Back to basics

Back to basics: valuations - how do you work it out?

Now you know what a valuation is, how do you figure out what your valuation is?

The short answer to this question is simply “whatever someone will pay.” It sounds trite, but it’s true.

There are plenty of online resources describing the various methods for estimating your valuation; lots of places to get differing opinions on what the valuation “should be”; companies galore offering to (charge you to) help you “determine” your valuation; and places you can go (like a workshop) to learn about the strategies and techniques more.

All of these are nice, but fundamentally investors don’t care what other people (especially those with no skin in the game) think. For our money, all that matters to us is what we think this company is worth. That’s the right valuation.

Back to basics: pre- vs. post- complications

Four, more complexity between “pre-money” and “post-money”

Imagine a company that has previously raised a $100,000 convertible note whose terms require it to convert into equity if the company raises $500,000 of equity capital. Now it raises $500,000 on a $2 million pre-money valuation. What is the post-money valuation?

Per the last post, one would imagine $2M pre-money + $500k of money = $2.5M post money valuation, with the new investors owning 20% of the company ($500k/$2.5M). Right? No.

When a deal is done, there is often more complexity than simply “new money”. In this case, the conversion of the convertible note into equity; other times, the creation of an option pool for future employees.

To account for these complications, we actually calculate as follows:

  • Pre-money valuation = current number of shares multiplied by proposed share price
  • Post-money valuation = post-transaction number of shares multiplied by proposed share price

Back to basics: pre- vs. post-money valuation

Third, the “pre-money” vs. “post-money” confusion

Angels speaking in terms of “pre-money valuations” can lead to some confusion. Entrepreneurs often think in terms of “share of the company sold” and the cost of that stake in the company. So, for example, they might say “we are selling 25% of the company for $500,000.”

Multiplying each side by four: 25% of the company => 100% of the company; $500,000=> $2 million. So my valuation is $2 million.

This math is right, but that is not the pre-money valuation. It’s the valuation of the company including the investment that has been made – because the shares are purchased and the money goes into the company. So once we’ve invested, the post-money valuation is $2 million in this scenario.

To get the pre-money valuation, we have to subtract “the money” – i.e. $500,000 from $2 million. In angel language, this is a deal with a $1.5 million (pre-money) valuation.

Got it? Good – because this mistake appears quite a lot.

Consider this TechCrunch article from early March: on Dragons’ Den (Shark Tank with posher accents) M14 industries negotiated “a deal £80,000 for 20 percent equity, giving the young startup a £400,000 pre-money valuation.” No it didn’t.

Or a pitch we recently saw from an otherwise compelling company: “raising $350k for 10% equity, a $3.5M pre-money valuation.” No it isn’t.

 

Back to basics: what is valuation?

Continuing our “back to basics” snippets (see here on basic deal types and here on the types of angel groups), we are going to have a few posts about the “economic” terms of angel investments.

First up, what is “valuation” all about?

Most people get the basic idea about buying stocks. Apple’s share price is $139. There are a lot of Apple shares, so that if you would buy them all at $139 per share the total cost would be $730 billion. That’s Apple’s market cap, its valuation.

Angel deals work the same way. We buy shares in a company. When we speak about “valuation,” we mean the share price multiplied by the number of shares, to give a total valuation.

So, for example, we might invest in a company at a $2 million valuation.  This means we buy shares at a price that means if we bought all the shares in a company it would cost us $2 million.

This doesn’t mean we’re investing $2 million, or that our shares are worth $2 million, or that the company is receiving $2 million.

Back to Basics: types of angel groups recap

Over the last month we've outlined the thinking behind why VentureSouth groups are organized the way they are.

Starting here we outlined the basic types of angel groups, then tried to explain the pros and cons of each part of our structure (of a network of angel membership groups, run by a professional team, whose members meet in person to help individuals invest their own capital in early stage companies across the southeast).

Hopefully you found it useful. We know this structure doesn’t work for everyone all the time, and we will continue to modify and improve – adding more committed capital funds and working on ways to provide better “virtual access” to our investments, for example. And we are always looking for constructive criticism, so if you have it please let us have it!

 

Back to Basics: why across the southeast?

Why “across the southeast”?

