Tag Archives: Angel investor

A Case Study on Startup Equity

Business Ethics, Starting a Business, ,

I had an interesting exchange over the weekend. Shane Diffily tweeted:

Setting the Scene

Shane was referring there to a post on startup equity I did a while back, highlighting the problems that happen all too often as founders fail to define their own functions and ownership, in writing, in time. The situation I described was a hypothetical. Here’s a quick summary of that post for you:

Parker  comes up with a great idea for an iPhone application, and works on it for three months in spare time. … develops sketches and designs…

About three months into it, Parker has spent maybe 10 to 20 hours on it so far. [enter Leslie, programmer] … Leslie is excited, which rekindles Parker’s excitement. They agree to be partners in a new business based on this initial iPhone application.

Four months go by. Leslie … gets into the code … discovers Parker’s initial idea isn’t quite possible … revises the idea radically, makes it practical and develops a prototype. Parker meets with him three times, they talk, she accepts his changes begrudgingly. At this point Parker’s total hours have gone from 15 to 25, but Leslie has worked a lot, probably 120 hours, on the programming. … [they] … take the prototype to Terry, who has been through a failed startup, has a business education and is looking for a startup to do again … Terry does a business plan and networks with local business development groups to find angel investors. They win an opportunity to present to an angel investment group. Another three months have gone by. Parker has now put in more like 40 hours, Leslie 250 hours, and Terry 120 hours. Leslie wants to quit a current job and work full-time on the new thing but needs to get paid. Parker doesn’t want to quit a current job but wants to stay involved; she’s not quite sure how. Terry wants to lead the new company as soon as he can get financing.

I asked three questions at the end of the post. I asked, but didn’t answer them:

  1. How would you suggest that Parker, Leslie and Terry divide up the 100 percent ownership of the company now, before they go to the angel investors. Who owns how much?What do you think of the management team here?
  2. Leslie and Terry both want to work full-time on the business when there’s money to pay them. What titles should they take? How much salary?
  3. How much of the company should these three offer to the seed investor for $250,000?

Pre-money Valuation

It was relatively easy to answer the third for Shane. I put it into a tweet:

“Pre-money” means the valuation for the transaction with the initial seed round investors. To clarify, “post-money” would be the valuation after new investment funds are received. So if “pre-money” was $750K, then the angel investors’ $250K would buy 33.3% of the shares and the founders would end up with 66.7% of a business values post-money at $1 million.

I can’t get more specific than that without filling in some value judgments about the relative value of the application, the presumed product-market fit, and the credibility of the team. If all three factors are positive, then I’d suggest starting the negotiation with a valuation of $1 million. That would give the angels 25% ownership and the founders 75%. That leaves enough equity for future rounds. Otherwise, if the deal isn’t that stellar, then the three founders would have to go down to $750K or even $500K, hoping to get some angel investment to develop traction and increase the valuation later.

For the sake of explaining dilution, I’m going to go with the $750K valuation for the discussion on dilution below.

Startup Equity

Shane then asked the much harder question:

Keep in mind that I just made these people up and imagined an unspecified iPhone app without describing what it does for whom. In the real world it would take a lot more of understanding who these three people are and how credible their real skills. Here’s what I think:

  1. First, Parker can’t have much equity because she hasn’t done that much. Her initial idea didn’t work. She has put in only 40 of the 410 hours (less than 10%) and her hours weren’t all that useful. Still, she was the originator, she came up with the market need, and she set the wheels in motion. So she should stay involved as long as she wants. However – also very important – Parker doesn’t even want a full-time job. I’d ask her to take 10% of the pre-investment 100% shared by the founders. And I’d give her a seat on the three-person early board of directors, with the assumption that she’s going to go off to make room for investors.
  2. With Terry and Leslie, I’d put Terry in charge and at the top of the business, with a title like CEO or President or some such; and Leslie should be the technology/product development lead, reporting to Terry. I’d want both of them to take minimum possible full-time salaries as soon as possible, Terry’s a bit more than Leslie’s. Their salaries should be a compromise, enough to support them and their families, but less than market value because they have to keep the burn rate low. And I’d want to get their salaries up to their market value as soon as possible. In a real company, if it’s going to make it, the people it depends on get paid.
  3. I’d want Leslie to take 50% of the founders’ 100%, and Terry 40%, bringing the total, including Parker’s 10%, to 100%.

Why? Obviously I’m making some assumptions on the unknowns. I assume that Terry has a credible background in startups and holds up as lead founder. I assume Leslie has a credible background in tech and can run the technology, even as the business grows. I assume Parker has knowledge and experience beyond just the idea, and can contribute to the business even if not an employee. I assume all three are there for the long term.

I confess to some bias here too. I don’t believe the original idea has much value without ongoing contribution. I do believe in product-driven businesses, and technology-driven businesses, which is why I end up giving Leslie more equity than Terry. And I assume Terry’s MBA is a healthy number of years in the past, which means (to me) that it has been tempered in the field and has more value.

