I was amused when a young entrepreneur was outlining the capital needs for his early stage, pre-revenue company the other day. His company is pursuing an interesting idea and has secured $150,000 of “friends and family” investment. He is looking for a further investment of $1 million for expansion purposes and was hoping that our group of angel investors would be interested.
The discussion was sailing along nicely as he provided some background on his company, his addressable market – the use of the term “addressable” market got him some important marks - and the uses for the $1 million. But he stumbled when we brought the issue of “valuation” to the table.
“So”, I asked, “if we write you a check for $1 million what do we receive in return?” Then the top hat and cane, along with the soft shoe, were in full motion. Lots of humming and hawing until he finally allowed that he was hoping a 10% common share interest in the company would be reasonable compensation for the $1 million investment.
I have to confess that my amusement level took a major downturn at this point. These terms translate to a $9 million “pre-money” valuation. Pre-money is the value of the company immediately prior to the investment, which in this case would be necessary in order to realize a 10% share position for the $1 million investment. And a $9 million pre-money valuation is an extraordinarily high valuation for a company that is pre-revenue and early stage.
By the way, “post money” valuation, a term often used in this context, is the sum of the pre-money valuation, in this case $9 million, plus the proposed investment, in this case $1 million, for a post money valuation of $10 million. It is imperative that the entrepreneur spend some due diligence time researching what are assumed to be reasonable valuations.
In most cases, an announcement of a $9 million pre-money valuation for an early stage, pre-revenue company would result in a very short meeting, if a meeting were granted at all. But in the interest of educating our young entrepreneur, it wouldn't take much research to determine what pre-money valuations angels typically consider reasonable.
Indeed, I am aware of a well known angel group that makes it crystal clear on its web site that it will not consider any companies whose pre-money valuations exceed $3 million. In general, these guidelines seem consistent throughout the angel investment community. And there is a good reason for that position.
An angel's average investment approximates $50,000 – some are lower and some are significantly higher. So a $1 million investment would likely require a syndication of 20 angels. It's hard work to assemble a group of 20 investors. Additionally, many Angels want to make a contribution to the company, in addition to their financial commitment, and they require a significant share position in order to insure that their voice will be heard.
This concept of attracting angels who will make an intellectual as well as a financial contribution to the young company is a two way street – a concept, by the way, that is often referred to as “smart money”. As indicated above, angels are often interested in being involved intellectually in the company's affairs. Equally, the entrepreneur should be seeking angels who can make this intellectual contribution.
It is very advantageous to have among your angel group of investors one or more persons who are well-versed your “space.” They can make use of some of their personal contacts for the benefit of the company. They may have deep intellectual knowledge of this business. They may have an expertise in a particular technology that will be of benefit to the company. Clearly, raising the required capital is job #1, but it is worthwhile to attract capital to your company that also has a “smart” component to it.
So, back to the “valuation” issue. In most cases the pre-money valuations that will appeal to “smart” angels will be in the $500,000 to $3 million range. This seems to be the “sweet spot” for angels. They want to have a meaningful voice in the company and this seems to translate to an effective common share position in the 25% to 50% range. In our example, if a more reasonable pre money valuation of $2 million were agreed upon and the angels invest $1 million, they would expect a 33% common share interest in the company. We're assuming common shares in this example but a question for another day is whether angels would consider, or indeed prefer, another investment instrument. And, we haven't even touched on what “rates of return” an angel would typically consider reasonable – but that's a topic for another discussion. So, at least our young entrepreneur walked away with a reality check!