Look beyond the valuation

I received this question today via email:

… I am a young entrepreneur… I am currently involved in a… start up… We are currently in the process of raising a friends and family round of funding, and right now we are struggling with the valuation. I am looking at the Techstars framework (a $300,000 post-money, if my math is right) because it appears outwardly that we are at a similar stage of business development compared to the Techstars companies. However, I would like to confirm with you what stage a typical company is when they apply for Techstars? We currently have a BETA test version of our website up with 1700 members, and we pull about 2000 uniques per month. I am wondering if we are on par with a 300K post-money?

I’ll come at this answer two different ways. First, I’ll address the flawed thinking inherent in simply comparing your company to another known data point based solely upon valuation. Second, I’ll address the question of how to think about and possibly determine a fair valuation, especially in the peculiar context of a friends and family round.

Techstars is providing much more than just money. It’s providing access to extensive mentorship, a very large network, a community of startups, office space, legal work and other free services, a platform for credibility, and access and opportunity with literally hundreds of investors. It’s unlikely that friends and family will bring the same resources to bear. It’s more likely that they’re simply bringing money. Clearly, it’s not going to be an apples to apples comparison. So in order to compare a Techstars valuation to a friends and family valuation, you first need to somehow determine the value of all of the things that Techstars brings to the table. Unfortunately, this is not easy to do. The value is in the eye of the beholder. But clearly, a simple comparison is flawed thinking.

More broadly, the lesson here is that you can’t simply compare valuations in any context. Valuations tell only a small part of the story. “When” matters: Consider the average startup valuation a year ago vs. today. “Who” matters: Consider Bill Gates doing his next startup that is exactly like yours, vs you doing it. Or consider who the investors are. Investors who bring more to the table might well deserve a lower valuation. Even “Where” matters: The same startup in Silicon Valley is probably going to draw a higher valuation than if it were located in rural Iowa.

Now that I’ve cleared that up (I hope) and all the readers from Iowa are gone, let’s address the part of the question pertaining to coming up with a valuation for friends and family. This is really tricky, because in my experience it’s very easy to drive an extremely high valuation in these scenarios. Usually, friends and family are investing in you, and will not pay so much attention to the valuation. They’ll often trust your judgment above theirs (which is part of what makes them “non-professional investors”). Depending on all of the factors I’ve described above, typical web company startup valuations run somewhere in the $1M-$3M range, pre-money. From what little context I have from the email, I’m guessing the startup in question would be valued on the low end of that range, assuming investors wanted to do the deal in the first place. With professional investors (angels and venture capitalists) this simply turns into a negotiation. There is no magic formula – it’s simply a number that both parties can agree to. But with friends and family, given the dynamic, I generally recommend a completely different approach.

With friends and family investors, the right approach for companies that think they may want to raise more money in the future is almost always going to be to use convertible debt. Instead of issuing equity, you can simply document it as a loan to be repaid with interest potentially with a right to have their money “converted” at the next value event (funding or acquisition) based on the valuation that is assigned at that point. Often, a small discount (10-25%) will be offered so that early investor gets additional equity at that point as compared to those bringing in the new money. The benefit here is that the valuation at this next value event will typically be assigned (and negotiated) by an acquirer or by professional investors. It avoids the whole messy discussion of valuation with friends and family, and feels “fair.” The other benefit is that it’s likely that venture investors are going to want to buy out any friends and family investors when they do a large financing. Using a debt instrument makes this an easy step, while still rewarding your early friends and family investors.

Now, you may be wondering if this advice is in conflict with other advice you might have heard about “misalignment of interests”. After all, if you raise a debt round, isn’t it going to be in your investors best interests to keep your next valuation as low as possible, so that they get the maximum effect from conversion? The answer is yes, which is why I generally recommend and use preferred equity in most of the deals that I participate in. However, I’d submit to you that in the case of friends and family, they’re unlikely to take that point of view for the same reasons that they’re unlikely to push valuation as an issue in the first place. Finally, another benefit is that it’s less expensive to create legal documentation for a debt financing than for an equity financing.

In summary, I generally recommend using a debt instrument for a friends and family round. I also think that it’s critically important to look at much more than the valuation in order to truly understand any equity financing.

file under: Ask-The-Angel, Blog, Venture Capital