Category: Investing

In last month’s post Why Not More Startup Success Stories, reader Jeff offered an interesting idea where institutional investors would be encouraged to buy 10% of the equity from the angel investors, assuming they’d be interested in selling. For most startup communities, there are very few exits resulting in long/indefinite delays before angel investors receive a return on their money and thus the rate at which returns are recycled back into the community is limited. If institutional investors more routinely bought a small stake from the angel investors — say 10% — that’d generate angel returns faster and allow institutional investors to buy a larger piece of the startup.

Here’s how it might look:

• Angel investor buy 10% of the startup for $150,000 resulting in a $1.5 million post-money valuation
• Startup achieves strong traction and raises a $3 million Series A at a $7 million pre-money ($10 million post-money)
• Institutional investor that’s buying ~30% of the company (less the pro-rata from any existing investors that want to invest more) is willing to increase their investment up to $3.14 million such that the existing investor that owns 10% before the financing round can sell up to 20% of their stake which represents up to 2% of the company (10% ownership of the $7 million pre-money represents $70,000 for one percent) for $140,000 thus nearly recouping their initial investment while still having 8% of the company remaining (pre Series A investment)
• Post Series A investment, and after selling 20%, the angel investor now has 5.6% of the company (8% diluted by 30%, not counting a potential increase in option pool)

The institutional investor would want the angel’s equity reclassified as the same type of equity as the Series A otherwise there might be a discount.

By encouraging institutional investors to buy a small piece of the existing equity held by the angel investors, angels are more likely to invest in other startups and capital will be recycled faster in the community. Entrepreneurs should consider asking institutional investors about this when raising capital.

What else? What are some more thoughts on the idea of encouraging institutional investors to buy a small amount of equity from existing angel investors?

When raising money from angel investors, they often require a fair amount of due diligence to ensure the startup is what the entrepreneurs say it is and that it has proper record keeping. If the startup raises money from Institutional investors, like venture capitalists, the amount of due diligence increases substantially. Here are a few commonly requested items as part of due diligence from angel investors:

• Operating agreement
• Founder legal agreements like non-compete, non-solicitation, etc.
• Cap table with any equity grants, stock sales, etc.
• Customer contracts
• Employee IP assignments
• Financial forecasts
• Financial statements
• Recent bank statements

Entrepreneurs would do well to keep their legal and financial affairs in order generally, but especially so when close to the term sheet phase of the fundraising process.

What else? What are some more thoughts on due diligence when raising money from angel investors?

Recently I was talking to an entrepreneur that was working on raising money for his startup. After asking the normal questions including “why do you want to raise money”, he volunteered something I don’t hear too often: I want to raise money to bring on a partner that will position the business for an exit in a few years. The idea is that raising money will act as a forcing function to drive towards an exit.

Here are a few questions to think through:

• Why not sell now? What additional value will be gained raising money?
• What specifically is desired in a capital partner?
• What’s the ideal timeline? What milestones need to be hit?
• Are there any market dynamics at work that might improve or decline over the next few years?
• How many more rounds of capital, and dilution, will be required to achieve the desired exit?

Planning for an exit in a timeframe is never really doable unless the business is profitable with enough scale to know that there’s an exit based on an EBITDA multiple to a private equity firm or other financial buyer. Most startups want a buyer that pays up based on growth potential, and those are nearly impossible to plan for confidently. Raising money does create more pressure to eventually find an exit, but isn’t a guarantee.

What else? What are some more thoughts on raising money as a forcing function to drive towards an exit?

Recode published an article earlier today that PetSmart is acquiring Chewy.com for $3.35 billion in the largest e-commerce acquisition ever. This is a case where raising venture capital helped a startup grow significantly faster, resulting in a much larger and more valuable business when compared to growing organically. According to CrunchBase, Chewy.com started in the summer of 2011 and is less than six years old. Last year, Chewy.com did almost $900 million in revenue (source) and presumably will do over $1 billion in revenue this year.

For a venture perspective, this is a homerun. Let’s look at how the economics might play out:

• Volition Capital invests $15 million in the Series A in 2013 (source) and buys ~25% (a guess) of the company (typical venture rounds are for 20 – 35% of the company)
• Chewy.com goes on to raise a total of $236 million in equity over multiple rounds (source) resulting in dilution to the Series A investors (depends heavily on pro-rata participation)
• Assuming the original Series A investment was diluted down to ~10% (a guess), that $15 million investment would be worth $335 million now (depends on earn-outs and other behind-the-scenes factors)
• Turning $15 million into $335 million is a 22.3x return and likely returned more than the entire Volition fund

Congratulations to Larry at Volition Capital and the whole team at Chewy.com on the acquisition.

What else? What are some more elements of this successful venture deal?

With startups in vogue for many years now, more people are becoming first-time angel investors (“tourists” is the parlance for angel investors that come and go). A number of would-be angels have asked for advice when evaluating an angel investment.

Here are a few thoughts:

• Team – At this stage, it’s 70% the team. Are they resilient? Will they grind it out? How resourceful are they? Most entrepreneurs don’t have the necessary grit.
• Idea / Market – At this stage, it’s 30% the idea / market. Is it a small, fast growing market? Is it resegmenting an existing, large market? Great ideas in great markets are key.
• Timing – The ideal timing is 2-3 years before mainstream adoption. Being too early is a failure. Being too late is a failure.
• Pro Rata – Investors are commonly granted the right to participate in future financing rounds based on their percentage ownership. Angel investors should plan on reserving $2 for every $1 invested (e.g. invest $100,000 initially and then have another $200,000 ready for future rounds to participate pro rata).
• Next Round Likelihood – Raising an angel round is one small milestone in a long journey. What are the chances the startup can raise money in 12-18 months at 3x the current valuation? Most startups require multiple rounds of financing.

Evaluating an angel investment is very subjective. With limited metrics and operating history it’s a bet on the team and market. Remember that angel investing should be viewed as charity and most angel investors never make money even after doing a number of deals.

What else? What are some more thoughts on evaluating an angel investment?

Last week an entrepreneur reached out for help on an estimated valuation for his pre-revenue startup. After building a prototype and getting some non-paying early testers, he’s looking to raise an angel round and wanted thoughts on what’s normal in the market. I asked a number of questions and offered up a few ideas:

• Base Valuation – Pre-money valuations are usually $1-$2 million for a startup with a prototype and a handful of users. Typical funding rounds are for $300-$500k whereby the entrepreneur sells around 20-25% of the business.
• Management Team Premium – If it’s an experienced management team or highly-regarded prior employer, there’s a large increase in pre-money valuation to $3-$4 million. Investors view an experienced management team as more likely to be successful and pay up for it.
• Half the Next Round Valuation – Figure out the milestones for this round (e.g. revenue targets), and estimate the corresponding valuation for the next round with those milestones. Then, with the expected next round valuation, divide it in half to value this round. Investors want to believe that they can double their money on paper in 18 months, and see a clear path to get there.

Pre-revenue valuations are always subjective and come down to how eager either side wants to get a deal done. There’s no exact number but these are good guidelines for normal deals.

What else? What are some other ideas for valuing a pre-revenue startup?