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return on investment will be in five years but whether the company will sur-
vive at all. Entrepreneurs can talk glory, but if the company cannot survive
the first 18 months, negotiations about value become immaterial. So first the
entrepreneur has to convince an investor that the company will survive.
Finally, we want to reiterate a point we made in the negotiation section,
one especially important when the investor invests a larger percentage of the
total financing round and plans to be more active in the company after in-
vestment. Entrepreneurs may come across investors who choose to be an ag-
gressive negotiator, that is, don the guise of the stereotypical Wall Street
investment negotiator and beat the entrepreneur down to get the best possi-
ble deal, squeezing everything possible out of him or her. Keep in mind that
the chemistry between the entrepreneur and investor must be there in order
to make the early-stage investment work. An investment relationship suffers
from inherent fragility because it™s so risky. Most knowledgeable investors
appreciate that it™s folly then for an investor to try to squeeze every last dime
out of the entrepreneur, first because valuation is so subjective, and second
because such behavior destroys the chemistry essential to a healthy working
relationship. For those who fail to understand that entrepreneurs will re-
member bad treatment at this stage: the entrepreneur must have the courage
to walk away. These partnerships require the investor and entrepreneur to
work together for a long, long time. And no investment transaction can long
endure a backlog of resentment by either party.


RISK

In valuation, then, everything centers on the degree of risk. When investors
look at an investment prospect, they hope to determine the amount of work
272 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


the entrepreneur has already done in developing a product, developing the
market, or selling the product”all things that reduce risk in the deal. Again,
such determination remains subjective.
Furthermore, risk is layered in terms of the stages of the deal. Obviously,
if only a concept exists, if we have no more than an idea, we place ourselves
at great risk. In fact, the investor may feel that despite the talent and trust-
worthiness of the entrepreneur, the risk simply remains too great.
On the other hand, if the entrepreneur is already selling a product, and
the market has already validated its willingness to buy it, the risk is substan-
tially less. The valuation depends largely on how investors perceive the risk.
Different investors will perceive risks differently. Investors will not measure
risk in the same way or to the same degree. Investors want answers to some
specific questions: How much risk remains in the deal? How far along is the
entrepreneur in the process? Has validation through other investors oc-
curred? Is the market already buying these products or services?
Investors struggle with these questions as they try to value the company
to determine whether they will obtain enough ownership percentage to jus-
tify the risk of investment and lose the use of capital for an extended time.
Thus, as an entrepreneur you must defend your valuation in terms of
risk/reward. You have to understand the process that the investor is going to
go through. You should have in mind a range of valuations. Valuation, after
all, is a negotiation, probably one of the more subjective negotiations an en-
trepreneur will endure because of so many nonfinancial factors”nothing
pat, nothing to map the area. No set value at one percent of revenue, or one
times revenue, or a price-earnings multiple. In valuation, where there is no
earnings, there cannot be any price.
The question becomes one of why an investor should invest in you.
What makes you a decent soul? What is right about the deal? How might it
be structured to lower the perceived risk?
But before all other considerations comes the importance for the entre-
preneur in selling the dream to the investor, best accomplished by bringing
that investor into your vision of the future early on. Make sure that you and
the investor have the appropriate chemistry, a vital aspect of any venture.
The part such chemistry plays in valuation is hard to overestimate.
Because these types of investment are such precarious things, because so
much operates beyond our control, good chemistry among the active parties
is paramount. Compatible chemistry with sophisticated investors who un-
derstand the risks is far more important than a high initial valuation.
And without investors who understand the risk, who understand that
private investing is a long-term process, who are willing to sail with you for
the long run, frankly, a high initial valuation is a shallow, short-term victory,
often a negative rather than a positive. Entrepreneurs should trade a lower
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Valuation of the Early-Stage Company


initial valuation for helpful, smart partners with the right chemistry and the
willingness to stand by them.
Valuation, after all, boils down to what percentage of ownership of the
business the entrepreneur is giving to the investor in order to get the capital
needed to grow the business. In effect, the entrepreneur is bringing in a part-
ner, somebody the entrepreneur will virtually be living with. Valuation is not
a sale, after which the buyer strolls away. This is partnership”a partnership
built on compatibility. Moreover, the smart entrepreneur will be hoping to
get more from that partner than just money. In fact, the chances are better
than not that the entrepreneur will be returning to that same partner for ad-
ditional infusions of capital. So valuation is far more complex and selective
than simply selling a business to the highest bidder and then cartwheeling
away.
Valuation, then, can certainly occur prematurely. It can dampen a rela-
tionship like nothing else. It can badly influence a deal, especially if it occurs
before the entrepreneur sells the dream. Make no mistake; early valuation
has killed many early-stage deals.
Valuation is not guided by something as unchanging as a euclidian for-
mula. The best that valuation can offer are rules of thumb. And again, all in-
vestors may view such “rules” differently. How investors perceive risk, or
stage of the venture, relates to value. In other words, the higher the risk in-
vestors perceive, the higher the return they will require; the higher the return
they require, the lower the valuation is likely to be. The farther along you
are, the less risk investors perceive. Put another way, investors are willing to
pay more for what you already have.