This balances two offsetting requirements.

1) Diversification. We make many investments in South Carolina because of where most of our groups are – but we can’t invest exclusively in deals in Charleston (let alone Spartanburg or Anderson) because there are not enough high quality opportunities in a small geography. Diversification is critical to early stage investing – and that means looking for the best deals across a sufficiently wide area.

2) Supervision. Angels make money by evaluating companies and helping them succeed. Companies based two states away from our members are much harder to supervise and assist, so reduce our chances of making positive returns.

So we settle on “across the southeast” – with almost all of our investments in the Carolinas and Georgia.

Back to Basics: why "early stage"?

Why “early stage” (not “seed” or “growth” stages)?

We use “early stage” to mean companies that are beyond just an idea, have a team in place, have created a business plan and strategy, and can provide some evidence of traction (ideally some initial revenue). They do not necessarily have a long history, wide user base, or profitable operations.

We think early stage is a good place to invest. It is impossible to judge whether an idea will be successful, so “seed investing” is too hard for us. Having some evidence of traction or a product / market fit – enough to give us at least some estimate of the potential of a company – mitigates some of the investment risk. Even then, we know we will make some investment mistakes, but there is less guess work.

On the later-stage “growth” side, VCs typically need to a lot more traction and deploy much more capital. This means they write larger checks at higher valuations, and therefore need bigger exits to generate good returns. This can obviously be extremely successful. But there are not many large VC funds in the Carolinas, suggesting it’s hard to do it here (for reasons that go beyond this post). Hence we focus on early stage companies.

Back to Basics: why private capital?

Why individual private capital (not public or institutional funding)?

1) No strings. Grants or other public funding for early stage investment, if it even exists in a particular market, comes with significant strings. These might be obvious (e.g. can only invest in companies in South Carolina – which limits the opportunity for diversification); or they might be subtle (e.g. job creation must be an important element of the investment criteria – which neglects companies able to generate substantial value without necessarily creating jobs). But public money comes with strings that private individuals’ capital typically doesn’t have.

2) No strings – again. Similarly, funding from a large institutional investor comes with implications. A corporate investor, for example, might want preferential services from portfolio companies that may not be in the best interests of the company or other investors. Private individual capital tends to have fewer “other considerations” – and because each individual is writing a much smaller check they have less ability to negatively direct a company.

But of course both public and large institutional investments can be great sources of capital. We don’t have many around the Carolinas interested in investing in early stage companies, so this part of our structure is as much through necessity as choice!

Back to Basics: why in-person groups?

Why in person (not virtual or online)?

There are a few reasons why we prefer in-person angel groups over virtual or online-only platforms.

1) Pitch quality. It can be hard to judge an entrepreneur’s pitch based on a video, and hard for an entrepreneur to pitch effectively through video or writing because they don’t get the immediate feedback and response from people in the room.

2) Offline value. Some of the value of the groups come from in-person discussions, debates, and arguments; post-meeting one-on-one discussions and Q&A; and networking and idea exchange. Virtual and online groups typically lack those interactions.

3) Due diligence. We consider the “team” key to evaluating an investment opportunity. Meeting that team is critical in evaluating it!

Nonetheless, online facilities are important and we use them extensively across VentureSouth in areas like screening reviews and document storage. Wholly virtual and online platforms are popular and can be an effective way for people to be engaged, particularly in places that are too small to support their own local in-person group.

Back to Basics: why a professional team?

Why a professional team?

Angel groups can be led effectively by unpaid volunteers, often members of the group itself. But a professional team brings multiple additional benefits.

1) Sustainability. When the volunteers get distracted by other activities (like their day jobs), it can be hard for groups to continue functioning.

2) Record keeping. In a volunteer structure, particularly if there are multiple volunteers over time, it can be difficult to maintain the knowledge necessary to record and supervise investments successfully. Some investments might take ten years to mature: without an established process, particularly of record keeping, under the direction of a full-time team, it can be very challenging to keep everything straight.

3) Expertise. Making angel investments requires some expertise – particularly in structuring and executing the investment. In groups where each deal is led by a different volunteer, each new “deal leader” has to learn that expertise each time – or the group reverts to a small number of volunteer deal leaders, returning to challenge number 1. In a professionally-led group, this expertise can be retained – perhaps even honed to a higher degree – in its professional staff, making the groups potentially more expert, more consistently, than volunteer groups.

