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One of the standard debates between angel investors and entrepreneurs is whether or not angel investments should be for common stock or preferred stock. Common stock is the same stock the founders have and usually doesn’t have any special rights. Preferred stock is senior to the common stock where in the event of a sale of the business, the preferred equity holders get paid at least their money back before the common shareholders. Unfortunately, this really only matters when the business sells for less than the post-money valuation when the capital was raised (downside protection).

Here are a few thoughts on angel investors buying common or preferred stock:

• Preferred stock, in the form of 1x non-participating preferred, the most standard type, really is for protecting the downside of a deal so that in a less-than-ideal exit there’s a better chance the investors at least get their money back
• Preferred stock also has anti-dilution rules associated with it so that some level of protection is in place in the event more stock is issued later (e.g. for fundraising or more employee stock options), which again is protecting against the negative
• Angel investors that have been successful, through luck or skill, will often say that protecting the downside doesn’t do much since all the success is through the huge winners, not the small losers (e.g. when a startup does great, everyone wins and it makes up for other losses)
• Convertible debt often converts into equity once a certain amount has been raised, and this is usually for preferred stock

Personally, I’ve invested in both common and preferred stock as an angel investor but I believe preferred stock is the way to go for angels. Providing extremely risky seed stage capital warrants getting paid back first in the event of a sale where the startup wasn’t successful. By at least getting some capital back, angels are slightly more likely to invest in future deals and continue to put capital to work. With the fact that most startups fail, returning some money keeps capital in circulation helping the greater good.

What else? What are your thoughts on angel investors buying common or preferred stock?

A month ago I wrote a post titled Growth Stage VC with 3-5x Money in 3-5 Years about the idea that once startups are in the millions of dollars of revenue stage, the venture investment criteria changes. Instead of VCs talking about getting 8-10x their money back in 5-7 years for the early stage, the growth stage investors still have aggressive return goals, but are more modest compared to riskier scenarios.

A 3-5x return in 3-5 years seems simple and memorable enough but often it’s hard to visualize what that actually means in practice. Here are a couple scenarios:

• Business has $5MM in trailing twelve months revenue
  Valued at 3x revenue for a pre-money valuation of $15MM
  Investor puts in $5MM for a post-money valuation of $20MM and owns 25% of the business
  Assume no other dilution or capital raised
  To get a 3x return, the business needs to sell for $60MM and be at $20MM in revenue (going from $5MM to $20MM of revenue is very difficult)
• Business has $20MM in trailing twelve months revenue
  Valued at 3x revenue for a pre-money valuation of $60MM
  Investors puts in $15MM for a post-money valuation of $75MM and owns 20% of the business
  Assume no other dilution or capital raised
  To get a 3x return, the business needs to sell for $225MM (very few exits at $100MM+) and be at $75MM in revenue

From these two slightly different scenarios, and a number of simple assumptions, you can see that one takeaway is that if taking the outside money helps get you to a revenue size equal or larger than the post-money valuation in 3-5 years, you’ll be in the money. The next time an entrepreneur with a growth stage business mentions raising money, ask them what pre-money valuation they are expecting and ask them how quickly they can get their revenue to the size of the contemplated post-money valuation.

What else? What are your thoughts on the numbers for 3-5x return in 3-5 years?

Last week I was in San Francisco at the Dreamforce conference and I had the opportunity to catch up with several awesome entrepreneurs that I’ve known for a few years. It’s always fun to hear stories first-hand to see if they corroborate what’s being said in the news, especially with regards to acqui-hires, valuations, and fundraising. By all accounts it appears that things are frothy and that there’s a localized bubble around technology in that market. Valuations that have continued to be exceptionally high for Y Combinator companies, even after PG warned they would correct 12 months ago, but haven’t done so to date.

As for other geographic markets, I’ve seen several angel deals for different parts of the country in the past few months. Here are approximate pre-money valuations outside the money centers of California and New York:

• Idea with no prototype: $500,000 – $1,000,000
• Working prototype: $1,000,000 – $2,000,000
• Successful entrepreneur: add $500,000 – $1,000,000 on top of standard valuations
• Accelerator program graduate: add $500,000 – $1,000,000 on top of standard valuations

As you can see, these valuations are pretty generic and not based on revenue, profitability, or other factors since most things don’t exist at this idea or prototype stage. In the end, it’s likely to be a $1MM – $3MM pre-money valuation for pre-revenue technology deals outside the money centers.

What else? What are your thoughts on these startup valuations outside the money centers?

One question I really like to ask idea stage entrepreneurs is how they’ve split up their equity. Now, for a startup with traction, investors, etc that question can be like asking how much money someone makes, so take it lightly. For two entrepreneurs that are just getting started on their idea, it’s usually no big deal. Almost always the answer to that question is that the equity has been split evenly among the founders.

Joel Spolsky, who’s famous in the startup world, argues that equity should be split 50/50. When entrepreneurs ask for advice on splitting equity, I take the 50/50 split approach and add slightly more nuance to it as follows:

• Start with a 50/50 equity split (rarely should there be three or more co-founders)
• Add an employee stock option pool of 10% of the equity (so now the founders each have 45%)
• Come up with an arbitrary valuation for the business, say $500,000, and use that to determine contribution values like:
  – Salary differences where one person needs $50k/year to live off of and the other person needs $30k/year, then that $20k delta for year one would count towards more equity at the valuation
  – Money invested in the business by each founder would take place at that valuation

In the end, the founders, outside the stock option pool, might have a 60/40 split, which is a better representation of monetary contribution and extraction from the company.

What else? What are your thoughts on this quick method to decide on co-founder equity splits?