NEGOTIATING VALUATION
The pricing of venture investments is part art, part science, and part old-fash-
ioned Yankee horse trading. Old-fashioned Yankee horse trading, of course,
means negotiating. And few things, it seems, escape negotiation. “Every de-
sire that demands satisfaction”and every need to be met”is at least poten-
tially an occasion for people to initiate the negotiation process,” noted
Gerard I. Nierenberg 30 years ago in The Art of Negotiating.
Negotiating means dickering over fair market value, a term defined by
the American Society of Appraisers as “the price at which a property would
change hands between a willing buyer and willing seller when neither is act-
ing under compulsion and both have equal access to all relevant information
about the business.” However, in early-stage companies, as we have said,
value lies in the future, infusing valuation with its subjectivity. Such subjec-
tivity renders established definitions useless. Cadle offers, instead, this ex-
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panded, real-world definition of value for the small early-stage business: that
“point at which an investor™s fear (risk profile) is in equilibrium with his
greed (return requirements).”
Valuation is part of negotiation. In fact, valuation provides the basis for
negotiation.
As we have said, in the valuation negotiations, the parties are trying to
come up with percentage ownership between the investor and entrepreneur.
The objective of the negotiation is to bridge the gap between an entrepre-
neur™s high expectations and an investor™s valuation model. The entrepreneur
seeks to relinquish the least amount of equity possible in order to obtain the
capital necessary to grow the company. Meanwhile, the investor pushes for
lower valuation to own more of the company so that at exit, when multiples
on investment are realized, capital appreciation will have justified the risk.
So it is in the interest of both parties to use multiple valuation methods
in trying to arrive at a mutual value. Since early-stage investors are risk
averse, they appreciate the risks involved in early-stage investing and intend
to manage those risks through due diligence, valuation, negotiation, and
close monitoring of the venture after they invest. Additional valuation tools
successful investors use include correlating desired return with time to liq-
uidity, discounting projections, establishing realistic desired multiples for
cash-out in advance, and correcting equity share with dilution factors. For
the entrepreneur, the amount of money raised is a function of the value as-
signed by the investor and the result of successful negotiations. It will not pay
the entrepreneur to be unreasonable, even when the market value attained
was less than expected.
In the real world, then, an equity ownership position should produce an
expected annualized rate of return over a reasonable time period propor-
tional to the investor™s tolerance for risk. Valuation in this context does not
depend on hard assets, prior sweat equity, intellectual property, book value,
or similar items. These factors enter into the equation only to the extent that
they can generate future value. Valuation depends on the creation or expan-
sion of a going concern into a marketable commodity through an event that
provides liquidity for the investor, such as by acquisition or IPO. Valuation
also depends on the amount of risk that has already been mitigated by the
company in product development, marketing, customer franchise, and cohe-
sion of the management team.
In sum, entrepreneurs need to alert themselves to certain existing condi-
tions. Leverage in establishing value normally operates in favor of the investor
for the following reasons: approach to value is primarily subjective, not ob-
jective; there exists a limited, inefficient market; the seller (entrepreneur) needs
capital while the buyer (investor) does not have to invest; and the investor may
not believe he or she has all the relevant information about the business.
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Valuation of the Early-Stage Company