4) Best practices. It is hard enough to run an angel group’s day-to-day activity. It is harder still to find, study, and replicate the best practices of the leading angel groups. A professional team – which gets paid more the better the group works! – are incentivized to find and implement these best practices (and staying compliant in a complicated regulatory environment). This is one reason why Matt is on the ACA board with some of the leading angel investors in the country.

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Back to Basics: why a group?

Continuing from here and here.

Why a membership group (not a fund)?

Our lives might be easier if we had committed capital funds waiting for us to invest them. Instead, we have a membership group structure. Why?

1) Encouraging new investors. We operate in markets with limited histories of angel investing. It’s too hard (and, aside from that, not a good idea) to persuade people to invest $25,000+ upfront to become an angel investor if they have no idea if they’ll like angel investing.

2) Blind pools. Similarly, people generally like to know what they are investing in before they invest. (Crazy, right?) A committed capital “blind pool” is harder to raise as a result, particularly in markets like ours that do not have much history (and even less positive history) of successful venture capital funds investing.

3) Getting started. Related to those first challenges, raising a fund is not only harder but it has to be bigger to get started. To make an investment in a group, we need to pass the hat and find (say) 10 investors investing $10k each to fund the first $100k investment in a company. To do the same through a fund, the fund would need to raise $1MM to reach a minimum level of portfolio diversification for its members – so much harder to get started.

4) Individual autonomy. We want our members to make their own investment decisions, not to rely on an advisor or fund manager (like in a private equity fund). We also like people to invest proactively in things they like – and not feel compelled to invest in what they consider bad ideas simply because of the structure they’re investing through. Each of our members decides to invest, or not, on each time; they are never forced to.

5) Decision making. In a fund structure, there needs to be a decision-making process. A fund manager, investment committee, or voting thresholds determine when and how much to invest. Our structure (you decide if you want to invest in any deal) is easier, eliminates potential conflict, and never leaves anyone feeling “forced” to invest in something they think is crazy.

6) Flexibility. Turn out that you didn’t like angel investing after all? In our groups, you can leave any time. In a fund, you are “locked in” possibly for multiple years – and potentially funding capital calls for investments you aren’t interested in. The penalty for not funding a capital call obligation in a fund is high; there is no penalty to not investing in a group model.

So although a few committed capital funds would be nice, for both practical and philosophical reasons we prefer the group model.

(You might note, having said all that, that VentureSouth also operates two funds (the Palmetto Angel Fund and the VentureSouth Angel Fund II)! Guilty. Our funds face some of the same challenges as other funds – it is hard to raise these blind pools that need $1MM+ to get started, particularly is areas unfamiliar with angel investing. However, as “index funds” that automatically invest when “triggered” by an investment from our active angel groups, they have no “decision making” issues that can impact a “group fund.”)

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Back to Basics: why a network?

Types of angel groups

In our last post, we outlined the different kinds of angel investor structures.

Next, we wanted to explain why we chose VentureSouth’s structure – a network of angel membership groups, run by a professional team, whose members meet in person to help individuals invest their own capital in early stage companies across the southeast.

So over the course of a few posts, here are a few reasons why we think this approach is effective – and where it has room for improvement. We’d love to hear where we’re wrong!

Why a network (not a single group)?

1) Economies of scale. Operating a single stand-alone group is hard work. When Matt was running UCAN as the only group in South Carolina outside of Charleston, he was working more-than-full-time screening, reviewing, diligencing, negotiating, structuring, and executing investments – investments that were only partially-funded because a single group has limited firepower.

As part of the VentureSouth, the 13 groups and funds create more work, but not 13x as much work as 13 single groups. And importantly, by multiplying the investment firepower we can fully fund rounds more often. This lets the entrepreneurs get back to building businesses, not get stuck fundraising for longer, which leads to better results for companies and investors.

