Slicing the Pie: Views on Valuations and Negotiations
29th June 2012 · 0 Comments
One of my guiding tenets in this process comes from the First Duke of Wellington, who reputedly said: “The whole art of war consists in getting at what is on the other side of the hill.” As he proved at Waterloo in 1815, he had an uncanny ability to see and prepare for the next move in a battle.
If the Duke were alive today as an angel investor, he’d be thinking ahead to the next round, perhaps even to the exit, and possibly to the tax consequences. (The current 8th Duke of Wellington will turn 97 next week, so he’s probably beyond the age of long-horizon angel investments.)
A couple of weeks ago Austin lawyer Cindy Grossman in a TechDrawl post argued that the positives of tax-advantaged structures may outweigh common assumptions that the financing goal of a new venture is to get to a typical VC round and then potentially an IPO. She makes very good points in that respect, but for the purpose of this analysis I’m going to focus just on increasing value and not get into the complexities of taxation.
I’m also speaking to the real world, i.e. more than 50 miles east of the Bay Area. The rules are just different out there. My readership is concentrated in the South, primarily Austin and Atlanta.
Let’s look at three stages of startups:
1. A smart person with an idea and a compelling case for it: It’s possible to raise a true seed round at this level, where investors are motivated as much as anything by wanting to see the entrepreneur succeed and are generally risking modest amounts of money in the $10K-25K range. These are typically investors for whom a lucky 10X pop would make a difference and is tempting, but they can afford to lose their bait with no hard feelings. This is almost like R&D money that allows the idea to be developed to the next stage. There’s usually a very simple Reg D document, often just a risk factor and subscription wrapper around a PPT deck with the business idea, and there’s nothing to negotiate. The offering is at a set price per share and common stock. Pre-money valuation can range from $.5M for a new entrepreneur moving out of his or her field to perhaps 3X that for someone who brings relevant credentials and prior entrepreneurial experience to the table. That’s pretty cut and dried. If you are the investor, you are probably not analyzing the idea and are just betting on the character of the person. (Note that in CA, particularly for accelerator graduates, the norm for this is a convertible note that lets the “smart money” figure out the value later, but locally there’s a clear preference for priced deals.)
2. The above plus some signal milestones, e.g. rounding out the tech team, creating a thorough design or perhaps even a working V1.0 of the product, finding a customer, adding expertise via board members or new investors, or any other forms of market and user validation: In this stage the first round investors might re-up, and perhaps some fresh money comes to the table. This may be a second seed-like round, prepackaged and pre-priced as above, but at a valuation maybe 3-4X that of the first round. Or, in this intermediate step where the full capital requirements have been calculated and potential sources identified, this might be a bridge loan toward that end. It can be a convertible note, even in markets that prefer priced deals, but only if there’s land in sight at the other end of that bridge. Investors will have to have seen enough to believe that the company can deliver a viable product, and that they are fueling its launch.
3. The first “smart money” round: With no disrespect intended for the seed investors, this round attracts serious angels who play with much bigger chips and either invest individually or as part of organized networks, or it may be institutional VC’s. Here’s where the due diligence first really comes into play. You’re beyond just betting on character, and if, say $.5M-$2M is being sought, it’s time for investors to understand the business plan in some detail. The investors often rally behind one leader who does much of this homework and who has domain knowledge and the ability to help the company as a board member. Here’s where valuation is normally up for grabs. And that valuation is enhanced if the company has a deliverable product, some paying customers, and a demonstrated ability to acquire new customers efficiently. Let’s say for the purposes of this discussion that this round buys one year of runway, at the end of which either the company is self-sustaining or it’s to the point that bigger investors will be drooling over the deal at much higher valuations.
Here then are some important factors to consider in the negotiations and valuations at this smart money stage:
1. The company needs to raise enough money to get the job done. Not all opportunities can be addressed by bootstrapping. I’ve been evaluating payments systems for one particular project, and even a company with $5M+ in funding, including some brand name VC’s, has gone live with a product that has so far taken me 10 customer support interactions just to open an account. (That’s a longer rant for another time.) The smart money investors, like Wellington, are looking on the other side of the hill, and they know that enough troops now and perhaps a few in reserve may be required to minimize the risk of defeat.
2. That said, after this first big valuation round, the founders still need to own enough of the company to be viewed as motivated and in charge. Look at how much of Zynga and Facebook those founders retained, and, current stock market prices aside, they got to successful IPO’s while staying in control. Entrepreneurs tend to focus on percentages, investors tend to focus on the terms that affect their rates of return. It may be fine to pay $2M for 20% of a company, or an effective $8M pre-money valuation, in hopes of getting an $100M exit. The founders (along with their seed investors) have a lot of paper wealth and feel great about the deal. But, here’s where it all boils down to the details of the investment instrument. Let’s say you’re investing $2M in a participating convertible preferred with a 2X preference. Without going into all the details of a waterfall chart, let’s says the business just doesn’t progress and sells for $10M in a couple of years. Your investment claims $4M off the top, plus 20% of the next $6M, so you get 52% of the pie and the founders get 48%. The percentages have flipped in this simplified case. Bottom line, it’s the terms of the deal that protect the investor downside, and if the company does have a huge win, then every party to the deal achieves his or her goals.
And, lest this become a semester syllabus, let me close with a few warnings. Trading substantial equity early on for services can be a big negative. Investors want to see equity in the hands of ongoing contributors, not development shops or marketing agencies that may have long since gone out of business. Similarly, burning through a smart money round without getting to revenue makes it nearly impossible to raise money to carry on. I’ve seen multiple cases of the latter, and the overhang of early money that didn’t create results is a major psychological barrier to future players absent some significant restructuring.
The goal, then is to march the value upward in each succeeding round so that all participants have a nice payday at exit. That means every round has to accomplish something tangible. If not, and, if you’re getting to those J, K and L round cram-downs that flourished in 2007-2010, then there’s no happy ending.
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