Valuation and Dilution

founder-shares-and-dilutionAfter angel investors put in $250K, they own one third of the shares. Usually the legal work is done with preferred shares and more subtlety, but, for purpose of illustration, let’s assume this is all done with common shares and the total founders’ shares, before the angel investment are 1,000. That’s a small number because startup attorneys usually write up the original corporate documents with more shares, such as 10 million instead of the 1,000 I’m showing. I’m using these simple numbers because it shows how the founders are diluted when the angel investors join the ownership. Each of the founders retains the founder shares he or she has, but the additional shares mean that they end up owning less of the company than they did before the deal.

 

Q & A: Investment: Size Matters

Business Planning, Entrepreneurship, , ,

Question: Hello. I, along with a partner, have 20+ years combined experience in the carpet cleaning industry. After investing over 10k of our own money, we will still need an additional 30k for start-up of our own business. We are in the middle of writing a business plan for possible private investors or an SBA loan. I was wondering, on average, what sort of ROI or security is offered to the potential investor. Such as: A straight loan with repay plus interest? A percent of ownership? A percent of annual income? Or, is an initial offer usually propositioned by the investor? Also, what sort of numbers or percentages might be ‘entertained’ as an offer to possible investors looking at our 30k request? I’m sure it can vary quite a bit, but we’re just looking for an average to negotiate around. Any advice will be much appreciated.

Start by forgetting the idea of some arms-length investor you don’t already know. There are lots of reason. First is that it’s illegal, forbidden by the SEC except for “sophisticated investors.” Second, the $30K amount is peanuts in that context, it won’t happen, they won’t take you seriously. third, the legal costs on an arms-length investment are a lot more of that. One of the problems angel investors deal with is that it costs as much to invest $100,000 as to invest $2,000,000. Outside investment isn’t practical at those low levels. You need to be looking for a few hundred thousand at least, and have a plan that shows the need.

Furthermore, whatever the range of returns that private investors want, they don’t get any return at all until you sell your company. That’s what “exit strategy” is all about. Are you building this carpet cleaning business to sell it? I doubt it. Take a moment to consider the investors’ point of view. They spend the money to invest in your company and they get nothing back from that investment at all until they sell their shares.  Who do they sell them to?

One of the worst deals in the world is a minority share in a privately held small company without an exit strategy. The return on that is zero.

And, realistically, do you have an exit strategy when you start a carpet cleaning business? No, of course not. You want in, not out. That’s perfectly normal. Don’t apologize for that, but realize that investors aren’t interested.

You could legally get that kind of investment from close friends or family, but that’s still not a good idea. Somebody who invests $30K to your $10K is going to expect to own a substantial portion of your business. Ultimately, the $30K isn’t that hard to get, and if you get it as investment you won’t have to pay it back but you will have to sell a substantial share of your company, and you will have to live with one or more partners, and manage another relationship like a marriage. Do you and your partner want another partner? Are you ready to get into a close relationship equivalent to a marriage? Are you ready to have an investor who will essentially be the boss of you? I doubt it. I wouldn’t.

And, by the way, I do speak from personal experience. My wife and I built our business, Palo Alto Software, without outside investment. It wasn’t easy — at one point we had three mortgages and $65K in credit-card debt — but the good side is that we have 35 employees now and healthy cash flow and 80% market share in retail, as I write this, and we own it outright. It was worth it.

if you borrow what you need instead of getting investment, you have several options:

  • If you want friends and family involved, do it as a loan and write it up with the correct legal documentation so that your lender has legal recourse and you have to repay the loan and therefore there is no confusion that he or she is an owner. I recommend you use one of the family lending websites, or a lawyer, to give you the right paperwork. Search also for person-to-person lending.
  • The SBA has some programs for smaller-size loans. Generally they loan you no more than 70% of total investment required, which would mean you’d have to put in $13K to borrow $30K, but it’s a loan not an investment, so you still own your business. You can follow up on that by going to a local bank; SBA loans are managed by local banks.
  • Not that I recommend credit card debt as start-up financing, but it does happen a lot. The interest rates are very stiff, but people use credit card financing anyhow because it’s easy to get.
  • You might also be able to get a personal loan from your local bank, assuming you have assets you can afford to risk, so you can borrow $30K from the bank.

Remember of course that borrowed money is a risk because you will have to pay it back. Still, if you needed $200K to start that business we might talk about investors, but with only $30K, like it or not, the best practical answer is to borrow.

By the way, just so it doesn’t seem like I’m dodging your question, private investors generally want very high returns. They need to believe that every $30K put into your business will pay them back $1 million or so in 3 years and $3 million or so in 5-10 years. They know that only 1 of every 10 investments (or so) will be successful, so they need to believe each one has a chance to return 100 times or more the initial investment.

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