How to Negotiate Valuation with an Angel

Last week I was talking with an entrepreneur who was negotiating his initial financing for his most recent startup. He had a group of Angel investors that appeared ready to go, but he had a problem – a big one – his expectations for the valuation of his business didn’t match up with theirs. He had done all the right things: checked with many entrepreneurs, investors and experienced service providers as to appropriate valuations for businesses like his, proposed a convertible bridge structure and been cooperative in due diligence. I really couldn’t fault his approach. 

As I listened to his story, and he told me what the investors were offering, I came away feeling that they were trying to rip him off. I told him so, for what it was worth. Later, as I thought about the situation further, I realized that the advice I had given him was less than helpful and revealed more about how we tend to think about deal pricing and terms, rather than giving him any particularly useful advice to act on. I didn’t know his circumstances – were the proposed investors his only option? Were they going to provide some meaningful strategic assistance or advice? Perhaps under the circumstances they were fairly valuing their investment in his company (or at least as they saw it). 

The rest of this post provides some of my thoughts on how to value an Angel deal, and is the advice that I wish I had offered to my friend. Perhaps it’s not too late, and he can get some use from it too. But, at the minimum hopefully it will be helpful to you.

Valuation does not exist in a vacuum. Neither do deal terms. Ask anyone who does a large number of deals, either as a service provider or as an investor. They will tell you that deal valuation and terms tend to cluster around certain commonalities. When you hear an investor say “a Series A pre money is around $3M for a pre revenue company” he is telling you that the deals that he has seen have done for similar companies have fallen into this valuation range. This is one of the advantages that experienced investors have over entrepreneurs – they have a better sense of what is “market.”

When thinking about valuation the best place to start is to appreciate that all investment opportunities are evaluated against a collective sense of what is “fair” for a similar company. For issues of valuation – “fairness” is measured by the tradeoff of risk versus expected return. To understand this better you need to have a bit of corporate finance theory. What few entrepreneurs appreciate is that every investment opportunity, from investment in US Treasuries to investments in early stage startups is priced on the Capital Market Line. The Capital Market Line is the collection of equilibrium points in the capital market where the tradeoff between risk and return is “fair.” Over time, transactions tend to coalesce around the “fair” price, based upon the normal practices of a market. For those of you who are not familiar with how markets work – basically, they work on the principle of “price discovery,” participants will not generally overpay, or underpay, for an investment over time. That’s how markets work – as people participate in the market, buyers and sellers will eventually coalesce around a market equilibrium (or, a/k/a a “fair price”).

 

As you can see, in the capital markets there are at any moment of time fair prices for all investments in our economy. For market investors, all investments are basically evaluated the same way – are they getting the appropriate level of return for the risk that they are taking? There are times when the market can get out of whack for a particular type of investment (a situation which we often refer to as a “bubble”) and prices move away from the Capital Market Line. But, as we have learned from the Mortgage Backed Securities meltdown of 2008 or the Internet bust in 2001, particular investments eventually return to the general market line. 

If you understand the Capital Market Line, then the next thing to appreciate is that investors and entrepreneurs each have a reason to seek to move prices away from the Capital Market Line. Investors want to get more return, and the entrepreneurs give up less return, for the same level of risk. In the context of an Angel investment in a startup, the way that return expectations are managed are through price. Simply put, Angels want to pay a lower price than the CML and entrepreneurs want them to pay more.

 

In addition to the trade off on price, there is a second trade off around risk. The biggest mistake that investors and entrepreneurs alike make is that they forget where a particular investment actually should be placed on the Capital Market Line. Generally, the issue surrounds a mispricing of risk on the downside. Rarely do people pay too much for risk (which means accepting a lower return). Usually they think that they are paying too little (which means getting a higher return) for the actual risk that they are taking. It is only later, when the actual risk becomes apparent, that investors realize that they were under compensated for the risk. And, when that happens, prices adjust downward to more properly match the actual risk. Now, you know how bubble happen and how they correct.