2) Makes small groups feasible. Similarly, because of the “fixed” minimum amount of work, an angel group needs a certain number of people to be feasible. (There aren’t many single angel groups with less than 40 members according to ACA data.) However, most communities can’t bring together 40 investors, which is why angel investing tends to be concentrated in larger cities. However, a 15-person group is feasible if it uses the same infrastructure as another group – which is how we can operate Electric City Angels in Anderson, for example.

3) Varied deal flow. Our network model requires investors to be interested in funding the best deals wherever we find them. A single “local” group typically has fewer relationships outside of their home town, so has a lower volume and less variety of deal flow. This, often coupled with a focus on home-grown deals, can lead to weaker returns that make single groups unsustainable.

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Back to Basics: types of angel groups

Angel investment groups come in many flavors. Does it matter to know the different types? Potentially, yes:

  • as an entrepreneur aiming to pitch, knowing whether an investor is a network or fund can help you understand if you are a good fit for each other
  • as a potential investor evaluating the different types of angel investment methods, knowing how local options work is key
  • as a community thinking about forming a group, understanding the different options can help you design a platform that can be successful, and sustainable, in your location.

So, continuing our angel investing “back-to-basics” series, here is our outline of the different flavors of angel investment groups.

VentureSouth is a network of angel membership groups, run by a professional team, whose members meet in person to help individuals invest their own capital in early stage companies across the southeast.

This is what each of the terms in bold mean and how they might be changed.

Network vs. single group. Some groups are “single groups” that operate independently. Other groups band together in “networks” of groups and operate more collectively – from mostly autonomous groups to centrally-coordinated “firms.”

Angel membership groups vs. committed capital funds. Some entities are committed capital funds – meaning investors fund a pot upfront and then decide how to invest it over time. An investor might have to invest at least $25,000, which gets invested over 2-5 years. Other groups have a membership model where people join the group first and later make investments if they choose.

Professional team vs. volunteers or member-led. Some groups are led by part-time volunteers, often drawn from their members. Others are led by full time professionals.

Meeting in person vs. online / virtual. Some groups are “virtual” platforms where investors pitch by video and diligence is conducted online. Others (like us) require pitches by entrepreneurs to investors in person and conduct due diligence face-to-face.

Individuals’ private capital vs. public money, grants, etc. Most angel groups invest money that come from individuals investing their own money. Other entities are funded by the state or some other public, grant, or corporate entity.

Early stage companies vs. seed funding, or venture capital. Some groups invest $10k-$50k in ideas; others (like us) invest $250-500k in early-stage or companies “going to market”; others invest in later stage “growth” rounds of $2-10M. (The terminology here is not very precise. “Seed” to us means “before an angel investment,” but “seed” can mean “a small VC round” or “an angel round.”)

Across the southeast vs. locally-focused. Some angel groups (especially online platforms) will invest anywhere or cover a national geography. Others are very focused on a small area. Most are interested in a 2-4 hour driving radius of their center.

When you factor all these together in combination (and add it how due diligence is organized, how often groups meet, how active they are, how the fees work, how the actual investments are executed, and many more) you can see how groups can vary significantly. Just in Charlotte alone, as William Bissett discussed last year, there are different flavors to sample.

Some nearby examples:

We'll provide our thoughts on the pros and cons of different groups in future posts.

Four myths of angel investing

Thanks to the Upstate Business Journal for letting me discuss some of the myths about angel investing this week.

Keep an eye on Mac's blog for more angel investment mythbusting, and take a look at our earlier posts about typical angel meetings and investment strategies.

Or better still, come to one of our interest meetings in January to hear what angel groups really do. We'll have sessions in Anderson, Spartanburg, Aiken and Charleston to start off 2017. Contact us to learn more.

Back to basics: liquidation preferences pop quiz

We’ll send the first person who gets the right answers to these four questions two free tickets to our “how to pitch workshop” in Columbia or Charleston (or other places next year) (worth $78!). Bonus prize for showing your workings. Give you answers to the nearest whole dollar.

Assumptions:

I invested $500,000 to own 1/6th of a company. The company is sold after three years.

Questions:

1)      If I have a 1x liquidation preference (non-participating) and the company is sold for $10 million, how much is my payout?

2)      If I have a 2x participating liquidation preference and the company is sold for $10 million, how much is my payout?