SWEAT EQUITY

Valuation is an emotional issue with entrepreneurs because their egos are in-
volved. They want value for their sweat equity, the time and effort they have
previously invested in the venture. Understandably, entrepreneurs want the
highest value for the hard work they have already invested. Most angel in-
vestors appreciate that sweat equity enters into the negotiation, because it is
a way that entrepreneurs show investors how dedicated they have been.
Investors, of course, want somebody who is willing to do anything to achieve
a projection. Perceived sweat equity is important in the investor™s evaluation
of the entrepreneur.
But attributing monetary value to that sweat equity in a valuation calcu-
lation is difficult, if not impossible. Sweat equity gets translated into specific
value in this way: If the investor is comfortable with the management, the in-
vestor will decrease the estimated risk of this deal, resulting in a higher valu-
ation. This move by the investor results, in turn, in more equity for the
entrepreneur. For example, the entrepreneur might want to be back-paid,
saying, “I could have gone to company X and earned half a million dollars a
year. I™ve been doing this for five years now, and I™ve only been paying my-
self $50,000 a year, so I want to be back-paid for the $450,000 per year I
gave up. In other words, I want $2 million.” This proposal is ludicrous.
Successful investors are more sophisticated than that. They simply don™t play
that game anymore.
The investor appreciates that entrepreneurs have chosen years of sweat
equity instead of a salary, that they may have mortgaged their home, and so
forth. But smart angel investors judge that sweat equity only on what they
will realize from this point on. The arrow points to the right, not backward
to the left. What is on the investor™s mind is how far along the entrepreneur
is in the process and what the investor can get in the future for his or her
investment.
So sweat equity carries different emotional messages to entrepreneurs
than it does to investors, a difference that entrepreneurs especially need to
understand. Your facts and the investor™s facts may differ markedly. Failing
to get inside the investor™s perspective on this issue can quickly derail the val-
uation process. These are different perceptions, different starting points. The
task falls, of course, on the entrepreneur because it is the entrepreneur who
must try on the investor™s shoes, not the other way around.
For a time, during the dot-com boom, the early-stage, private equity in-
vestment culture changed from when sweat equity meant working in the
garage and taking salary cuts in exchange for equity to entrepreneurs work-
ing in palatial buildings and taking handsome salaries as the angel investors
continue to pump in money. If improved rates of return are to be achieved by
276 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


investors, the equation had to change. The fact is an entrepreneur may be
able to find some investors who are unsophisticated and thereby gain an un-
realistically high valuation. But an initial ego gratification of an exorbitant
valuation on sweat equity belies the essentials of a long-term partnership, a
mutually respectful and beneficial partnership built with investors who un-
derstand the business and the process, partners who will be there to smooth
the inevitable bumps in the road.


THE “LIVING DEAD”
So if the entrepreneur is concentrating on sweat equity, what is the investor
mulling over? We have an idea of what sweat equity means to the entrepre-
neur. But in valuation, different starting points are generated by the cavity
between the entrepreneur™s sweat equity and the investor™s fear of gaining
membership among the “living dead.” Who are the living dead and what
does the term mean to investors?
If you have a business and an investor invests in you, he or she becomes
your partner. You are your own boss, having a wonderful time manufactur-
ing your widgets”as any entrepreneur would. Things are fine with you. But
if the investor can never obtain liquidity from the investment, a problem
emerges. The business is doing well, and you are enjoying what you are
doing because it is what you enjoy doing for a living. But to the investor,
the investment is a failure because he or she cannot get money out at an
appropriate multiple of the investment. The investor needs a liquidity event.
As John Cadle explains, “If I™m looking at a deal, and I think I can get liquid
in two years, I™ll probably accept a lower rate of return, rather than accept a
long-range development project that is not going to be liquid for seven
years.”
Liquidity can be achieved through a number of different mechanisms”
for example, through a sale back to the entrepreneur, a merger, an acquisi-
tion by a public company, trading of illiquid stock for publicly traded
securities, the sale of the company to other entrepreneurs, or an IPO. The in-
vestor has to keep in mind that very few of all venture-backed companies in
the past several years have reached liquidity through IPO. Either the entre-
preneur has to buy the investor out or some other situation has to occur that
turns the investment into a return for the investor. In other words, the in-
vestor has to get money out of the investment sometime. If none of these al-
ternatives works, we have an investor who has become a member of the
living dead.
And while IPO is only one way”and not the typical way”to obtain liq-
uidity, people are often fooled by the publicity generated by an IPO. The fact
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Valuation of the Early-Stage Company


is that many more businesses are merged or acquired than experience an ini-
tial public offering. Perhaps this is the reason entrepreneurs often fail to re-
alize how important it is to impress in advance on the investor what liquidity
options are available out of an investment.
No investor wants to suffer in financial purgatory by being left in a ven-
ture without liquidity. For many investors, being a member of the living dead
has been a dreadful financial experience”hanging in limbo, not wanting to
slip backward, but unable to move forward. The money is in, but the in-
vestor has no way to get it out.


STRATEGIES FOR CIRCUMVENTING
NEGOTIATION ROADBLOCKS

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