences, such as students or graduates of a nearby university.
Another term, incubator, is increasingly being used to define real estate operations run by universities or private groups in which the principal added value is the reduced price or free rent and access to resources from the incubator’s sponsor. Accelerators, on the other hand, put entrepreneurs through a three week to three month intensive program closely monitored by accelerator management and volunteers, teaching, coaching, aiding and building the fledgling business to make it ready for its next round of financing upon graduation.
And graduation is typically marked by an organized “demo day” in which prominent investors, VCs, angels and super angels are invited to attend and see demonstrations and hear presentations from graduating entrepreneurs. There are many stories of funding deals made on demo day amid the excitement of seeing new, polished startups with great ideas and the beginnings of an infrastructure.
Are you a candidate for an accelerator? You’ll give up some small amount of equity to the accelerator, receive some amount of cash in return during the program, and learn more in a short time than you’d expect from more formal education programs.