by Mike Sage
The use of friends, business associates and Angels as sources of financing often appears attractive as a relatively uncomplicated, readily available capital source. For startups, they are often the only form of capital available. Yet, care must be taken to ensure that this early round of capital does not interfere with long-term financing.
Angel financing is typically a one-time source, in which the investors have unrealistic return expectations. Typically, these sources are not professional investors with diversified and balanced portfolios. They can hardly be blamed for nervousness over the inevitable ups and downs of the your company's development cycle; however, as friends or previously successful entrepreneurs themselves, you can be sure that they will make their advice and concerns well known to the company. Part of the problem some of you encounter is that you tend to over-value the company for the Angel round. Then you are placed in the uncomfortable position of explaining to people who often do not understand venture capital that they have to take what they would consider to be a valuation "haircut."
We've encountered entrepreneurs that say, "We've just raised a $10 million pre-money valuation, and now we're going to go out and get a $15 million valuation." Then we learn they only raised $500,000 at the $10 million pre-money valuation. That's not a solid basis for a $10 million pre-money valuation. Yet there are some of you who mistakenly believe it is a solid valuation and potentially put the company in jeopardy to fail in the next financial round.
Angel Round Strategy
Here's one option to consider when trying to value your company for a seed-round investment. Avoid it altogether; after all, it doesn't make sense and can only present a potential liability down the road. Instead of offering equity, offer debt that can be converted into equity at some point in the future. This is a much more secure financial instrument, which will provide a lien on the assets to the Angels if the business does not progress. The lien would be released upon a debt-to-equity conversion that could take place at the first round of a venture capital investment. The conversion price can based on the pre-money value paid by a VC, adjusted with a discount based on how much time passes until conversion.
For example, let's assume that an Angel investor group provides a convertible loan in the amount of $1,000,000, and one year later a VC buys 2,000,000 shares of stock at $1 per share. The Angels could then have the option to convert the $1,000,000 loan into shares at a price discounted from the $1 price that the VC paid. Assuming further that the discount is 20%, the Angels would then convert this loan into 1,250,000 shares of stock at 80 cents per share.
This strategy avoids the problem of applying an improper valuation too early in the life of the company. Using debt instead of equity for Angels will provide an equitable solution for all investors and help you avoid a major headache. The Angel is protected, assuming that a future investment takes place, because they see an increase in the value of their investment. The venture capitalist is pleased because the Angel did not buy stock at an abnormally low price relative to the valuation the VC is applying. And you are content because you have your money and your investors are happy.
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