Cramming Down Grandma: A Company Valuation Lesson
One of the biggest challenges with closing an angel deal is the valuation discussion with the entrepreneur.
In the mind of many angel investors, two components in the valuation equation are necessary in order to close an angel deal:
- The value of the deal has to be low enough to attract capital. (Angels writing checks)
- The value of the deal has to be high enough, so that the entrepreneur feels motivated to create value for the investors.
Thinking about the life cycle of a capital consuming company, the financial ecosystem to support these types of companies is outlined below:
- Entrepreneur funds company
- Friends and family invest in company
- Micro-lenders can/may provide debt capital
- Angel investors provide early stage or seed capital
- Venture capitalists provide capital
At each stage of the capital raising process the valuation question becomes a part of the financing conversation.
As angel investors, we review hundreds of potential deals each year. The valuation question is one that is that is evaluated at the start of the screening process.
Seasoned entrepreneurs understand and learn about the valuation question before they approach outside capital investors. We suggest that all entrepreneurs learn and understand the valuation question before they approach outside investors.
The friends and family round of capital is very important piece of the early stage investing process. Whether the first investment in a company is $5K or $100K, this first outside capital helps validate the business and the entrepreneurial vision. However, the first capital in, can complicate the future capital needs of the company, if the valuation is too high or the terms of the deal are too complicated.
Cramming Down Grandma: An American Story
An entrepreneur/scientist creates a company to allow faster movement of data packets across the Internet. The entrepreneur has a patent, a business plan and the passion to start a company. The entrepreneur funds the company from his savings and starts to develop the technology into a product for the market. As part of his fund raising process, the entrepreneur approaches his friends and family to invest in his company. In this example the only person with capital is his Grandma.
In pitching the deal to Grandma, the entrepreneur informs her about the enormous potential of the Internet and the value of the companies playing in this space. He mentions large internet companies such as Google, Cisco and others. His final pitch was the valuation discussion, for Grandma’s $100K, Grandma would own 2.5% of his company. He further suggests to Grandma, that in four years his company would easily be worth $100 million, so her $100K would grow to $2.5 million dollars in a very short time.
Fast forward, six months. The timeframe that our entrepreneur envisioned for product development has taken longer and the financing he needed is a lot more than he budgeted for.
As our entrepreneur approaches angel outside investors, one the first questions they ask for him is how much investment has he raised. As the outside angel investors review the deal, they have addition discussions with our entrepreneur about the product, the market, the IP, the management and the valuation.
For this example, we are going to assume that all those items the angel investors review, the product, the market, the management are in place and acceptable.
For the valuation equation the discussion goes something like this. The angel investors working with our entrepreneur start out with their valuation of $1 million pre-money with a $500K investment into the company. So the new angel investors would own 33.3% of the company after they put in their money.
After negotiations with the angel investors, a deal is struck with the money terms, $1 million pre-money with $500K money invested and a couple of provisions such as board seat, financial reporting and other rights.
So what happens to Grandma’s Investment?
Crammed down in Angel investing is when the early investors’ stake in a portfolio company is reduced by the new investors who put new money into the deal. This is accomplished by the new investors valuing the portfolio company at a valuation less than the earlier investors valued the company when they invested in the company.
As outlined above, Grandma came in as an investor at the friends and family round at a $3.9 million pre-money valuation, and a $4.0 million post-money valuation. The new outside angel investors coming into the angel round at a $1 million valuation causes Grandma gets crammed down. The following math shows how it works.
Friends and Family Round: $4 Million Post Money Valuation
- Entrepreneur: Owns 97.5 % and his stake is valued at $3.9 million dollars
- Grandma: Owns 2.5% and her stake is valued at $100K
After the Angel round the valuation, percentage ownership and ownership valuation has changed.
- Angel Round: $1.5 Million Post Money Valuation
- Angel Investors: Own 33.6% and their stake is valued at $500K
- Entrepreneur: Owns 64.4 % and his stake is valued at $975K
- Grandma owns 1.6% and her stake is valued at $25K
Grandma still owns part of the company but her percentage ownership and her value has fallen. Given the example outlined above, the entrepreneur is put into a difficult position informing his Grandma about her investment position in his company.
Being informed about valuation of start-ups
In our example, our entrepreneur had a vision, business plan, IP and money from his Grandma. While being crammed down in an investment does happen. Educating oneself about the valuation process from outside capital sources will allow entrepreneur to avoid having a difficult conversation with your friends and family investors.
There are a number of resources which an entrepreneur can learn about valuations, Technology Ventures Program managers are well versed in the valuation equation. The NM Angels have the Angel Bootcamps that provide a section on valuation. Having a conversation with a venture capitalist would allow for an indication of their valuation thoughts in the capital marketplace.
While the story above is just an example, I am aware of two deals, in which the deals were not done because the entrepreneur did not want to cram down his friends and family investors. In both of these deals, the company did not survive because they were unable to raise outside capital.