 

The pricing of deals between Angels and entrepreneurs is mostly about perceptions of risk. Angels will always think a startup is riskier than an entrepreneur. That is why determinations of pricing are so hard in an Angel deal. Often neither the Angel nor the entrepreneur has the broad experience of many deals to be able to relate the current transaction to market trends and place it accurately on the CML. Moreover, Angel investors often have inadequate tools to evaluate the inherent risk of the company, since they have not invested in similar businesses in the past.  And, the entrepreneurs are rarely more experienced (in fact, most experienced entrepreneurs try to avoid Angel financing, going from friends and family to VC when they can – if they do VC at all). Since neither the Angel nor the entrepreneur has a clear appreciation as to placement of the CML or inherent risk, it’s very hard for them to have a fundamental agreement about how to locate the investment on the Capital Market Line.

In addition to using pricing as a mechanism for dealing with risk, Angels (like VCs) often use deal terms as a way to limit risk. Deal terms such as multiple liquidation preferences, board designation, rights of first refusal and so forth can all be explained in the context of allowing an investor to limit the risk in an investment. On the other hand, entrepreneurs perceive deal terms as a way to limit their independence, so that they look to avoid such terms. Put another way, entrepreneurs would like investors to take on more risk not less.

Therefore, to price an Angel deal, both the Angel and the entrepreneur have to reach agreement on the following things:

1.      What is the “fair” price for similar investment opportunities on the CML.

2.      What would be similar investment opportunities.

3.      Are there aspects to the transaction which make it appropriate for the investors to overpay for the risk in the investment, or for the investors to be overcompensated for taking the risk.

4.      Are there aspects of the transaction which make it appropriate for the investor to get more deal protections, and therefore lessen risk, or for the entrepreneur to have more independence, and therefore increase risk.

By appreciating the relationship of startup investing to the CML, let us apply this to the practical. In order to value a startup investment, the entrepreneur must start by forming a view of what is the fair price. This cannot be done in a vacuum. The entrepreneur must talk with as many people as possible who are in the market and doing deals. The entrepreneur must ask the following questions of these people:

1.      How do you perceive my company. 

2.      What stage of development is it.

3.      What sector is it in.

4.      Are you aware of any comparable companies in our market.

5.      What were the terms and pricing of deals that they did at a similar stage of development.

6.      How many investors in our market do deals like this.

What the entrepreneur must do is to come up with an objective opinion of the risk of his deal, its desirability as an investment, how much competition he can create among investors for investment in his company. The more the entrepreneur knows and can defend where to place his company on the CML the better able he is to negotiate.

For the investor, the biggest questions to ask are:

1.      What are the pricing and terms of similar deals.

2.      Is this company attractive to other investors.

3.      Can I encourage the entrepreneur to pick me over other investors on similar terms and pricing.

4.      Can I get the entrepreneur to give me better pricing or terms because I am a more attractive investor than others.

Going into a negotiation, the more that the Angel and entrepreneur have a shared sense of the market and the company’s location on the CML, the more likely they will have an effective negotiation and do a deal. The less informed that they are the greater likelihood that one side or the other will end up doing a bad deal (when compared to the CML). The problem is that when someone does a bad deal, sooner or later they will find out, either in a subsequent transaction or from a peer at a bar. Because Angel investing is fundamentally about individuals, bad feelings are rarely ignored, and will come into play somewhere along the line. I have yet to see an individual who feels like they were badly treated just “take it.” It’s just not the way it works when money is involved.

In addition to understanding the fair price, and becoming clear on the inherent risk of his company, the entrepreneur who wants to get a fair deal (or a better than fair deal) must create competition among investors. By creating competition the entrepreneur will get better terms or pricing, than one who does not. The best that an entrepreneur will get in a non-competitive situation is a fair deal. He can do better if he creates competition.

When my friend had his disconnect with the Angel investors on pricing, it likely happened for one of the following reasons:

1.      The Angels did not know what was fair for a similar company.

2.      They did not agree as to the inherent risk of my friend’s business.

3.      They understood clearly the fair price and correct risk, but didn’t want to pay a fair price and provide appropriate deal terms.

Therefore, if I had enough sense I would have said to my friend the following things. If you want to get better terms find another investor. If you can’t do that, then you can try to educate them as to the right way to look at the company. If that doesn’t persuade them, and you have no alternative, then you should do the deal if you need the money. Otherwise, walk away.

Perhaps that is the biggest lesson of all. When negotiating to take capital from any Angel investor the most valuable thing is to be able to say no. Competition is terrific, but the ability to walk away if you need to may be the most useful asset you can have. The fact is that even if you do everything right, and completely understand your company’s location on the CML, an Angel investor might still want to be unfairly compensated. It doesn’t happen often, but it does happen.