Preview:
Nothing commands more discussion among angel investors than the often subtle but endless variations in measuring pre-money valuation of pre-revenue investment opportunities. While it may be, as most describe it, more art than science, little doubt the artists outnumber the scientists by some unknowable multiple.
Article:
Nothing commands more discussion among angel investors than the often subtle but endless variations in measuring pre-money valuation of pre-revenue investment opportunities. While it may be, as most describe it, more art than science, little doubt the artists outnumber the scientists by some unknowable multiple.
That conundrum is what made the final plenary session of the recent NASVF annual conference in Little Rock so fascinating that the discussion carried well into the following week. Bill Payne, aged angel with more than 40 deals and innumerable exposure to others in his quarter century at the wheel, examined the subtleties of valuation with John Huston, a commercial banker, who crossed over the bridge to angel investing less than a decade ago.
As with most valuation discussion, there was no conclusion in absolute terms beyond a joint admonition to ‘be careful out there’
Perhaps, nearly as interesting as that hour-long discussion of the valuation issue has been the continuing discussion via e-mail, set off by a question Sue Strommer posed to both the next day:
I think John said that he feels a lot of downward pressure on angels in later rounds of investing. But why should this be true? We all say there are too few seed investors and too many later stage investors right now. So seed deals should be a buyers' market, and later stage exits should be a sellers' market. Everyone seems to agree that valuations at the angel round haven't increased for a number of years, so angels should be getting some great exits later on. Is the A round the one where angels are taking hits? Or are the angels making money hand over fist and not telling anyone?
I've read Luis' article on divergence and I get that this happens, but it doesn't explain why it happens. And we don't have any reliable data on angel exits, so we don't know what an average divergence rate is, do we?
Bill, in keeping with his pattern of prompt responses, answered:
I’ll let John defend himself re his comment on valuation pressures in later rounds.
Re the concept of Divergence: The answer to your question is that angels generally do not have sufficiently deep pockets to participate in later rounds. If you look at Luis’ Gadzoox example on page 21 of the handout, it would have required the angels in Luis’ round invest over $10 million to maintain their percentage of ownership. And, often subsequent investors are not willing to share the deal with earlier investors. So, Luis “suffered” the dilution and only made 101X, not the possible 279X he would have made had he and his fellow angel investors been able to maintain their 30.3% ownership. Does that help?
John rejoined:
Way out here in the heartland of Ohio we presume that the upper limit of total sophisticated angel capital we can attract to any venture is $2.5 million, presuming a $1 million angel Series A is raised, the venture hits its marks, and then we can tap the original and other angels for an additional $1.5 million. That’s about our limit due to a limited number of active and educated angels. Incidentally, I have witnessed homegrown angels dump over $6 million into one of our Columbus-based ventures, but they are mainly wealthy tourist angels, not members of our group, and closer to donors than investors!
SO: The pressure comes for the reasons Bill states. Frankly the best defense against oppressive dilution is dry powder!
By then, the conversation has a new label, Economics and Alchemy, to which Bill said:
But, John-
Are you still seeing lots of valuation pressure in subsequent rounds, for deals that were priced correctly to begin with? I have not seen this kind of pressure in several years. Of course, I have learned to become a tiger at negotiating valuation on seed and Series A angel rounds.
And John responded:
I can’t recall what I might have said to give this impression. We fumbled a few valuations early on, but have written off those deals. None of our OTA portfolio companies has ever had a down round because we usually suggest a flat round whenever we agree it’s wise to only approach current investors to assemble another $500- 750K to see that we view to be “the last card.” Again, this reflects our strategy: “The best antidote to a down round is dry powder.”
I have attached two items for your reflection or entertainment:
The first identifies a common cause of a down round: waking up to the large exit price tag needed to generate an adequate return when significant dilution factors suddenly become obvious.
When we reach an impasse on valuation we will consider “trading terms for dollars”…..or as Luis mentions in his article……..consider implicit valuation factors.
We’re all excited to have you visit Ohio October 23 & 24, Bill! After I view the videos I might want to spar with your on some of the issues. I’m intrigued by all the mathematics our young MBA interns are anxious to perform, but it always seems to come back to the envelope of pre-money valuations for pre-revenue ventures: $1 – $2……really tough to make an adequate return >$3 MM
The Luis referenced in John’s reply is Luis Villalobos, another angel of long experience who is often quoted in valuation discussions. (See link to E-Venturing Series below). Bill then added:
John-
I most appreciate your musings on Dilution and Trade-offs. While I have no quarrel with the Dilution piece, I must tell you that I am much more likely to walk away from a deal than negotiate many of the more “stringent” terms you describe in your High Valuation scenario. I am simply more inclined to politely suggest early that the entrepreneur go talk to others about valuation and feel free to come back to us if they change their minds.
Onerous terms have the impact of alienating the entrepreneurs (when s/he discovers what s/he has done) and really turn off subsequent smart investors. Yes…these terms can be reversed later, but that can be painful also. Further, it signals to all that the Series A was an acrimonious round.
I think our differences are more stylistic (or perhaps strategic) than “right versus wrong.” I would NEVER look at a deal negotiated with your High Valuation terms, and say that is a BAD deal. It is just not my kind of deal. I personally have been an angel for a long time and will likely continue into the indefinite future. I have no need to invest my shekels quickly nor under terms and conditions that raise my hackles.
Only to expose my commitment to this strategy, we in Montana just looked at two very attractive deals (much better than any deals we have seen in Vegas in the past year). We simply walked away from one (due primarily to valuation) and will likely invest in the other at the right price. I know that there is always another good deal around the corner.
Regards,
Bill
PS I remember a recent deal in Vegas where I negotiated long and hard to get a 1X participating liquidation preference (at the right valuation). I was willing to tough it out because I was convinced that a 1X participating was both fair and typical. I am not sure I could do that for a 3X participating.
And John responded:
We don’t disagree at all. (editor’s note: this is the alchemy part. No two angel investors ever don’t disagree on valuation) We’ve assembled an 8 member working group which is finishing up a 20 page whitepaper on valuing pre-revenue ventures. It includes a survey of two dozen approaches. Our initial bold goal was to design a proprietary formula which we would always use, but we have settled for stipulating that each DD team must use four of the methods (and record them for posterity in our files). Only one of the methods must always be used…….the Venture Capital Method…..because we don’t seek deals which aren’t “ventureable.”
The most valuable outcome of our toiling has been to shift our focus from the math & models to concocting a handbook for how best to negotiate valuation. We’ve identified a seven step process we’ll be presenting to our members Thursday night. It is in this section that we recommend ways to close a bridgeable valuation gap. The reason we include the two sets of terms is merely to facilitate a discussion of the fact that the entrepreneur does gain some benefit in implicit valuation from a lower explicit valuation.
To be clear, we start with our generic term sheet and only suggest tweaking if an impasse erupts. We share you philosophy…….or, as we remind our DD teams……”Deals are like busses…….there’s always another one coming, so just wait till one arrives with the right number!”
And so it goes.
If you would like a relatively brief education in valuing potential angel investments, here’s a link to the E-Ventures collection on which Bill and Luis collaborated for the Kauffman Foundation, which, after careful reading, you too, will by able to ‘not disagree’ on pre-money valuation in pre-revenue investment opportunities.