3)      If I have a 4x liquidation preference (non-participating) and the company is sold for $1.75 million, how much is my payout?

4)      If I don’t have a liquidation preference and the company is sold for $1 million in a fire-sale, how much is my payout, and how much do the founders (who own the other 5/6ths of the company) receive from the disposal even though they lost me money?

Best of luck.

Back to basics: liquidation "participation"

What is “participation”?

One last complication about liquidation preferences. A liquidation preference may, or may not, be “participating.”

What does this mean?

If the preference is participating, the preferred shareholder takes its preferred return (the 1x liquidation preference) AND then converts its shares into common stock and splits the rest of the return in proportion to how much it owns.

If the preference is not participating, the preferred shareholder can EITHER take the preferred return OR convert its shares into common stock and split the proceeds in proportion.

An example would be helpful.

Let’s say a company is sold for $30 million and VentureSouth’s angels had a 1x participating liquidation preference from $500,000 of preferred stock we invested to buy 1/6th of the company.

At the liquidation event, $30 million needs to be distributed.

(A)    If the preferred return is participating, we get 1x (our initial $500,000) back, which leaves $29.5M in the pot. We then convert our shares into common stock, then split the pot 1/6th to us and 5/6ths to the other shareholders.

(B)    If the return is not participating, we can either (i) take our 1x preference ($500,000) or (ii) we can convert into common stock for 1/6th of the company and split it. As 1/6th of $30 million is much more than $500,000, we obviously do (ii) – convert and take our $5 million.

Here's the calculation

 
 

Is participation standard?

It’s a touch “investor-friendly,” but it is pretty common. Around half of our investments have a participating liquidation preference.

How can you justify “having your cake and eating it”?

Well, the smaller the exit, the larger the relative impact of the participation. (In the example above, it was an 8% boost. If the exit had been only $10 million it would have been a 25% boost.) Or you could say: the more the entrepreneur fails to hit the plan he or she promised investors, the more protection the participation provides to investors.

Back to basics: what is a typical liquidation preference?

The next question is “how much preference” do preferred equity shareholders usually get?

The basic answer is “a one x liquidation preference” – or 1x.

What does that mean?

Liquidation preferences are phrased as multiples of the amount invested. So 1x means one times the amount invested by the angels.

If we invest $500,000 in a company and have a 1x liquidation preference, then at a liquidation event we get 1x our investment – $500,000 – before the common shareholders receive anything. So if the company is sold for less than $500,000, we take all the proceeds.

Does that vary?

Yes. Most deals have a 1x liquidation preference, but we have portfolio companies that have raised capital with many different preferences – in one case as high as a 4x preference. A higher liquidation preference can attract capital when it is needed.

Back to basics: what is a liquidation event?

On the previous post, we said the “preference” is relevant at a “liquidation event.” What does that mean?

A liquidation event covers various scenarios through which the shareholders in a company get “paid out.” It covers both good situations and bad.

Good:

1)      Sale of a company for cash. Angels invest in private companies whose shares not “public” (so they cannot easily be sold). The only exception is when another company (or investor) buys (all the existing shares of) the company.  The “liquidation event” is a cash payment from the buyer to the selling shareholders (us). This is our goal, and what happened in Sabal Medical, The Iron Yard Academies, Verdeeco, and our other “exits.”

2)      Sale of a company for shares. Like (1) above, except this time the buyer is offering publicly-traded shares. The liquidation event is the “swapping” of shares in our company for shares in the acquiring company. This happened when Selah Genomics was acquired by EKF Diagnostics.

3)      IPO of a company. An Initial Public Offering (IPO) is where a company sells shares on a public market (like the New York Stock Exchange), and converts its existing shares into publicly traded shares. This is rare for southeastern early stage companies, though we have at least one portfolio company that is planning to IPO soon.

Bad:

1)      Less good is the most obvious “liquidation” –quickly disposing of any assets of the company, or simply closing it down. A significant minority of angel investments face this form of liquidation – though thankfully few of our portfolio companies so far.

So when does the "preference" matter?

The “preference” in preferred shares is most important in the situations labeled (1) above. Preferred shareholders receive whatever proceeds come from the liquidation before the common shareholders receive anything.