As touched upon in the previous section people getting into angel investing are sometimes put off by the idea that in order to get a good deal, they need to understand how to negotiate to get a favourable valuation. In the previous section, I dismissed this saying that good angel investors are not judged on how well they negotiated a deal, but rather on the success of the company in which they invested. I still stand by this, but there are a few more nuances to this than I allowed previously.
The valuation of a company in which you invest affects the amount of equity you get for your cash. The lower the valuation, the more equity you will get for the same amount of money. It therefore seems instinctive to negotiate the valuation with the entrepreneur in order to get the best ‘deal’ possible for your capital. This is a natural way of thinking, but there are number of caveats to consider.
First, however, you might find it useful to understand why negotiation is possible at all.
Startup Valuation Overview:
Valuation, put simply, is the estimated value of a company. It is something of an art form and its calculation is never entirely quantitative. Startup valuation requires a reliance on factors that demonstrate a company’s potential for success rather than its historic performance. Startup investment is a game of risk and reward; and obviously, potential is not always fulfilled. That is the risk investors must take. And that is why a reasonable valuation is an essential part of the process of raising funds.
As Anna Vital from FundersandFounders.com puts it;
At the early stages valuation does not show the true value of a company. It shows how much of a company an investor gets for his investment.
In a sense then, an early stage startup is worth very little in concrete terms (perhaps a few assets and cash committed by the founders). It is only when a company becomes profitable that anyone can really assign a quantified valuation. Therefore, startup valuation is inevitably predicated upon a focus on the future and, as such, is more qualitative.
And so, because so many of the factors that contribute to the early valuation of a startup are unproven and open to interpretation – artistic validation rather than scientific – it is possible for negotiation to take place.
How is valuation worked out then?
Ultimately, the valuation of an early stage startup is a mutual agreement between the entrepreneurs and the investors. It is basically an indication of the founders’ bargaining position – if they’re confident, they can make the valuation high; if they’re desperate the valuation will typically be lower.
There are, however, a number of factors which you should be looking for when attempting to deduce whether a valuation is reasonable. Keep in mind though, that many of these are subjective.
Traction/Proof of concept: obviously, a sure indicator of future success is current reception. Milestones achieved by the company all add up to contribute to the valuation.
Team experience: the stronger the team, the more likely a company is to succeed. And so it follows that a strong team with a notable advisory board will help the valuation.
Assets: any assets owned by the company can quantifiably contribute to the valuation.
Market opportunity: the market size, the number of players in the market, the timing of the venture all contribute to how good the idea is and thus the valuation.
Comparative valuations: the general trend for valuation sizes for companies at similar stages will also play a considerable role in the dictating the sizes.
Useful Definitions:
Pre-money valuation is the valuation set by the company based on factors listed above.
Post-money valuation is pre-money valuation plus the fund invested in that round. Your equity stake will be a proportion of this depending on how much you invested.
When you negotiate terms with a startup you care about two numbers: how much you’re investing and the valuation which determines how much equity you’ll receive in exchange. If you invest £50,000 at a pre-money valuation of £1 million, then the post-money valuation is £1.05 million. In this example, you would receive (0.05÷1.05)×100, so 4.76% of the company.
(If the company later decides to raise more money, the new investor(s) will take a chunk of the company away from the existing shareholders. This is called dilution. Dilution is normal. Normally when dilution occurs, all shareholders are diluted including the founders so that everyone ends up of with a smaller portion of a more valuable company.)
Should you negotiate?
It is first important to note that negotiating is often impossible; if an investor has already invested in the round at a given valuation, it would be extremely problematic for the founders to accept funding from other investors at a lower valuation. So unless you’re the first investor going into a round, this discussion is redundant. That said, it will still be valuable for when evaluating an investment opportunity to see whether it’s actually worth your investment.
This the crucial point. Most of the time you are unlikely to be able influence the valuation (usually because someone as already invested at that valuation), but when making the decision to invest you need to consider how much that valuation is likely to increase before the company exits. You don’t want to risk your capital when the reward is unlikely to match the risk.
For instance, if you invest £50k into a company valued at a pre-money valuation of £20 million, you’ll get (50,000÷20,050,000)×100, which is 0.25%. If the company then sells for £50 million two years later (without having raised more funding so with no dilution), you’ll receive 0.25% of £50 million, which is £125k. So you can see that for the level of risk the reward is relatively slim and not what startup investors are looking for.
In contrast, let’s now say that you invested £50k at a pre-money valuation of £2 million giving you a 2.44% stake in the company. If it then exits for £50 million (without any further funding and dilution) you’d get a pay-out of £1.22 million. This is the importance of investing at the right valuation.
So in reality what you are checking for when considering investing in a company, is that the valuation is not unnecessarily and unjustifiably high to the point where the risk is no longer sufficiently incentivised by the chance of reward. Too much risk for too little reward is to be avoided.
With this in mind, the potential upsides of negotiating a valuation down seem more apparent. And if you can justify it, you’re perfectly within your rights as a prospective investor to tell a company that their valuation is too high.
But here’s why you should be careful...
In simple terms you’d like to get as large an equity share as possible for your capital. That way, if the company exits your pay-out will be greater. With startup investment it is always an ‘if’. But you can make it even ‘iffier’ if you turn the screw too hard regarding valuation.
Consider that your receiving more of the pie for the same amount of money, while on the face of it a better deal for you, might mean that down the line you have a larger chunk of a pie worth nothing.
And here’s why: if the founders are strong-armed into giving away too much equity too early, it can hamstring the company’s ability to grow and succeed. Giving away too much equity too soon can leave the company unable to close later funding rounds and unable to recruit top talent and incentivise employees. Both of which are crucial if the company is going to achieve the big exit that startup investors yearn for.
N.B. Typical startup valuations range from £500k to 5 or 6 million; though you may find yourself involved in something higher if you are investing in a second round.
Summary
In summary, the chances are that you will never negotiate a startup’s valuation. But it is important to be aware that companies are sometimes overvalued; and that investing in a company that has been overvalued is a pitfall best avoided. On the flip-side, a company that has been forced to undervalue itself by investors may fail for that very reason. As such, when picking an investment, valuation is something for you to consider seriously. Ultimately though, we come back again to the same point: whether you invest at a valuation of £1.5million or £3million, it doesn’t matter so much; what matters is that the company is successful.
Founders like their investors would do well to remember this: there is a distinction between making a company look good to raise funds and actually making the company good. Both parties should try to focus on the latter.